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 trading.
(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 report:

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.