Energy Markets: Insufficiently Regulated

Why regulate markets? In the case of the stock market, the answer is that retail

investors – what you might call low-net-worth individuals – have

their livelihood at stake, and don’t have remotely the same amount of sophistication

as the big players in the market. As a result, regulations help to ensure that

small shareholders don’t get taken unfair advantage of.

In other markets, however, such as credit default swaps and foreign exchange,

there are few if any small investors. Everything that happens is transacted

between consenting adults, as it were: sophisticated investors walking in to

a deal with their eyes open. So in these markets, there’s much less regulation.

Which brings us, finally, to the energy markets. Here, there’s a lot more tension.

On the one hand, there are no small investors in these markets, which means

that there’s a prima facie case to keep them only lightly regulated.

On the other hand, these markets directly affect energy prices, and energy prices

directly affect not only investors but all Americans. As California saw when

Enron was manipulating the market, unregulated traders can cause huge amounts

of pain to millions of individuals who have no direct market exposure whatsoever.

Which brings us to the report

of the Senate Investigations Committee into the Amaranth affair. Amaranth was

trading on exchanges which were either lightly regulated (NYMEX) or completely

unregulated (ICE). Here’s one of the Senate report’s conclusions:

(3) Amaranth’s actions in causing significant price movements in the

natural gas market demonstrate that excessive speculation distorts prices,

increases volatility, and increases costs and risks for natural gas consumers,

such as utilities, who ultimately pass on inflated costs to their customers.

(a) Purchasers of natural gas during the summer of 2006 for delivery in the

following winter months paid inflated prices due to Amaranth’s speculative


(b) Many of these inflated costs were passed on to consumers, including residential

users who paid higher home heating bills.

According to Ann

Davis in the WSJ, Amaranth has already seen and responded to the Senate


Amaranth released a critique of the Senate report by Chicago economic consultancy

Lexecon Inc., saying the statistical analysis was "based on spurious

correlations and incomplete data analyses" and failed to establish that

Amaranth was the cause of the big price moves. Amaranth also said it didn’t

"dominate" or "distort" natural-gas trading, that many

economists reject the theory that speculators can control prices, and its

closure occurred without major repercussions in the broader markets.

This is less than compelling. "Many economists" don’t set prices;

the markets do. And markets can be manipulated, at least in the short term,

even if in the long term the speculators tend to lose out, as Amaranth found

to its own cost.

It’s true that Amranth’s closure, in a market awash in liquidity, had no systemic

repercussions. On the other hand, in a more bearish environment things might

have been very different. And in any case Amaranth had already manipulated energy

prices by that point, and consumers had seen higher energy bills than would

otherwise have been the case.

So I’m inclined to side with the Senate on this one. Markets don’t always need

to be tightly regulated. But when traders at hedge funds can make billions of

dollars essentially by artificially increasing the energy bills of the rest

of us, there’s a strong case that regulators should step in.

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