Hedge fund Amaranth and its star trader Brian Hunter built up such large positions in the US natural gas derivatives markets last year that they single-handedly sparked abnormally high gas prices for consumers across the US, a congressional report claims on Monday.
The report is the first to lift the lid on months of frenetic trading that eventually cost Amaranth over $6bn in losses and sparked renewed fears over a hedge funds meltdown.
The findings, by the Senate Permanent Subcommittee on Investigations, will fuel congressional concern that US energy market regulation has failed to keep up with a flood of hedge fund money into commodity markets.
Concern is focused on the over-the-counter markets, where deals are negotiated privately between counterparties. Industry experts say OTC accounts for 75 of US energy trading.
Yet they fall largely outside the scope of the US futures regulator, the Commodity Futures Trading Commission.
Carl Levin, a Michigan Democrat who chairs the committee, said current commodity laws were “riddled with exemptions, exclusions and limitations that make it virtually impossible for regulators to police US energy markets.”
“I don’t care whether they [Amaranth] lost all their money; they are gamblers. We do care when they take others over the cliff with them,” he said.
He proposed that the CFTC be given extra resources, partly by empowering it to charge “user fees” on the exchanges it regulates – as the Securities and Exchange Commission does with stock and options exchanges.
Gregory Mocek, head of CFTC enforcement, warned in a Financial Times interview in April that the commodity markets were growing so fast that the regulator did not have the funding to keep up with the scale of policing needed.
The report is the result of nine months of interviews with Amaranth traders, including Mr Hunter, a Canadian who made a fortune in 2005 when hurricane Katrina hit after he bet in the future markets that gas prices would rise.
It claims to show how Amaranth built up vast positions in natural gas futures on the New York Mercantile Exchange and later on the Intercontinental Exchange, an OTC electronic platform.
The report accuses Amaranth of “excessive speculation” that had a “direct effect on US natural gas prices and increased volatility in gas markets.
It did so by widening the spread between winter and summer month futures contracts on the New York Mercantile Exchange beyond a level normally expected due to “normal market interaction of many buyers and sellers”.
Utilities typically commit to buying gas for delivery to customers many months in advance to be sure of supply. The prices they pay are benchmarked off futures prices on Nymex – prices the report claims were the result of “excessive speculation”.
It said: “Amaranth’s purchases of contracts to deliver natural gas in the winter months, in conjunction with [its] sales of natural gas contracts for delivery in the summer months, drove winter prices far above summer prices. These differences between winter and summer prices, called ‘price spreads’, were far higher in 2006 than in previous years – until the collapse of Amaranth, when the price spreads returned to more normal levels.”
In testimony that Amaranth will make at a hearing of the subcommittee on Monday, the hedge fund said the report’s conclusion that its activity has “a causal impact in market prices runs contrary to the views of many economists and regulators that speculative trading cannot control prices”.
“The [report’s] analysis simply fails to support its assertion that Amaranth dominated the natural gas derivatives market or caused either price distortions or volatility and, in fact, we did not,” Amaranth will tell senators.
However in a key finding, the senate report said that Amaranth, after receiving repeated warnings not to violate pre-set “position limits” on Nymex, shifted trading to natural gas swaps on ICE to continue its strategy of accumulating record positions without regulatory scrutiny.
Electronic trading platforms like ICE were exempted from full CFTC oversight under a law passed in 2000, after lobbying by Enron and the investment banks that were the largest users of OTC energy markets.
Since then, Mr Levin and Dianne Feinstein, a California Democrat, have repeatedly tried to passed laws that would close what they call the “Enron loophole” by extending the CFTC’s jurisdiction to OTC markets.
Lobbying by the banks and the International Swaps and Derivatives Association, the trade association for OTC derivatives, blocked such efforts.
ISDA dismissed the report’s findings, saying: “Tired allegations that activity in the privately negotiated derivatives industry somehow adversely affects consumers have been thoroughly rejected by the federal agencies charged with their policing.”
The report said traders treat Nymex futures contracts as equivalent to ICE swaps “for the purposes of risk management and profit-taking”. Yet “one is regulated and one is not”.
ICE responded by pointing out that it has been providing the CFTC with “daily [trader] position information” to the watchdog, at the CFTC’s request, since late last year.
However insiders at the regulator say the quality of what ICE provides does not always match what it receives routinely from Nymex.
On Friday, the CFTC proposed amendments to an existing rule that requires anyone holding or controlling a futures position to keep records and hand them over on request to the regulator.
It was designed to “enhance the Commission’s ability to deter and prevent price manipulation or any other disruptions to the integrity of the regulated futures markets, to ensure the avoidance of systemic risk, and to clarify the meaning of the regulation”, the CFTC said.
Mr Levin may stand a better chance in his effort to tighten OTC market regulation this time with his party’s control of Congress. A report by his committee one year ago into the role of market speculation by hedge funds in rising oil and petrol prices failed to garner attention in the then Republican-controlled congress.
Republicans on Mr Levin’s committee disagreed with some of the report’s conclusions on Amaranth’s role in affecting natural gas prices.
But in a boost to Mr Levin, they agreed that report’s findings raised “valid concerns that demonstrate the need for greater transparency in our energy markets”.
Norm Coleman, the senior committee Republican, said: “The ongoing shift of energy trading to unregulated, over-the-counter electronic exchanges undermines the CFTC’s ability to monitor and prevent excessive speculation and price manipulation.”
One dilemma faced by Democrats as they seek legislation to close the Enron loophole is that the effort is focused on dealing with ICE and other so-called “exempt commercial markets” – meaning that they are exempt from full CFTC jurisdiction – at a time when a vast amount of OTC trading also takes place between counterparties on the telephone.
Mr Coleman said “we must ensure that any proposed cure is not worse than the disease”.
“If we extend CFTC oversight and regulation to electronic, over-the-counter exchanges we must avoid unintended consequences – namely, creating incentives for traders to shift their business to the far less transparent and unregulated bilateral, voice-brokered markets.”
An added problem for Mr Levin is that the Chicago futures exchanges are likely to lobby aggressively against the imposition of user fees by the CFTC.
Industry experts say the agricultural committees of congress that oversee the exchanges are unlikely to sanction user fees given the exchanges’ deep-pocketed connections to their members.
