ETF/ETN Investors Have To Watch CFTC Speculation/Limitation Rules (USO, UNG, GAZ, OIL, JJC, GLD)

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We are witnessing a pivotal moment in investing history.  After a decade of opening up all markets to the public and to more speculators with exchange traded products, some might soon be closed to speculators and investors alike.  If these markets are not closed off to the bulk of the public and investors and speculators, the writing on the wall is as obnoxious as street punk graffiti that access might become limited.  For better or worse, speculators are likely going to have a harder time.  This week marks a review by the Commodity Futures Trading Commission that could have a broad impact on exchange traded funds and exchange traded notes.  The exchange traded funds and exchange traded notes which track energy are the United States Oil (NYSE: USO) and the United States Natural Gas (NYSE: UNG).

iPath DJ AIG Natural Gas Total Return Sub-Index ETN (NYSE: GAZ) is one we do not cover as frequently because of its volume. It seeks the returns potentially available through an unleveraged investment in the futures contracts on physical commodities comprising the index plus the rate of interest that could be earned on cash collateral invested in specified T-Bills. The index includes the Henry Hub Natural Gas futures contract traded on the NYMEX.  iPath S&P GSCI Crude Oil Total Return Index ETN (NYSE: OIL) is another one we do not cover as much because of its volume. This ETN seeks returns that are potentially available through an unleveraged investment in the West Texas Intermediate crude oil futures contract plus the T-Bill rate of interest that could be earned on funds committed to the trading of the underlying contracts.

iPath DJ AIG Copper TR Sub-Index ETN (NYSE: JJC) is not in energy, but it invests primarily in copper contracts and instruments that hopefully mirror the price of copper.  But do you expect that if regulation goes into curbing energy prices that the same effort would not be applied to metals and other inflationary hard goods?

The SPDR Gold Shares (NYSE: GLD) actually buys and sells gold bullion.  It is so large that it holds more gold than many large nations hold in reserves.  We could cover grains and other hard and soft goods as well.  The list almost feels endless.

I recently noted that some ETFs and ETNs might be forced to either close or adjust their scope like a closed-end structure, and part of this could include changing to a closed-end fund status.  That could create inefficiencies, but it would still be better than investors having no access at all.  It seems unlikely that the regulators would systematically begin shutting down ETFs and ETNs, but we could easily see these forced to some sort of closed-end or size-limit structure.  This will seem like heresy to some and mother’s milk to others.

The CFTC noted that it is directed to “ensure the fair, open and efficient functioning of futures markets.”  CFTC Chairman Gary Gensler has asked his staff to present all available regulatory options to carry out the CFTC duties and said, “My firm belief is that we must aggressively use all existing authorities to ensure market integrity.” The result is a series of hearings during July and August that will include input from consumers, businesses and market participants to determine how the CFTC should use its existing authorities to accomplish its mission.

The first hearing will focus on whether federal speculative limits should be set by the CFTC to all commodities of finite supply, in particular energy commodities.  Yep, that is crude oil, heating oil, natural gas, gasoline and other energy products. This is said to also include a careful review of the appropriateness of exemptions from these limits for various types of market participants.  Do not expect this to stop there.

This is stated…… The Commodity Exchange Act states that the CFTC shall impose limits on trading and positions as necessary to eliminate, diminish or prevent the undue burdens on interstate commerce that may result from excessive speculation. The CFTC currently sets and ensures adherence to position limits with respect to certain agriculture products, but not for energy markets where futures exchanges set position limits and accountability levels.

If you think the ETF’s or ETN’s are immune, they are not… The Commission will be seeking views on applying position limits consistently across all markets and participants, including index traders and managers of Exchange Traded Funds (ETFs); whether such limits would enhance market integrity and efficiency; whether the CFTC needs additional authority to fully accomplish these goals; and, how the Commission should determine appropriate levels for each market.

At the end of the day, many people hate speculators.  Many speculators hate other speculators.  But doing away with speculators entirely would be a cardinal sin to the markets.  We won’t bother calling these free markets any longer, but this would represent a sin if the CFTC decided to take this one to the strongest degree. Fortunately, it seems unlikely that the strongest form of regulation would occur.

Last summer, oil was trading at ridiculous premiums.  The speculators said they had no part in the price.  It may take another half-decade before someone can prove in a quantified amount by how much speculators (and commodity pools and funds that held public retirement funds) added to the price of oil.  It is hard to quantify, but it was obvious as a heart attack that it was there.  In retrospect, it is even more obvious.

In early March, the stock market was in free-fall and the edge of the abyss was very close.  The economy was shut down, the debt markets were shut off to companies large and small, and there was enough panic in the public investors that selling was just the norm.  And the mood and outlook, we’ll just remind you about how firearm sales and buying of silver of gold was becoming common.  But that first week in March when the meltdown was coming, that was speculators throwing the money in with the bet that finally enough was enough.  There was government help to the capital structure of course, but that was money from hedge funds, millionaires, and the public looking at DJIA components and major S&P components finally buying up stocks at prices not seen in a decade or longer.  Call it what you will, but speculators saved the market then.

Again, change here looks more likely than ever.  Speculators are not evil in general.  Public pension funds from states, counties, and municipalities were investors in commodities through last year’s peak.  Eliminating them entirely doesn’t seem fair either.  But eliminating speculators in the entirety would be a move that goes above and beyond a normal market.

Jon C. Ogg
July 7, 2009