Speculation in the natural gas market

January 29, 2009 by Andrew Soto · 2 Comments, leave one of your own
Filed under: energy

Energy market speculation remains an area of concern. On January 22, I participated in a teleseminar sponsored by the National Regulatory Research Institute discussing speculation in commodity markets, and whether speculation was a cause of the significant price increases in the natural gas market experienced last spring and summer. The main feature of the seminar was a paper written by Ken Costello entitled, “Speculation in the Natural Gas Market: What It Is and What It Isn’t; When It’s Good and When It’s Bad.” All in all, the paper did a very good job of describing a complex issue, and properly focused on the potential for investment capital to flow into commodity markets in ways that adversely impact consumers, businesses and financial markets.

In general, commodity consumers should be protected from harmful price movements that may be caused when investment capital flows into commodity markets in ways that produce prices untethered to supply and demand fundamentals. However, efforts to prevent those kinds of capital flows should not result in “good” speculators exiting the financial markets in ways that impair the efficient functioning of the financial markets. Follows is an overview of my remarks.

Microsoft Word - Speculation Paper Printable Final 11-6-08.doc Natural gas consumers have, on balance, benefited and continue to benefit from competitive wholesale natural gas markets. Gas utilities purchasing on behalf of natural gas consumers have an interest in making sure that both physical and financial markets for natural gas are efficient and deliver the benefits of competition to natural gas consumers. Physical wholesale natural gas markets should be workably competitive and produce accurate price signals that reflect not only the momentary balancing of supply and demand but also long term investments costs for the production, transportation and storage infrastructure needed to bring gas supplies to market. Financial markets should allow gas utilities to hedge their gas procurement costs to reduce the impact of price volatility on customers. Both physical and financial markets should be sufficiently liquid with geographically diverse counterparties, transparent as to price formation and risk allocation, and free from manipulation and the sustained exercise of market power.

When capital flows into commodity financial markets in sufficient quantities that result in prices that are untethered to the underlying fundamental supply-demand balance or long-term infrastructure costs (whether it’s speculative bubbles or herd mentality), markets eventually correct such flows. However, these events can adversely affect consumers, businesses and financial markets. The concern is not so much that investors should be protected from the adverse impacts of the bursting of a bubble they helped to create. Rather, the concern is that commodity consumers should be protected from significant and harmful price movements that may be caused when capital flows in ways that do not reflect the momentary balancing of supply and demand or the long-term infrastructure costs needed to bring supplies to market.

That said, the prescription for protecting commodity consumers should not itself have an adverse impact on the efficient operation of physical or financial markets. We have all seen well-intentioned legislative and regulatory initiatives to correct certain market flaws succumb to the law of unintended consequences in ways that adversely impact consumers. With regard to speculation, efforts to prevent the kinds of capital flows that generate harmful price movements should not result in so many “good” speculators exiting the financial markets that the remaining potential counterparties are able to exercise market power or that the cost of hedging becomes unreasonable thus raising prices to consumers or exposing consumers to greater price volatility.

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2 Comments on Speculation in the natural gas market

Rick Weiss on Tue, 3rd Feb 2009 9:47 am

There is a simple cure for excessive speculation in all commodity and derivative markets: federal sales tax on the contract value. Commodity markets are currently line energy systems made of all springs and no dampers. A sales tax is like a friction damper on market oscillations. Folks wanting to hedge physical delivery or receipt will not be substantially affected by paying a couple of percent sales tax. Speculators jumping in and out of the market a thousand times on sentiment will find sales tax may make their activity much less profitable. Bonus value: reduce the federal deficit. Don’t regulate the market: tax it!

Andrew Soto on Tue, 3rd Feb 2009 10:11 am

One of the concerns that I expressed in my remarks is that the remedy should not itself have an adverse impact on the efficient operation of physical or financial markets. A sales tax on hedging transactions in the financial markets may substantially, and adversely, affect natural gas consumers. A tax could either raise the cost of hedging transactions and thus increase the cost to consumers or deter utilities from engaging in hedging transactions thus potentially exposing consumers to greater price volatility. I agree that a tax would have a greater impact on “speculators jumping in and out of the market a thousand times on sentiment,” but I remain generally skeptical that taxes are the right answer. “The power to tax is the power to destroy.” – John Marshall.