Back in the 80’s, Olivia Newton-John came out with her hit song Physical, and though tame by today’s standards it was considered avant garde by the standards of AM radio back in the day. Well, the D.C. Circuit Court of Appeals just told the Federal Energy Regulatory Commission to get physical and keep its nose out of the futures markets, but the court’s tune was significantly less romantic than Olivia’s. The case involved Amaranth Advisers, the hedge fund that failed spectacularly in 2006.
Not on the D.C. Court of Appeals
In 2005, Brian Hunter was a natural gas futures trader with Amaranth making more than $100 million a year. The next year Amaranth collapsed after losing more than $6 billion on natural gas trades. In fact, it was J.P. Morgan, Amaranth’s clearing firm, that took Amaranth’s positions in exchange for $2.5 billion. Today he’d probably be called Amaranth’s Calgary Whale, were the company still alive. Every bank and hedge fund should have a whale, just to be sure they lose enough money to make the papers and spark Congressional hearings.
The gist of Hunter’s alleged scheme was to sell as many natural gas futures contracts as he could at the end of the trading day. He hoped to drive the closing price of the futures lower in order to benefit swap positions that Amaranth held.
In 2007, FERC charged Hunter with manipulating natural gas markets and pursued the case until last week, when the D.C. Court of Appeals said that the energy regulatory agency had overstepped its authority. Hunter was a futures trader, not a physical trader.
FERC’s position had at least some support. A futures contract does envision delivery of a set quantity of the physical commodity at the standard delivery location at some point in, well, the future. If you think futures contracts don’t have a connection to the physical markets, just ask any trader who tried to offset a long position with a short for the same delivery month, but hit the “buy” rather than the “sell” button. Far from clearing the position, he wound up with twice as much of the unwanted commodity. In the immortal words of Gomer Pyle, “Surprise, surprise, surprise!”
But the reality is that in an active, heavily traded futures market like natural gas, about 99.99% of the open interest is cleared by the contract’s last trading day with no physical delivery whatsoever. Sure, some hedgers will take delivery under a futures contract, but for the most part the players in the futures market trade the contract, not the commodity.
In the Deutsche Bank case that we previously commented on, the situation was very different. There, Deutsche Bank was manipulating the physical market in order to benefit its separate position on financial transmission rights, and FTR markets are regulated by FERC.
FERC argued that it had jurisdiction over Hunter because his futures trades affected the price of natural gas in the physical markets that FERC oversees.
Well, of course they would. So would the outbreak of war in the Middle East, but I don’t think FERC wants to negotiate an end to the Intifada or try to muzzle Mahmoud I’m-a-Dinner-Jacket.
In an odd twist, the Commodity Futures Trading Commission, which does regulate futures markets, including natural gas futures, intervened in the case on Hunter’s behalf. The CFTC argued that FERC should not be allowed to walk its dog near CFTC’s fire hydrant, and mark for their what should be the CFTC’s regulatory turf. The D.C. Circuit agreed, ruling that FERC did not have jurisdiction to pursue charges against Hunter for his activities in the futures markets.
After the court ruled in Hunter’s favor, his lawyer set a new standard for fatuous attorney statements to the press. He claimed that FERC had been unjustly vilifying his client for years, but in fact it was FERC that had acted outside the law. He forgot to mention that the CFTC is also pursuing charges against Hunter for these same activities, and that its intervention in his client’s case was made not to help his client, but to protect their fire hydrant from FERC’s watering can. Put another way, he might as well have said: “The frying pan has been trying to cook my client for seven years, but it was really the frying pan that was acting outside the law. We are pleased with the Court of Appeals decision, and my client is now securely in the fire.”
Energy Law, Policy and Development 