HardAssetsInvestor

Written by Lara Crigger  |

October 01, 2009

Craig Pirrong: Argument For Position Limits 'Nonexistent'

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When it comes to increased regulation of the commodities market, this University of Houston finance professor and derivatives expert is not a fan.

• Blaming speculators is nothing new
• Will position limits reduce volatility?
• The coming ex-U.S. exodus

 

The Commodity Futures Trading Commission isn't expected to deliver its final verdict on new position limits and other market restrictions until later this month, but already we've seen plenty of reaction, including DXO's liquidation and the development of new indices.

Expect it to continue, says Dr. Craig Pirrong, professor of finance for the University of Houston and Energy Markets Director for the school's Global Energy Management Institute. A highly regarded expert in derivatives and the commodities markets, Dr. Pirrong has written three books and a slew of published articles. He regularly shares his thoughts about everything from dark pools to cap-and-trade at his blog, The Streetwise Professor.

Recently, HAI Associate Editor Lara Crigger chatted with Dr. Pirrong about his thoughts on the CFTC's proposed regulations, including why everyone blames the speculators, whether position limits can reduce volatility and why tighter regulations will just send investors overseas.

 

Lara Crigger (associate editor, HardAssetsInvestor.com (Crigger): Let's start with a biggie: Do you think that speculators are to blame for last year's run-up in energy prices?f

Dr. Craig Pirrong, finance professor, University of Houston (Pirrong): No. It's just a little issue relating to theory and evidence. It's very difficult to see how market participants who aren't accumulating the physical commodity, or who are trading using cash-settled contracts, are injecting any real demand into the marketplace that could cause price distortion. Maybe it could be the case, if someone were doing what the Hunts did in silver in 1979-1980: as in, actually accumulating and hoarding huge amounts of a physical commodity, and keeping it off the market. Then speculative activity could cause prices to be higher. But I've looked at a variety of markets-copper, in particular-where the periods of price spike correspond with substantial drawdowns in inventory. So this possible speculation story doesn't appear to be consistent with the evidence.

I talked about this on my site recently: People look at the Commitments of Traders reports, and see that there's a positive correlation between changes in noncommercial open interest and changes in prices, like oil or copper. So they say, "Aha! Speculators are having an impact!" But you can look at the period of the price run-up in the late 2007-2008 time frame, and examine the evolution of speculator positions and see how much of the price impact we can attribute to speculators. Well, ballpark figures: Prices went up about 100% from Q3 07 to July 2008; essentially about 2% of that could be attributed to speculators.

So there's neither the theoretical nor the quantitative data to support all these wild claims about the impacts of speculators.

Crigger: So why do you think speculators have become such a scapegoat in the political discussion over this?

Pirrong: Well, I guess I'd quarrel with the words "have become." It suggests that this is a new development. The fact is, speculators have been the bogeymen for a very long time. There are some parts in Adam Smith's "Wealth of Nations" where he compares attitudes and laws against speculators in the 1600s and 1700s to the same kinds of actions taken against witches. So this is a hardy, perennial piece of argument that has been around for a long period of time. It's just that people are always looking for a scapegoat.

I mean, if we knew what the "right price" should be, we wouldn't need markets, now would we? But people look at high prices and say, "Gee, I don't like this; who can I blame?" And we can't blame the virtuous farmer, or the poor airline that's hedging its fuel prices. The natural scapegoat is the speculator.

Crigger: What's your opinion on the CFTC's proposed position limits in the energy markets?

Pirrong: Well, there are different kinds of position limits. For example, position limits like what the Chicago Board of Trade has on its Treasury futures, that apply from the last 10 days of an expiring contract-well, I'm not wild about those, but at least you can argue they're addressing a potential real problem. They're addressing that which would be a real manipulation, a corner or "squeeze" in the marketplace.

Other kinds of position limits intended to tamp down on "excessive speculation"-in particular, those being considered by the CFTC-in my view, are wholly misguided. The intellectual foundations for imposing them, as we've just discussed, are nonexistent.

What's more, they can interfere with the proper operation of the market. These are risk-transfer markets: You have people who want to get rid of risk, and speculators who want to take it on. These are transactions between consenting adults. Position limits essentially interfere with that risk transfer function, leading to higher costs for some hedgers. In my view, they're generally detrimental to the functioning of the market.