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Fear the Boil

By: Matthew Hunter

The Desk editor passed along to me a recent Bloomberg article entitled, “Natural Gas Buying Spree Has Traders Fearing Wild Swings,” by Gerson Freitas, Jr. He asked that I comment, given my long history as a Wall Street commodities trader and my two decades later at FERC and the CFTC in their market oversight and enforcement offices. In the historical period the Bloomberg article focuses on, I was directly involved in discussions about the issues at the heart of the article (trading, market dynamics, market innovation, government policy and enforcement). I retired in December 2020.

See article on Bloomberg.

To better understand the subject, it helps to know the players. There are several kinds of traders: • Professional traders • Investor speculators • Scalpers • Hedgers •

Professionals trade for large institutions. They trade relationally using every instrument available. They may take fixed price risk. They are price makers and provide liquidity to customers and others. They trade physically and financially. They have access to capital. They take positions for many different terms and purposes and as such, the portfolios of professional traders can be very complex, often have highly structured products as well as plain vanilla physical and derivatives instruments and assets. A subgroup of professional traders includes Commodity Pool Operators and Commodity Trading Advisors. Hedge funds can be CPOs. Significant hedge funds and CPOs may trade SEC-jurisdictional products or those regulated by the CFTC. A few hedge funds trade physically too.

Investor speculators include mostly private money; they trade in retail products and wholesale products, but they never trade in the wholesale physical market. They have a limited set of trading instruments available, and these participants are never market makers.

Scalpers are “day traders” and short-term spread traders. The most prevalent scalpers are algorithmic high frequency traders who buy and sell rapidly, trying to profit from other traders’ interests. They can be market makers. They are not position takers generally. Some scalpers specialize in spread trading. The roll of ETFs is only one reason to trade spreads. Spread traders seek to understand the likely change in spread values by anticipating the potential changes in the spread value fundamentals-based inputs.

Hedgers are physical and consumer value chain entities that mitigate their production or consumption price risks with physical and derivative trading instruments. They can be small to very large in size and have only a few or many commodity interests. They can be merchants who stand between consuming entities and producers. They can be manufacturers or processors. They can be utilities, refiners and raw material producers.

Professional traders do not generally fear price swings – price volatility. I traded, hedged and speculated for nearly 30 years before my government career. I led trading desks. Traders rather fear their position will be on the wrong side of volatility and therefore lose money. They expect to be on the right side of price and volatility swings and express their convictions through risk acceptance. The volatility that supports and improves the value of their positions is welcomed. The more extreme the volatility that produces profits, the better.

Violent price movements do happen, and they can occur often and quite naturally. Sustained price movement direction also happens. Markets trend for substantial periods. Neither is necessarily a problem. The Bloomberg article touches on the real issue, the securitizing of commodity interests and its relationship to excessive speculation. It is an old but actual problem that must one day return fearsomely as the issue: aggregated speculative interest as a consumer burden. Ultimately, I believe consumers will again pay more for commodities for the failures of Congress and the CFTC to address excessive speculation. Price dislocations driven by financial product speculation, whether in wild price swings or in a gentle sustained or continued direction, are harmful to consumers.

I will touch on the subject of “excessive speculation” later on. The Bloomberg article focuses on price volatility rising from a sudden change in passive security investments, specifically those financial instruments that track natural gas futures prices being disgorged. The author assumes that the BOIL and UNG natural gas ETFs are passive trading instruments because they are derivatives. These securities and other commodity-indexed “passive investments” have long been recognized as part of the natural gas futures price formation chain. They, of course, contribute to daily price formation, and I agree that it is true that one day the sudden disgorgement of a large number of positions may again contribute to violent price movements. But it is equally valid that speculative trading impacts are transferred to consumers daily, just not in a sensational manner. The boiled frog analogy fits here.

The author states, “ETFs aren’t supposed to move the market, just trade in line with the underlying asset. They’re designed to be highly liquid securities similar to stocks, ideal for giving investors exposure to commodities like natural gas that usually are traded by industry professionals using more complex futures and options contracts.” UNG and BOIL ETFs are based on inherent futures hedges or swaps hedged with futures they hold to create their shares.

First, an immutable hedging commandment is “LIKE HEDGES LIKE.” Price risk hedges (mitigate) price risk. Simply put, if securities traders take price risk in a futures contract lookalike product, then only a fixed-price futures contract, or another fixed look-alike swap can serve as the hedge.

A purchase must be met with a sale. If we understand this fundamental dynamic, we can ignore the complex daisy chain of trading interactions or risk transfers of the security itself and the nuances and complexity of share creation.

It is impossible to drain or flood futures liquidity by adding or decreasing futures open interest without a price impact. The article discusses the percentage of active month futures each ETF holds in aggregate. Everyone knows demand contributes to rising price formation and supply contributes to falling price formation. Even the most minor trade has some price impact. Thus, the article’s centering on the worry of some participants that the sudden disgorgement of investment in ETFs and ETPs will cause price movement in futures prices is correct. Disgorgement is the selling of long speculative security positions at some point and must transfer to sales of futures. The trading of the security is not in absolute isolation as ETF trading to futures trading can be arbitraged. The initial construction of the security is to fractionalize the futures into shares for trading by a different sort of trader. The objective was to encourage trading and ease new participants’ ability to participate in risk taking. And necessarily, the security depends on holding as hedges those same futures and swaps by BOIL or UNG that the security tracks. The hedge itself connects the price changes in the underlying futures contract to the security. The two securities and any hedging swaps are not independent of the underlying pricing assets. Nor are they independent of the price formation/discovery process.

We had lived through this before and in a far more extreme way when investment cash demand poured into commodities by investor speculators purchasing the S&P Commodity Index (initially called the Goldman Sachs Commodity Index or GSCI) and other similar products in the early 2000s. The introduction of “passive investment in commodities” flooded the futures markets with futures hedging needs. Not to mention the large new participation in other speculative investments directly into the futures contracts themselves. Starting roughly in 2002 or so and building after that with unbridled enthusiasm for commodity risk investing, speculators injected billions of investment dollars into what was ultimately touted as the commodity “supercycle.” Here began the promotion of commodities as a special asset class. Previous commodity investment had created bubbles that eventually burst. The word was that the supercycle would be different. Every increase in oil prices brought about new enthusiasm and new entrants with investment capital. Bubble-driving hysteria was rife in the media, with commodity price predictions of new historic highs. Prices were discussed as fundamentally driven, and conversations about risk premiums were continual, especially in oil, as prices moved higher. The passive speculation demand for futures price exposure drove futures prices themselves when hedging occurred. And investor funds of all kinds were injected into all manner of commodity speculation. All commodities were considered undervalued, but energy commodities were considered especially underpriced. The GSCI was comprised mainly of energy futures, and the index was predominantly weighted to contain the NYMEX WTI futures and, secondarily, the natural gas futures contract.

There were complaints about the effects of the investment in commodities. For example, agricultural commodity participants complained about how passive money impacted agricultural commodities. In 2008, natural gas futures hit a record-high price of over $13. Oil prices surged to approach $150. Forecasts for $200 and even higher-priced oil were announced. Then, no one spoke about the injection of investors’ speculative demand as anything other than natural and without price impacts. Sounds familiar, doesn’t it?
Mike Masters founded Better Markets to address this issue and others in 2010. Still, in 2004-2007 there was little discussion in public about commodity speculation impacting prices. Consumers, of course, paid the full bill of speculative-driven prices determining cash market prices. When the financial crisis hit, passive commodity investments were suddenly and dramatically unwound. Prices plunged. Price volatility emerged. When called before Congress, I remember large banks’ managers testified that commodity prices, especially energy products, fell because of long position liquidations. When prices were on their way up, the excuse for the increases was that these prices were fundamentally driven only. No one spoke about long-holding speculative position-taking aggregation impacting price formation. Somehow, the long acquisition had no role in the price increases, but the long liquidation caused price declines. The products being traded were all derivatives of futures contracts hedged with futures. Then as now, the products were said to be trackers of futures prices only. As I recall, the 2008 FERC State of the Market Report declared that fundamentals alone could not explain the high prices or the fall in natural gas prices in the second half of 2008. Financial trading fundamentals, however, were highlighted as likely behind both the years’ price dislocations.

I recall a bank publication and public source that estimated the GSCI and other similar indices’ total investment dollars during 2007 or 2008. Staff at FERC extrapolated the natural gas futures investment dollars in passive instruments, and they concluded that the front-month futures investment was larger than the nation’s total annual natural gas consumption cost. While it is ordinary for derivatives to have large trading volumes, notational value and significant open interest before delivery, someone has yet to model speculation contribution to price formation. The separation in the price of production cost estimates to wholesale market prices is an art that leads to risk premium estimates. But, to believe that a speculative financial demand exposure greater than total United States natural gas consumption jammed into the lead-month futures contract had no price impact is a remarkable feat. Somehow those investment dollars never had a price impact, according to those who believe that tracking a price swap or ETF/ETP hedged directly with the tracked underlying asset is simply derivative and not price-contributing.

Years ago, the phrase risk premium was code for speculators taking positions and separating energy prices from their true fundamentally driven price levels.

Risk premiums generally do not include discussions about speculation interest but imply that unsettled physical fundamental conditions like geopolitical events cause some producer withdrawal or other withholding from the physical and forward markets. This is a convenient and self-serving disguise for speculative demand for commodities price risk appetites.

Accepting price risk or fixed-price exposures and creating new positions in futures-tracking trading vehicles means that futures must be acquired as hedges. Investment in futures directly or in securities dependent on futures are parts of price discovery liquidity.

Let me be clear: I am not against speculation. Speculation is necessary to allow producers and consumers to meet, across time. Producers and consumers do not trade in the market at the very exact moment. Their ambitions are opposed. Speculators provide a necessary service to the market.

I did find the following statement in the Bloomberg article misguided: “Neither ETF is designed for buy-and-hold investors because they’re structured in a way that will almost always lose money. They must roll their contracts forward as the front-month expires, and since longer-term deliveries are typically pricier, that erodes returns.” The role of futures that are passive instrument hedges to maintain risk exposure (SPCI, BOIL and UNG) is a different problem – or should I say opportunity.

When the futures markets are in backwardation, when tomorrow is worth less than today, the roll pays the passive investor to continue to hold a risk exposure but to surrender the near-term position and accept the deferred-month risk when maintaining a position. This is a serendipitous advantage. It is a small-dollar adder at the edge and not the driver behind the fixed-price exposure of the speculator. Backwardation is an excellent indicator of a nearterm supply shortage in some commodities.

When the market is in contango, when tomorrow is worth more than today, the passive investor pays to continue to hold a price risk exposure when surrendering the near-term contract for the deferred futures contract to maintain a position. Being in Contango does not mean the market is oversupplied, though it can. The critical consideration is that the investing speculator seeks to maintain the position indicating liquidation does not occur in an absolute sense. Some commodity traders are predators and understand that the mechanics of passive instrument transitions from the lead month to the next deferred month should be distinct from the investor’s directional risk profile and just another opportunity to capture trading profit from anticipating their rolling from the lead month to the next deferred contract. The spread trader tries to take advantage of the role requirements, whether the spread is in contango or backwardation. Suppose the speculative security investor liquidates rather than rolls to maintain a position. In that case, the OI will change, volatility in the underlying may occur and the spread commodity speculator may suffer financially as the spread will not reflect a predictable and formulaic roll requirement. Exacting a toll or a tax from the roll requirements to maintain a price risk exposure is just part of the game for the security holder. And spread values are fundamentally driven and only impacted at the edges by roll profiteers.

This statement in the article thus does not consider that commodity speculation is not about attempting to capture ordinary returns when taking directional price risk. Investment in commodity speculation is about attempting to capture outsized returns. If the ambition is to capture a 100% increase or more in value of a commodity, say from $2.50 to $5, then rolling a position several times that with costs of fractions of pennies, to say quarters with each roll, is undoubtedly acceptable.

Suppose the goal of commodity speculation is to capture explosive price growth, as the cycle between 2002 and 2008 demonstrated. In that case, the cost of the roll with the additional expenses of spread-trading profiteers is also worth it to a successful investor speculator. Losses from unforeseen or misunderstood market dynamics are never acceptable; they are just a fact of life for traders. Spread values in natural gas anticipate costs of storage, storage fill levels and weather forecasts, to name a few inputs. Roll costs can be anticipated, by and large, and even mitigated. The cost of rolls and ETF market design is a red herring discussion. Commodities trading has many risks but few guarantees.

Commodities are not buy-and-hold instruments at all. Commodities themselves are inherently one of three essences: bite, bury or burn. Buy and bite (eat), buy and bury (physical commodities like gold, silver and crypto assets), buy and burn (energy as fuel); however, securitizing a commodity is to convert the transitory nature of commodities into an evergreen-like security.

Securities can be left to future generations. A financial or physical futures contract cannot be an inheritance instrument. Each of these assets shares one trait, a constant reevaluation of its price. That there is a continuous change in price or value is irrelevant. All stocks have a continual mark-to-market value, but once paid for, the constant re-marking is irrelevant as an inheritance vehicle until its ultimate sale. An heir to a security can sell the asset whenever and capture a price to receive dollars; what was originally spent by the deceased for the asset is, at most, a curiosity. That is not true with margined instruments, especially instruments that either self-liquidate or require physical delivery. No one purposefully bequeaths a futures contract in a will.

In the early 2000s, the CFTC was, and still is, charged with preventing excessive speculation. To that end, the commission has the authority to place position limits on exchange positions and to limit trading. The commission can readily identify individual actors abusing position limits, trading rules and regulations. Years ago, there were position limit exemption battles related to hedging of financial products, like the GSCI and the ETFs. In response to Dodd-Frank requirements stemming from the financial crisis of 2007-8, the commission instituted position limit rule changes, some of which occurred as late as the beginning of this decade. There was always a debate about bona fide hedging, which was meant to support actual physical production activities (always permissioned) such as extraction, refining and agricultural production and processes. It is not true that bona fide hedge rules are intended to support the hedging of financial product speculative interests and product innovation. The idea is that you cannot circumvent or defeat speculative limits by inventing products for speculation and then hedge these products with infinite numbers of futures.

I expect that this problem will return, at some future date. The Bloomberg article rightly observed that the CME once constrained UNG’s futures hedge holding capacity. The situation was after natural gas prices had fallen from their highs and were perceived as cheap. Speculators were gambling on price increases. Again, that sounds familiar.

UNG, years ago, changed its rules to allow natural gas futures look-alike swaps to serve as hedges for the ETF shares. Those swaps were supplied by large institutions that used their position limits to hedge the created swaps with futures. The increased cost of share creation was easily absorbed, I imagine. Excessive speculation was neither addressed nor constrained in any absolute sense.

Why do I say this? CFTC and most market observers consider the actions of participant actors only when considering a working definition of excessive speculation. There is no legal definition of excessive speculation. Commentators do not consider the market as a whole when discussing excessive speculation. In most instances, without position limit guidance, I could not say what excessive speculation is. However, excessive speculation occurs when the market itself is buoyant with hyped exuberance, and the resulting positions in aggregate overwhelm the physical underlying market generating “risk premia.”

Of course, one can stress test the open interest in a liquidation exercise and perceive possible outcomes. Trading can be limited and made too expensive to discourage group-think-based excessive speculation. Exchanges can control the exuberance and rapid growth in OI and trading by raising margin requirements. No doubt exchanges would not favor such self-identification or self-imposed restriction. Free market advocates will be appalled by this idea. However, the CFTC’s mandate is to prevent excessive speculation as a burden on interstate commerce. Increasing consumer costs by excessive speculation was considered by Congress. The market has evolved away from single-market participant domination and single-participant position limit constraints.

To understand the position limits dilemma, consider that position limits apply only to CFTC-regulated futures and swaps. There is reporting to the CFTC on the positions of entities and links to affiliates and ownership levels. Exchanges and clearing firms send reportable positions to the CFTC every day. A speculator in natural gas futures could buy and control UNG and BOIL ETFs. If the hedge is a futures contract or a swap backed by futures, then the owner of the ETF controls the futures in the hedge. The commission would never know that the speculator held an equivalent futures position above a position limit. The speculative activity in products like the S&P Commodity Index is likewise not included. This is interesting and of note – how position limits could fail at the participant level by being hidden from the CFTC and the exchanges/clearing firms.

Most importantly, excessive speculation must be addressed at the broadest levels – widespread identical but noncollusive behaviors and speculation. The historic investment in passive instruments of the early 2000s did not attract any regulatory oversight. The problem is to identify what is genuinely excessive speculation in commodities. In my opinion, this occurs when large numbers of investors with significant capital act independently in the same direction. Remember, excessive speculation is a burden on interstate commerce. The commission has the authority to constrain trading and positions.

As a thought experiment, if a million one-contract futures traders came to the market together to buy, then their purchases would cause the futures market to rise suddenly and dramatically. We need only think of retail stock traders trading together in recent years to see such an effect. Outside observers would never declare that any individual of the one-contract traders and their position was excessive in any manner. However, if the aggregation of a million participants was considered a single participant solely, the aggregated position and the trading behavior would be understood differently as a violation of position limits. This is the problem of excessive speculation via “passive” commodity tracking products. These investment instruments can have profound market impacts and always contribute to price formation.

Why does it matter? In natural gas specifically, but in many commodities, the derivative futures contract sets physical prices.1 It is a continuous everyday event but is most noticeable at a contract’s final settlement1 . Futures are risk transfer instruments far more than predictors of future prices. If futures contracts have prices that include premiums or discounts to fundamental considerations, then speculation contributions to price formation are transferred to physical prices and consumers. This observable and empirical truth sounds impossible and perverse. A simple description of how the final settlement consumer cost transfer works follows.

Let us consider another example: How is the physical price determined if there aren’t any physically fixed-price deals to set an index or when there are too few transactions? In many instances, the physical price will reference a futures contract settlement. In natural gas, there are no contributing independent fixed-price deals at Henry Hub during bid week influencing and setting the final monthly price. This has been the market condition for many years. The natural gas market works remarkably well, however. Physical transactions are either relational to the futures at the time of pricing or are a physical basis trade. Physical basis trades include the NYMEX final settlement price plus a differential in determining the physical trades’ price. Henry Hub and Sabine’s differential is often set at zero or a fraction of a penny to a penny. Necessarily, then the financial trading during the settlement period includes all the elements of the interests of financial players who are devoid of a physical context, as financial players such as hedge funds, commodity pool operators, commodity trading advisors and ordinary citizens cannot make and take delivery of natural gas as they do not have rights and contracts to schedule natural gas. Rules once stipulated that participants without transportation agreements were prohibited from trading in the final trading periods of a terminating natural gas futures contract. These rules were not enforced and ultimately were removed and stricken from the record. That these rules existed means that when the contract was first formed, the designers recognized that pure financial interests interfered with the supply and demand fundamentals of physical commodity traders. Eliminating the rule means that financial interests and unrestricted trading are more important within the market than preserving the last of the fundamentals of supply and demand. I do not believe this is a “bad thing.” It just needs to be generally understood as part of the market.

In commodity trading, there is a desire for futures and cash prices to converge at settlement. There is absolute or perfect convergence in natural gas because the derivative determines the physical price. Convergence should be proximate between futures and its cash market. This is because traders do not execute trades with the intention of not making money and bearing transaction costs for societal benefit.

Of course, a futures final settlement does not include the roll trading of the SPCI, BOIL or UNG positions, as their rules for the roll to the next deferred month from the active month exclude the futures termination period of the lead-month contract. As all pricing of physical natural gas at all times relates to a futures contract, it also necessarily means that all speculative interests driving prices are reflected in what consumers pay. Now with my tongue firmly in my cheek, we’ll call it a risk premium caused, on occasion, by excessive speculation.

Originally published in The Desk. July, 2023. Scudder Publishing Group, LLC.

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