By Cyrus Sanati
March 26, 2012

Position limits on energy futures could be here sooner than Wall Street thinks. Legislators are pushing regulators to cap the speculative fervor in crude oil futures as gasoline prices in the U.S. climb higher. While regulators have dragged their heels in pushing this issue forward, election year politics could pressure them to speed up their timetable if gasoline prices continue to rise, catching the big speculators — namely the large U.S. banks — by surprise.

The much-maligned Dodd-Frank financial reform act called on regulators, in this case, the Commodity Futures Trading Commission, to impose and enforce position limits to calm volatility in the commodity markets. This would limit the amount of options or futures contracts speculators could hold in a commodity. Many in the industry believe that too much speculation by certain large entities, mainly the big investment firms, have pushed prices up and distorted the market for a whole host of commodities — most importantly, the crude oil market.

The move was nothing if not controversial. The commission received over 13,000 comment letters from across the spectrum of American business on this topic last year – from the agricultural mega firms, like ADM (ADM) and Cargill, to the big guys on Wall Street, like Goldman Sachs (GS) and Morgan Stanley (MS). The majority of those writing in were generally in favor of restraining the role of speculators in commodity markets, but Wall Street was vehemently opposed. They argued that a government-imposed position limit on commodities would at best do little to impact the market and at worst kill liquidity in certain commodities.

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Wall Street has a big interest in this market — it mints money trading and brokering futures. It makes up 85% of the volume in crude oil futures while bona fide hedgers, like oil companies hedging their production or airlines hedging their fuel costs, make up just 15%. Not all the volume, though, comes directly from the big trading houses. A lot of the speculative money comes from passive investment vehicles, like ETFs and ETNs run by investment management firms like PIMCO. Since those passive funds have a long bias, they tend to skew the market by dampening downswings in the market while augmenting run-ups.

In October of last year, a split CFTC governing board side-stepped Wall Street and voted to put in place position limits on 28 commodities, including the crude oil market. The position limits would restrict traders to 25% of the deliverable supply in the prompt month contract. It also limited the position in the more illiquid, and therefore more easily manipulated, contracts that settle out in the future. Investment by speculators would now be limited to 10% of the open interest on the first 25,000 contracts and 2.5% thereafter.

Wall Street could swallow a 25% limit on the prompt month given the immense volume on that contract, but it simply could not stomach the limits set on future month contracts. That’s because the traders usually play the crude market by betting on the spread between two contracts – some or all out in the future. By severely limiting the amount of future month contracts that a speculator can hold, the CFTC would be taking away a major profit center for the banks. Financial industry trade groups have since sued the CFTC to try to kill the rule, but have since have met with little success in getting it struck down by the courts.

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But now, nearly six months after the vote, the CFTC has failed to impose position limits on the crude market. That’s because the agency has decided to hold off implementing the new rules until after it figures out how to define a swap, as over-the-counter trades would also be subject to position limits, in addition to futures. It is unclear when the agency will be ready to announce its decision on swaps but there has been talk that it could be as late as mid-2013 until the agency would be ready to make a ruling on the subject.

This has angered proponents of position limits on Capitol Hill. Senator Bernie Sanders, the Independent from Vermont, has been advocating for position limits for years. His views were once seen as radical, but have since moved into the mainstream given the recent upward spiral in oil prices.

Last week, Sanders, along with several of his Democratic senatorial colleagues, including Sens. Richard Blumenthal of Connecticut and Bill Nelson of Florida, backed a resolution calling for the CFTC to implement position limits within 14-days of Congress voting to enact them. This comes after 23 Senators and 45 House members wrote a letter to the CFTC to explain their frustration over the delay. They have an ally in CFTC Commissioner Bart Chilton. He not only supports implementing position limits immediately but is also in favor of strengthening them by lowering the thresholds.

The Sanders bill seems to have strong support in the Democrat-controlled Senate but less so in the Republican-controlled House given the partisan nature of Congress. But high gas prices are no joke in an election year. With Congressional approval rates already at record lows, high gas prices could enlist a backlash on incumbents who would normally be sure bets. The pressure to act could be enough to cause the rest of the CFTC commissioners to speed up their timetable.


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