The “Close the Enron Loophole” has gained significant traction in recent months. While it's clear that the industry has made a strong effort to lobby Washington to initiate and pass legislation intended to eliminate trading on “dark markets,” another question also needs to be addressed. Will the time, effort and resources being allocated to “closing the Enron loophole” produce the results desired by many in our industry?
We need to recognize that recently there has been a significant “integration” of the energy markets into the global financial markets as a whole. Many participants in the financial markets now see the energy markets as an “asset class,” another sector of the financial markets where capital is being allocated. Take CalPERS (California Public Employees' Retirement System), the largest U.S. pension fund. Last April CalPERS allocated $450 million to the S&P Goldman Sachs Commodity Index and, in late January, they announced that between now and December 2010 they plan on allocating approximately $5 billion of their $240 billion in assets under management to commodities. As of Feb. 11, 2008, 71.38 percent of the S&P GSCI is allocated to energy, as follows: Crude Oil – 37.27 percent, Brent Crude Oil – 13.44 percent, RBOB Gasoline – 4.41 percent, Heating Oil – 4.81 percent, Gas Oil – 4.81 percent, Natural Gas – 6.63 percent. And CalPERS is not alone, numerous reports indicate that there are at least $100 billion invested in vehicles that track the S&P GSCI and AIG Dow Jones Commodity Index.
In addition, there is also the impact of the U.S. dollar and interest rates on oil prices. For example, the increase in oil prices that began last August was preceded with a weakening U.S. dollar and expectations of interest rate cuts by the Federal Reserve. Over the course of the past five years, the U.S. dollar has declined significantly versus most other major currencies. So, while oil prices have surged in recent years, these increases have not been as significant for those buying oil in euros, British pounds or even Canadian dollars. Numerous entities now use the energy markets to hedge and/or speculate on not only energy prices, but various financial markets around the globe.
So what do these issues have to do with “closing the Enron loophole?” The financial instruments (futures, options, swaps) that have long been used by our industry to hedge our risks are now being used by various entities around the world. While increasing the regulatory oversight of both exchange traded and over-the-counter energy contracts in the U.S. should, in theory, lead to less speculation and manipulation, this in itself will probably not lead to lower oil prices nor lower volatility. Why? The markets that our industry often considers our own are no longer just ours.
If the “Close the Enron Loophole” initiative was focused on natural gas, I would probably agree with the popular opinion, as natural gas is primarily a domestic market and a large percentage of natural gas is traded on ICE (Intercontinental Exchange), one of the so called “dark markets.” On the contrary, distillates and gasoline are global products and, excluding gas oil (the European equivalent of heating oil, which is traded on ICE), are primarily traded on the NYMEX, in the case of heating oil futures, and in the over-the-counter markets, via telephone and/or instant messenger. The over-the-counter markets are by no means limited to U.S. based traders or entities, even when trading products that reference U.S. benchmarked products i.e. NYMEX heating oil. And this isn't going to change. While it's difficult to quantify, based on data from the International Bank of Settlements, as of June 2007 there were approximately $7.567 trillion (notional amount) currently outstanding in over-the-counter commodity trades, up from $2.940 trillion in June 2005. Of this $7.567 trillion, gold and other precious metals account for $514 billion (again, in notional dollars), leaving us to assume that energy trades account for a large percentage of the remaining $6.26 trillion.
Furthermore, as the economy becomes more global, and foreign markets become friendlier to energy trading, there is a decent probability that the liquidity in the energy markets will no longer be concentrated in the U.S. and/or on the NYMEX. If the U.S. decides to increase regulations on energy trading, you can be sure that a number of “foreign” exchanges will be more than happy to introduce products that are similar to the benchmark NYMEX products (crude oil, heating oil, gasoline), which could, in turn, lead many participants taking their business outside of the U.S.
On a similar note, many organizations are now global as well. Most major oil companies, investment banks and many funds have offices around the globe. If the U.S. does increase the regulations on energy trading, it will be very easy for many of these companies to shift their trading activities to their traders and entities outside of the U.S.
Last but not least, if the CFTC becomes able to enforce increased regulations, what about the energy markets outside of the U.S.? Is the CFTC going to attempt to regulate energy trading outside of the U.S.? For example, say a European refiner and a Canadian investment bank enter into diesel swap that references NYMEX heating oil. Will the CFTC have the legal authority to regulate such a transaction? Most likely, no.
Regardless of whether or not the "Enron loophole" is closed, we have to expect that the energy markets will become more global and that energy prices will remain volatile and relatively high. The companies in our industry that are willing to adapt to the times and accept that this is not their grandfather's oil business are the companies that will prosper in the months and years to come.