Nymex, Others Downplay Impact of Hedge Funds on Gas Futures

The growing alarm about the impact that hedge funds are having in the natural gas futures market is largely unfounded, FERC Chairman Pat Wood, CFTC Chairman Sharon Brown-Hruska and Nymex Chairman Mitchell Steinhause said in three separate letters to Rep. John D. Dingell (D-MI), ranking member on the House Committee on Energy and Commerce.

All three dismissed the notion that rising participation by hedge funds has increased gas prices and market volatility. Dingell had asked for their opinion on the matter after receiving a letter from Stephen R. Etsler of Stand Energy Corp., a retail gas marketing company, that included an article on hedge funds in the gas market by Peter Fusaro and Gary Vasey of Global Change Associates.

"Nymex has conducted a review for the period Jan. 1, 2004 through Aug. 30, 2004 focusing on the volume of activity in natural gas futures, and determined that hedge funds accounted for only 9.56% of all months trading during that period," Steinhause told Dingell. He also said the exchange determined that hedge funds accounted for only 9.06% of near-month futures contract volume during that period, indicating that was hardly enough to cause continuing volatility and price spikes.

The exchange also used a technique developed by C.W. Granger to study the causal relationship between hedge fund open interest in natural gas and market volatility. "The results indicated that volatility appears to lead hedge fund participation into the natural gas market rather than hedge funds leading to more volatility," he said. "For open interest there is only a 9% chance that volatility does not entice hedge funds into the market, whereas there is better than an 86% probability that hedge fund activity or open interest does NOT lead to higher volatility."

Nymex believes that hedge funds serve a "constructive role in our futures markets, and while their participation has not been substantial to date we will nonetheless continue to monitor it closely," said Steinhause, adding that the exchange intends to release soon a more detailed study of hedge fund participation in gas futures.

Brown-Hruska said the CFTC has been conducting routine surveillance of hedge fund trading for some time and found several other interesting facts about their participation in the gas futures market. "Individual hedge funds' net positions generally are not large compared to total open interest in the futures market," she said. "Most hedge funds normally roll their positions into forward contract months well before expiration... Commission staff has also observed that hedge funds generally seem to trade in the opposite direction from commercial traders." She indicated that these behavioral tendencies should not cause concern, and in fact help support trading by commercial market participants.

She said the CFTC believes it has the tools necessary to monitor trading activity by hedge funds in the futures market. She also noted that hedge funds are routinely tracked using the CFTC's large trader reporting system, which "has not identified these traders as a particular source of concern... The staff is continuing to study hedge fund trading activity in the natural gas market...but at this time does not believe that hedge funds are the major source of price volatility in the natural gas market."

Etsler had expressed concern to Dingell that hedge funds are trading gas futures with no intention of taking delivery of gas, and as a result there have been these "wild" swings in prices to the detriment of traditional gas users.

However, both Brown-Hruska and Wood noted that gas futures are rarely taken to delivery. "Physical delivery usually is not contemplated by either hedgers or speculators in those contracts that provide for physical delivery," said Brown-Hruska. She noted that the purpose of leaving open the possibility of physical delivery is to ensure that gas futures prices converge with physical gas prices.

Wood and Brown-Hruska also both pointed to the inherent supply and demand factors as the likely root causes of market volatility. Brown-Hruska noted that demand has been steadily increasing because gas is an environmentally clean fuel. Meanwhile, the costs of producing gas and of competing fuels have increased.

Wood also noted that "there is little real-time information available on gas production and production potential, or on gas usage or latent demand... In my view, price swings in natural gas markets have been driven by market fundamentals, but these swings may have been exaggerated by the paucity of statistics on gas supply and demand and the over reliance on gas storage as an indicator of supply and demand," he said.

He said FERC has considered requiring daily storage reporting. But if a full picture of national storage inventories is desired, the Commission would face jurisdictional issues over requiring some storage companies, such as local distributors and intrastate pipelines, to report storage data.

Wood also noted that gas price volatility also may increase when traders follow price trends rather than independently verify gas market fundamentals. "This strategy can contribute to prices overshooting levels otherwise indicated by market fundamentals."

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