Rapidly escalating oil prices in recent years have led to increased pressure on lawmakers and regulators to curb speculation in the energy markets, making what could have been a dull few days of hearings at the U.S. Commodities Futures Trading Commission early last month a bit spicier. Even John Arnold, founder of $5 billion Houston-based hedge fund firm Centaurus Advisors, showed up to plead his case.
With regulators taking a hard line on natural-gas manipulation and lawmakers on Capitol Hill baying for the blood of commodities speculators, Arnold had been keeping a low profile. “I was surprised to see him testify,” says Peter Fusaro, co-founder of the New York–based Energy Hedge Fund Center.
Centaurus wants a fair, efficient, transparent market, Arnold told the panel. What it does not want are limits on the speculation of financially settled contracts — energy derivatives that are purely financial and not tied to physical delivery of the actual contract. The New York Mercantile Exchange is poised to implement such restrictions on certain key contracts in the natural-gas market, Arnold’s favorite hunting ground. The new Nymex rules “will have a range of detrimental effects on the market,” such as increased volatility and reduced liquidity, he told the panel.
The 35-year-old Texan first gained notoriety as a trader with Enron Corp., where, in addition to receiving an $8 million bonus in 2001, the year the former energy giant collapsed into bankruptcy, he was a pioneer in the electronically traded energy commodities markets. Not long after Enron’s massive accounting fraud was exposed, Arnold launched Centaurus. (He wasn’t involved in Enron’s downfall.)
Natural gas was at the heart of one of the largest hedge fund blowups in history. In 2006, Brian Hunter, who led the energy team at then–$9 billion multistrategy hedge fund firm Amaranth Advisors, made a huge bet that a tempestuous hurricane season would push natural-gas prices up sharply. When that didn’t materialize, Amaranth lost more than $6 billion in just two weeks, leaving the Greenwich, Connecticut–based firm little choice but to sell what was left of its energy portfolio and wind down.
Subsequently, the CFTC and the Federal Energy Regulatory Commission accused Amaranth and Hunter of attempting to manipulate the natural-gas market. Just days after Arnold’s testimony last month, the regulators announced they had reached a settlement agreement with Amaranth, which agreed to pay a $7.5 million civil penalty but admitted no wrong-doing. Still, the original charge by the CFTC and the FERC — that Amaranth tried to move market prices in the days leading up to the date the physical contracts were to settle — represents precisely the kind of activity Nymex’s proposed rule is intended to prohibit.
But Arnold says it won’t work. Caps on financially settled futures contracts will encourage large traders like him “to concentrate positions in the front end of the curve, which is naturally more volatile,” he explained to the panel. Rather than smoothing out prices, the changes would encourage speculators to focus on the soon-to-expire contracts, creating even more volatility while reducing liquidity in longer-dated contracts.
Position limits on financially settled energy futures contracts are misguided, Fusaro agrees, but he notes that the exchanges and the CFTC are under increasing pressure from Congress to chase speculators out of the market. Craig Donohue, CEO of CME Group, which owns Nymex, made it clear he knows which way the wind is blowing. There are plans to adopt a hard-limit regime “in addition to current limits that apply during the last three trading days of the expiration month,” he told the CFTC. Nymex is clearly acting before Congress or the CFTC forces its hand.
