An Energy Sarbox

The political class needed to blame somebody for the run-up in energy prices, and settled on "speculators" as the designated villains. The mob grew to include everyone from Barack Obama to John McCain, and Bill O'Reilly to Hugo Chávez. Congress held over 40 hearings this summer. It was cynical, sure, but serious people assumed that the politicians were in on the conceit.

Maybe not. While some kind of crackdown on the U.S. oil futures market is inevitable after so much political agitation, Congress has begun to believe its own demagoguery. The Senate may vote on a bill this week that will drive commodities trading overseas and decrease oversight and market transparency. Call it a Sarbanes-Oxley for energy.

Because commodity futures trading is a complex financial instrument, "speculation" makes an expedient scapegoat for edgy lawmakers and even aggrieved industries -- such as the airlines. But it performs a vital price-discovery function. Major energy producers and consumers, such as refiners, buy and sell these contracts to lock in oil at a future price, as a shock absorber against volatility. Essentially, they're bets that reveal market expectations about the supply and demand of oil, as well as the rate of inflation.

Even the title of the Senate's bill -- the "Stop Excessive Energy Speculation Act" -- is idiotic. True, the volume of trading has increased by about sixfold since 2000, but it can't be "excessive." The inviolable law of futures markets is that someone has to take the other side of any option. That is, the value of contracts agreed to by sellers anticipating that prices will fall must equal the value of contracts agreed to by buyers anticipating prices will rise. The overall size of the market is irrelevant.

Nevertheless, Congress's legislation, introduced by Majority Leader Harry Reid, aims to cut down the volume of futures transactions. Instead of merely increasing funding and manpower at the U.S. Commodity Futures Trading Commission, it vastly broadens the CFTC's regulatory purview. It also orders the CFTC to distinguish between "legitimate" and "nonlegitimate" traders. Legitimate firms are those trying to manage their price risks; the nonlegitimate are "speculators" purely in it for the money.

Those that happen to fall in the latter category will face position limits that restrict the contracts they can hold at one time. In the words of Senate ringleader Byron Dorgan, the bill will "wring the speculation out of this market." He's probably right, but that means the bill will drain off liquidity from U.S. futures exchanges.

Traders with exclusively financial purposes take the other side of options when the goals of "legitimate" short and long hedgers don't match up. Arbitrarily discriminating between commercial and financial investors is not only pointless -- price risk is price risk -- but destructive. In an increasingly integrated global marketplace, investment banks and clearing firms will merely do their business through affiliates in London or other less regulated exchanges, in Dubai or elsewhere. So will pension funds and other institutional investors trying to hedge legitimate inflation risks with energy-related contracts. "Legitimate" traders will follow them.

Dick Durbin, Barack Obama, Hillary Clinton and Chuck Schumer -- the home-state Senators of the Chicago Mercantile Exchange and Nymex, respectively -- need to decide if they're going to vote to wound the competitiveness of their shareholder-owned American brokerages. Not to mention the fact that increased foreign trading wouldn't be subject to CFTC scrutiny. Congressional rabble-rousers have exaggerated the problem of "dark" markets, but they certainly seem intent on creating more of them.

Despite the assertions of Mr. Dorgan and the likes of Virgin Islands fund manager Michael Masters, the climb in energy prices has been impelled by the tight margins between world-wide supply and demand, and exacerbated by the Federal Reserve's weak dollar. Congress could avoid blowing up the U.S. futures market by conceding that reality.