A new wind will start blowing in the US energy derivatives market later this year, when the Commodity Futures Trading Commission is expected to announce position limits and set a date for their implementation. But so far, no one knows how cold that wind will feel, or in what direction it will drive the market.
The Wall Street Reform and Consumer Protection Act, signed into law in July, hammered home the CFTC’s responsibility to set energy position limits, a job hitherto delegated to the exchanges. But the details of the limits are still anything but clear.
As many contacted for this article acknowledged, including those for and against limits, it is only when the full terms are known that the impact can be gauged.
Fears that CFTC position limits will drive the US energy markets overseas are probably vastly overblown. But at least one foreign exchange is watching the limits carefully, and depending on what is decided, may position itself to siphon business away from CME Group’s New York Mercantile Exchange.
Alain Miquelon, president of the Montreal Exchange, told FOW that US position limits could have an impact on what contracts it decides to launch. “The details announced in the US will play a role in deciphering where we put our focus,” he said. “Right now, we are waiting to see how the regulations pan out.”
On June 18, Montreal Exchange launched Canadian Heavy Crude Oil Differential Price Futures, known as WCH. They are designed to help customers hedge the risk involved in buying and selling Canadian-produced heavy crude, a newer blend that is different from traditional crude and therefore priced differently. “Heavy crude is traditionally priced at a discount to WTI, so the WCH allows the producer and the other interested players to hedge that differential,” says Miquelon.
Any future moves by Montreal to list futures on broader North American oil or gas types could also be influenced by the CME’s decision to step on to its territory. The CME launched a Canadian Heavy Crude Oil (Net Energy) Index Futures contract (WCC) in late July.
Part of the attraction for rival exchanges is that the CME’s crude oil derivatives have had a busy year so far. The Nymex Light Sweet Crude Oil contract (WTI) had a record trading day in April.
“The return to activity in many of the energy derivatives, including oil and gas, is driven by the need to hedge risk in the marketplace. So as price volatility returns, so does the need for hedging against that price volatility,” says Joe Raia, CME’s managing director of energy and metals products and services.
Walter Zimmermann, chief technical analyst at United-Icap, energy analysis arm of the interdealer broker, gives a different reason. Participants who stopped trading the sector after the financial crisis are coming back to the fold, he says. “Before hedge funds were hit during the financial crisis and many shut down, they had been one of the biggest sources of growth in energy derivatives for some years.”
Gas guzzlers lose their appetite
Natural gas futures traders have been shocked by a recent shake-up in market fundamentals, leading to partial backwardation.
Contracts for August delivery were priced higher than those for September – a pattern that goes against the grain. Now, October futures are trading around the same price as September contracts – not higher, as is usual.
Richard Goozee, a natural gas trader at New York-based Arctos Capital, says these shifts signal a deep-seated change. “The end of summer is when people usually inject increased amounts of natural gas into storage, but this year they are not – even though storage is by no means full,” he says. “The only explanation is that the long term demand outlook is drastically lower than what was expected.”
According to form, natural gas futures should be getting a lot more expensive at this point in the calendar, but instead, cash and futures prices are falling rapidly. “Right now, people are delivering natural gas for a price much lower than what they sold futures contracts for through August,” says Goozee. ‘They obviously do not believe that the prices will go back up before delivery in the winter months.”
The US Energy Information Administration reports a weakening of the natural gas storage curve in the last couple of months – a weakening that is expected to continue.
Antoine Halff, head of energy research at Newedge, believes natural gas fundamentals have changed in a way that is likely to keep futures prices at moderate to low levels, by historical standards.
“For many years, conventional wisdom was that US domestic production was declining and that consumption was increasing. But those two assumptions have been overturned in the last few years,” says Halff.
Just a couple of years ago, people were trying to work out how many terminals the US needed for importing liquefied natural gas. Dozens of projects were on the board. Now it turns out that the country doesn’t need any liquefied natural gas, says Halff.
Even with a serious upswing in the economy, the outlook for natural gas will be the same. “While oil derivatives have sewn their fate to the stockmarket, rising and falling as if in tandem, the price of natural gas derivatives have the burden of fundamental oversupply and a changing industry to overcome,” says Walter Zimmermann, chief technical analyst at United-Icap in Jersey City. “It would take one heck of an upsurge in the economy to be able to absorb the gas coming to the market.”
According to Antoine Halff, the head of energy research at Newedge in New York, it is not only pre-crisis participants that are stimulating activity in oil derivatives, but pre-crisis issues. “In oil in particular, fears of runaway demand and supply constraints, which were popular themes through to July 2008, have reasserted themselves in the market this year,” says Halff. But, he points out: “There is a lot more supply than a lot of people expected while the recovery in demand is not as compelling.”
As participants return to oil derivatives markets, established exchanges are seeking to protect their market share.
In an April letter to David Stawick, secretary of the CFTC, CME Group’s chief executive Craig Donohue points out that “no other foreign jurisdiction has demonstrated an intention to impose position limits”.
The exchange believes its self-imposed caps on positions are already very restrictive. “We have a lot of experience managing position limits against our futures contracts and our OTC contracts,” says Raia.
Many argue that the government is always the last ambulance on the scene of the accident, and that position limits should not be the prime concern in an economy where the recovery is stalling.
“Nevertheless, with or without position limits, if someone wants to put on a big position, they are going to find a way to do it, even if it means going outside the US-based commodity exchanges,” says Zimmermann.
A multipolar world
Already, several exchanges around the world have dipped their toes into the oil and gas market, providing new variety to firms wanting to hedge prices or speculate on them. And for most of these, the game is not about sucking business away from New York or London, but creating new activity.
Among them are the Dubai Mercantile Exchange, with its Oman Crude Oil Futures, and the Dubai Gold and Commodities Exchange, which lists WTI and Brent Crude Futures.
At the end of August they will be joined by the Singapore Mercantile Exchange, offering Brent in euros and WTI in dollars. Also preparing to launch is Hong Kong Mercantile Exchange, which plans to list jet fuel futures (see separate article on Asian commodity trading).
The DME, which is regulated by the Dubai Financial Services Authority, outsources its clearing to CME ClearPort, and therefore abides by US position reporting requirements.
Even though there would appear to be no requirement for a Dubai-regulated exchange to comply with US position limits, any advantage from ignoring them would be negligible, says Thomas Leaver, the DME’s chief executive.
Oman Crude, the largest physically delivered oil contract in the world, differs substantially from futures at the CME and ICE Futures Europe, not only in its delivery but also because it caters specifically to those wanting to mitigate risk associated with oil and its producers east of the Suez canal, says Leaver.
“There will be no advantage to us if the US imposes position limits because we offer a relatively specific product that is not in direct competition with other contracts offered elsewhere,” he says.
The DME has slated four more oil derivatives for launch later this year: Oman Calendar Swap, Brent-Oman Calendar Swap, Oman Average Price Option and Oman European Style Option.
Similarly, Eric Hasham, chief executive of DGCX, says that his exchange is not trying to win clients away from markets in the US or around the world, but simply to cater to the substantial demand in the Middle East. Currently, almost 85% of the exchange’s volume is from the region, with participants from Europe running a distant second.
Halff at Newedge believes that, whether or not some US trading ends up moving offshore to escape positions limits, there is anyway a significant need for more oil derivatives to be brought to market.
“The rise of new markets will create arbitrage opportunities that will not undermine the existing contracts, but create new strategies,” he says. “As new oil blends come on to the market and regional demand in places like China continues to grow, people will want to be able to reduce the associated risk.”
Encouraging words for those new and start-up exchanges – and for traders, wherever they are.