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In Commodity Swaps Explosion, a Bona Fide Controversy

Did public pension funds cause an energy price bubble? Institutional investors are concerned about the great pension push into commodities and swap dealer speculation.

Rich BlakeDid public pension funds cause an energy price bubble?

More than a few noteworthy investors, George Soros among them, believed there was, indeed, a correlation between crude oil prices running up toward $150 a barrel and the steady rush into the commodities markets by indexed, exchange traded funds and over-the-counter swaps dealers, this latter group deploying futures-reliant trading strategies on behalf of long-only, passive, elephantine pension funds.

The CFTC formed a task force in the summer of 2008 to study this very issue, examining the increased flow of assets into ETFs and into OTC energy swap arrangements alongside the rising prices and volatility in crude oil between January 2003 and July 2008.

During that period, the total amount of assets in listed ETFs and swaps products, as well as other commodities instruments, such as structured notes, grew from around $25 billion to nearly $200 billion, according to Barclays Capital, while Managed Futures accounts run by Commodity Trading Advisors (CTAs) rose from around $80 billion to more than $200 billion, according to Deutsche Bank.

The final verdict of the CFTC Interagency Task Force on Commodity Markets: no direct causal evidence for the general increase in oil prices. Swaps dealers and pension funds worried about their long-term, long-leaning impact in the energy market – and at the gas pumps – could feel a little better about things.

However, there is another half of the story concerning the great pension push into commodities and swap dealer speculation. And it’s not something institutions should necessarily feel good about. In 1990, the year Goodfellas came out, exactly zero dollars were invested in commodities index swaps. Then again, swaps were just being born. Interest rate swaps, done to hedge risk primarily and not as directional bets, were taking off around the start of the decade, as was passive investing, especially in equities.

In 1991, a new commodities index was constructed by Goldman Sachs. Soon enough, swaps trades tied to the Goldman Sachs Commodity Index were being transacted. Within a few years, more than $1 billion was being invested in OTC commodity swaps, much of them dealt by Goldman and tied to the GSCI. By this time, Goldman had extensively buttressed its commodities trading prowess with its acquisition, a decade earlier, of J. Aron & Company.

As the 1990s wore on, with technology stocks and not oil futures attracting the hot money, some other commodities indices were created, as were synthetic investment returns tied to them. AIG Financial Products built swaps tied to the Dow Jones-AIG Commodity Index, which was created in 1998 as an answer to the energy weighted GSCI.

Around 2004, institutions began, for really the first time, to seriously consider commodities, previously viewed as too volatile. The warming up owed partly to an influential research paper, “Facts & Fantasies About Commodity Futures,” written by K. Geert Rouwenhorst and Gary Gorton, a pair of economics professors (and AIG consultants) who found that commodities futures as a distinct asset class had been misunderstood, historically delivering non-correlating, equity-like returns. Seeing an inflation hedge and a non-correlating alternative asset, numerous pension funds carved out commodities allocations. Index swaps were the instruments of choice for obtaining exposure to the asset class. According to Barclays Capital data, assets in index swaps went from $50 billion in 2004 up to $125 billion at the end of 2007.

To implement these strategies, that is to replicate the performance of a basket of commodities with a little extra on the top, swaps dealers turned to the futures markets, specifically the products traded in the pits the New York Mercantile Exchange. But the NYMEX had speculative position limits to prevent any market participants from becoming too big, from perverting the market, from using futures contracts to corner a market like the Hunt Brothers infamously tried to do with silver in the late 1970s.

But swap dealers, with so much money to be made in derivatives, would not be thwarted by any rule or limits that impinged their speculative trading. They would find a loophole, and blow through it with a legion of lawyers and a fleet of armored trucks in tow. That loophole: the Bona Fide Hedge Exemption.

On January 26, 2010, the CFTC formally issued a proposal to impose federally mandated speculative position limits for four NYMEX energy contracts: crude oil, natural gas, gasoline and heating oil. The CFTC also proposed doing away with the bona fide hedge exemption, a controversial tactic that has been around since the early 1990s and which at the very least would seem to be an unfair means for the biggest players to circumvent the rules. That the CFTC is even taking the issue up at all is surprising, and, from the perspective of any market participant who has not been able to circumvent the energy trading market rules, overdue.

One of the first things I noticed when I began reading through the CFTC proposal on position limits and the hedge exemption (a lengthy, heavily footnoted document now being circulated for public comment) was a curious reference contained in a particularly tedious section spelling out the history of the bona fide hedge exemption.

Originally, these regulatory doctor’s notes granting certain market players permission to occasionally exceed position limits were designed to meet the price-risk-mitigation needs of commercial enterprises, i.e. the kind of companies that actually take delivery of physical commodities, such as General Mills or Cargills.

Beginning in 1991, the CFTC staff began to hear from swaps dealers seeking to manage price risks on their books arising from swap dealing activities. “The first such hedge exemption involved J. Aron, a large commodity merchandising firm that engaged in commodity related swaps as a part of a commercial line of business,” the CFTC report said.

That’s when I stopped reading and shook my head.

J. Aron? Commercial line of business?

Seeing that this “open bottle, release genie” moment took place in 1991, a full decade after J. Aron had been acquired by a large, prestigious investment bank, let me, on behalf of CFTC head Gary Gensler, re-phrase the hedge exemption origin:

The first such hedge exemption involved Goldman Sachs. Over the years, the CFTC went ahead and granted a number of similar exemptions, pursuant to delegated authority. With these exemptions, dealers could get around rules set by exchanges, such as the NYMEX. And of course, after Goldman had its exemption, everyone wanted one.

Having gotten to know several oil and natural gas traders at the NYMEX, I can say that the rise of the hedge exemption, especially in the oil market, is considered to be an open, dirty secret, one too complicated to draw much attention. But think of the controversy that should be arising here – traders, empowered by lawyers, persuading the CFTC to vouch for them that the rules and regulations need not apply.

Institutional investors, as much as anyone, should recognize a healthy commodities market has to be balanced between speculators and commercial hedgers. Speculators can’t vastly outnumber commercial hedgers; limits were put on speculative bets to ensure a true supply and demand dynamic. “Before long, exemptions were being passed out like candy,” one source close to the NYMEX told me.

When the CFTC told lawmakers that speculators were not to blame for $4-a-gallon gas, let’s be clear: Was the bona fide exempted trading considered? Or was that activity lumped in with commercial user trading? Did the genie escape from the bottle and might long leaning speculators have more of an impact on oil prices than what has been acknowledged? The CFTC’s move to impose position limits and do away with the hedge exemption would seem to indicate that the latter is the case.

It’s an issue that may draw more attention this summer, when final rules are hashed out, and with the onset of peak driving season. If oil prices head higher the issue is likely to get even that much more attention. As it should.

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