Financial titans J.P. Morgan Chase and Goldman Sachs are both getting out of the commodities speculation game, which could lead to less volatile crude and heating oil prices in the future (images: compliancex.typepad.com and money.cnn.com)

The financial reform bill signed into law by President Obama in July contained some major changes to regulations governing commodities and commodities derivatives trading, including the buying and selling of crude and heating oil futures and options contracts. While many of those regulations have yet to be clearly defined and fully implemented, the looming changes have already spurred some changes in financial markets, including commodities.

On Tuesday, the Wall Street Journal reported on investment banks moving away from the practice of proprietary trading on commodities markets in anticipation of more stringent rules. Proprietary trading is the practice of banks and other financial institutions investing their own money in search of profit as opposed to trading on behalf of clients. The withdrawal of banks from the speculation game began with two of the biggest names in investment banking, J.P. Morgan Chase Goldman Sachs. Both institutions have given notice that their proprietary trading operations will soon be shut down. The action is motivated by a desire to comply with the “Volcker rule,” the guideline put forth by former Fed chairman Paul Volcker that limits the proprietary investing activities of banks.

Critics of speculation on oil and other energy commodities (of which Raymond J. Learsy is one of the most vocal) must be pleased by this trend, as it could represent some progress toward the goal of reducing the volatility of crude and heating oil prices. However, their satisfaction could be heavily mitigated by the fact that other major institutional investors will likely step up their own proprietary trading and quickly fill the spaces vacated by banks’ proprietary trading operations at commodities markets. Furthermore, the practice of using commodities as a one of many investments in a diverse portfolio is not going away. Demand for commodities derivatives remains strong, and buyers and sellers will continue to need market liquidity to perform their trades, regardless of where that liquidity comes from. The Journal reported,

Some markets could see a temporary lull if other banks follow the lead of these large firms, and there are worries about the loss of liquidity in some sparsely traded products. But a permanent reduction in speculative activity isn’t in the cards. Hedge funds and other investment groups are expected to fill some of the void, and analysts are hopeful that rules will still allow for banks to serve their clients.

Opponents of tighter regulation of oil and other commodities markets claim that the loss of liquidity from banks could bring down total market liquidity to a level insufficient to meet demand from traders. Those who support new regulations argue that even without the participation of large banks, the market will provide adequate liquidity to meet demand.

While the practice of speculation on oil will continue to influence crude and heating oil prices, the removal of major banks from the equation could help reduce volatility somewhat. Because of the massive amounts of money they control, many banks have to power to move market prices for commodities simply by buying or selling a huge amount of contracts at once. With banks and their seemingly limitless amounts of capital removed from the speculative game, the same positions once occupied by one bank will be occupied by several smaller institutions, thus spreading control over the market across more companies and reducing individual companies’ influence over prices.

It may take a while for the affects of new financial rules to filter down into retail heating oil and gasoline prices, but when they do, it will be good news for the average American driver and heating oil user. The changes are far from a guarantee of lower prices, but do offer hope for at least more predictable prices that are less prone to sudden spikes and drops.

CFTC Commissioners Scott O'Maila (left) and Bart Chilton (right) agree that Infinium's "haywire" algorithm is proof that greater oversight of electronic trading methods is required on commodities markets. (images: cftc.gov)

In response to a report last week on a flawed trading algorithm that caused a spike in oil price volatility, two members of the Commodity Futures Trading Commission called for tighter regulation of computer-based trading. Reuters reported on Thursday that commissioners Scott O’Malia and Bart Chilton both characterized the flawed algorithm created by the Infinium trading company as an example of the dangers posed to market stability by increasingly computer-based trading practices. The commissioners went on to say that new regulations should focus on computer-based trading, as current regulations meant to govern in-person, open outcry trading of oil and other commodities are inadequate.

In recent years, commodities trading has been increasingly conducted electronically, and as trading software has become more sophisticated, traders are now able to execute hundreds of trades per second in a practice known as high-frequency trading (HFT). The computer algorithm created by Infinium Capital Management was used for HFT for only five seconds before its operators shut it down on February 3. But five seconds was enough time for the out-of-control algorithm to place thousands of buy orders that drove up the price of crude by $1 per gallon in less than four minutes. The following day, chaos generated by the faulty algorithm led to a sharp drop off in oil prices as wary traders sold off positions.

Neither Chilton nor O’Malia went so far as to condemn HFT outright, but both agreed that new regulations are required to keep up with rapidly evolving technical trading practices. The financial reform bill signed into law by President Obama on July 21 grants wider power to the CFTC in its regulation of commodities and derivative markets. The commissioners’ recent comments made it clear that specific regulations of HFT and other computer-based practices are at the top of the commissions to-do list. O’Malia told Reuters,

Whatever we do, the risks posed by high speed and algorithmic trading must be handled with great care because when things go wrong, five seconds can generate a lifetime’s worth of trading, not to mention a toxic trail.

New regulations will hopefully provide some protection from the wild volatility that has marked crude and heating oil prices in recent years by reigning in electronic trading’s influence over prices and limiting market participation by big-money speculators. A little bit of added oversight could go a long way toward making the prices that heating oil dealers and consumers pay for their fuel more predictable and less disruptive to their bottom lines.

A commodities trading group seeking the shiny first-ever $100-per-barrel crude oil contract disrupted the market in 2008 and is now paying for it. (image: proactiveinvestors.com.au)

First prints can be valuable collectors items. First editions of classic books can fetch several thousand dollars, and first prints of certain works of art can be worth much more. Apparently, first prints of oil futures contracts can also be attractive collectors items. The Wall Street Journal reported on Tuesday on a $15 million fine levied against an oil trading group for illegal trades it made in pursuit of the very first $100-per-barrel crude oil future contract in 2008.

The CFTC filed and immediately settled charges against ConAgra Trade Group, the former commodities trading division of mega corporation ConAgra Foods for causing a “non-bona fide price” on the New York Mercantile Exchange oil market on January 2, 2008. According to the CFTC, the NYMEX floor trader for ConAgra had been directed by his superiors to buy the first $100 oil contract for a full three months before the transaction took place. On January 2, the price of crude was rising toward the $100 level, with the electronic price at $99.60 and trading floor prices around $99.90. To ensure winning the golden ticket that was the first $100 contract, the ConAgra trader proceeded to buy up all of the available contracts at $99.90 a barrel, which prompted an offer from a seller at $100 a barrel. The sudden snapping-up of contracts at $99.90 disrupted the oil market, causing widespread confusion over the “true” price of crude and leading another NYMEX floor broker to file a complaint that he was offering the contract at a lower price.

The disarray the action set off on the oil markets was apparently of little concern to ConAgra, which was obviously focused on the prize of a freshly-minted $100 oil contract. According to the CFTC, a ConAgra trader boasted in an email, “some people collect art prints, we collect price prints.” The ConAgra Trade Group no longer exists, as it was sold off to hedge fund Ospraie Management for $2.8 billion in June of 2008, and now operates as the Gavilon Group.

While the incident’s effect on oil prices was short-lived and had little to do with the price of crude reaching its all-time peak of $147 six months later, it offers a glimpse into the reckless mentality of certain commodities investors. ConAgra Trade Group was so fixated on gaining a shimmering business souvenir, that its management and traders did not care how their efforts to secure the contract would affect other hedgers and investors in crude. In theory, ConAgra’s off-the-cuff crusade may have caused an end-user of crude oil to pay hundreds of thousands or even millions of dollars more for oil that it purchased on the day in question.

Certainly, the fine levied against the trading group for its selfish and irresponsible actions is a sign that the CFTC is taking on a more active role in enforcing trading regulations and clamping down on self-serving actions in the commodities markets that result in artificially high prices or other disruptions to the free market. But if one company was willing to cause temporary chaos on the oil market just to get its hands on a collectors’ item, chances are that a $15 million fine (chump change by Wall Street standards) won’t do much to deter a like-minded company from taking similar action in the future.

A company in London bought 240,000 tons of cocoa, which could give it control over the price of cocoa in the retail market. (image: thechocolatelife.com)

Crude oil and heating oil aren’t the only commodities traded on futures exchanges. There’s also cocoa. And just like in the oil market, people are worried that financial interests are leading to artificially high prices.

As NPR’s Planet Money blog reported on Monday, “Somebody bought almost all of the cocoa registered in European warehouses last week.” A company called Armajaro bought contracts for 240,000 tons of cocoa on the London market, worth about $1 billion. That’s about 7 percent of the total global supply of cocoa, which could give the buyer enough influence to raise the price of cocoa around the world, which would hit consumers any time they bought chocolate.

In the US, groups that want to curb speculation on energy commodities have called for position limits—caps on how many contracts any one trader can have. Now some in the cocoa business are asking for the same thing, says the Wall Street Journal:

Trade groups have criticized the exchange because it hasn’t implemented limits on the number of contracts a single trader can hold, which in the U.S. is regarded as a key check on participants’ ability to manipulate prices.

Whether it’s heating oil or candy bars, prices climb when large financial institutions buy up as much of the commodity as they can.

Senate and House leaders gathered at the signing of sweeping financial reform, which could have a large impact on the heating oil futures market and heating oil prices. The bill still needs to be signed by the president to officially become law. (image: pbs.org)

The US Senate passed the financial reform bill on Thursday, sending the sweeping legislation to the president’s desk where it awaits Barack Obama’s signature. The bill includes a wide range of measures, but one of its centerpieces is the increased transparency and scrutiny of derivatives, including heating oil futures contracts.

The legislation on derivatives originated in the Senate Agriculture Committee, which oversees commodity futures trading. Derivatives are a category of financial instruments whose value is based on (that is, derived from) an underlying asset, such as futures contracts for commodities like heating oil. Derivatives also include vastly complex financial instruments that many believe sparked the financial crisis, such as credit-default swaps, and the new bill aims to bring more transparency to derivatives markets and curb the influence of speculative traders.

Sen. Blanche Lincoln (D-AK), chair of the Senate Agriculture Committee, introduced a bill that would limit and regulate speculative trading in commodity futures, a proposal that quickly won the support of end users such as heating oil dealers and airlines. These end users buy futures contracts to hedge their risks against changes in the price of fuel, and are hurt by the excessive price volatility caused by speculation. The Agriculture Committee approved Lincoln’s bill, which was then combined with legislation from the Senate Banking Committee to form a comprehensive financial reform bill.

The Senate’s version of the financial reform bill, passed in May before it was combined with the House bill and sent back to both chambers, incorporated a regulation that the Commodity Futures Trading Commission proposed in January: position limits. The CFTC had been considering enacting position limits on energy futures, which would restrict the number of contracts an investor could hold at a given time, on its own but preferred that Congress make clear the CFTC’s authority to enforce position limits by inscribing it in federal law. Members of CFTC commissioner Bart Chilton’s staff worked with Sen. Lincoln to make sure of just that.

While we know that the financial regulation bill will increase the transparency of derivatives trading, curb speculative investment, and increase the power of regulators over commodity trading, many of the details of exactly how the new rules will be implemented will be left up to a variety of regulatory agencies. Critics contend that too much power is being placed in the hands of regulatory agencies, some of which are the same agencies that failed to prevent the financial crisis of 2008.

Despite the lack of details, some who have been affected by volatile and record-high oil prices are happy to see regulators given the tools to police derivatives markets. Jim Collura, vice president for the New England Fuel Institute and spokesman for the Commodity Markets Oversight Coalition, wrote in the Huffington Post that today’s oil markets were like the Wild West and that financial reform would help the end users (“hedgers”) who buy and sell derivatives:

If the “Wild West” was tamed by law and order, then the derivatives markets will be tamed by increased transparency, stability and confidence that legislative reform will bring. An important and reliable tool that hedgers have relied on for years will be returned to them and for this reason, end-users will benefit—not be burdened by—long overdue and comprehensive reform.

Hopefully Collura and other supporters of financial reform are correct and this legislation will bring stable and lower prices to commodity markets. Stay tuned to HeatingOil.com for more updates on how financial reform unfolds and how it will affect home heating oil prices.

The EIA’s plans to fix major deficiencies in its data collecting and reporting systems have been held up, but the agency continues to release inventory reports every week. (image: eia.doe.gov)

The system for reporting supplies of crude oil, heating oil and other petroleum products in the US is far from perfect. Each week, two organizations—the industry group American Petroleum Institute (API) and the Department of Energy’s Energy Information Administration (EIA)—release reports on stockpiles of crude oil, gasoline, and distillates (a category that includes heating oil and road diesel). The numbers in those reports, released 16 hours apart, are almost always wildly different. Last week, both organizations agreed that crude oil supplies dropped, but showed a 2.3-million-barrel discrepancy in their estimations of how much those supplies declined. Despite 2-million-barrel (and higher) margins of error, both the API and EIA reports are relied on heavily by oil traders and can bring about huge swings in oil prices. Clearly, the US oil industry is in urgent need of more reliable and accurate petroleum supply reporting.

With that need in mind, the EIA set out to improve its out-of-date and deeply flawed data collection processes in March, but has run into problems that has kept those updates from happening, the Wall Street Journal reported on Tuesday. Last September, an independent consulting firm found “critical” errors in the EIA’s systems for collecting and reporting inventory data. By March, the EIA had laid out a plan to fix many of those errors quickly and easily by “asking oil companies to report inventories at each facility, rather than aggregate them by region.” Unfortunately that solution only led to a new problem: more data broken into smaller parts that had to be entered into the EIA computer system by hand. Changes to address the new problem would require a major overhaul of the EIA’s data system, a process that would take years and need several million dollars to fund, said Stephen Harvey, director of the EIA’s office of oil and gas.

While the time and money required for the major overhaul will come eventually, it won’t be any time soon, as a request for funds to fix the system was denied in 2009. The agency is slated to receive an additional $18 million next year, but most of those funds are earmarked for other projects, Harvey said.

Last August, the Federal Trade Commission, in an effort to reduce instances of market manipulation, took steps to tighten regulation of oil companies that reported their own inventory data to the EIA. Today, the EIA is ready to reform its own methods in pursuit of fairer, more transparent, and more accurate petroleum supply data but is hindered by a lack of two crucial ingredients: funding and political support.

Until the EIA gets what it needs to make the changes, swings in crude and heating oil prices based on inaccurate inventory data will continue to affect heating oil users and all other consumers of petroleum products.