by Tom Bower
At a meeting with Rubin and Greenspan, Born was surprised when Rubin opposed her proposal. Under pressure from Wall Street, the traders and energy companies, especially Enron, Rubin insisted that the OTC market only existed because of the 1993 relaxation, and the CFTC was rightly denied any legal authority. Born disagreed about the legal nuances. When the two sides parted, Rubin believed he had triumphed. He was wrong. In May, Born issued her “concept release,” recommending control. Rubin’s assistant telephoned her and warned, “Brooksley, the big banks won’t like this.” Alan Greenspan, ideologically committed to free markets, successfully urged Rubin to initiate legislation to prevent Born’s proposed reintroduction of controls. Greenspan’s influence was marginal compared to the intense lobbying of Congress and the administration by John Damgard on behalf of the Futures Industry Association. In September, Born’s premonition of disaster unfolded. Long Term Capital Management, a $4.7 billion fund, famous for employing mathematical geniuses, began crashing, notionally owing $1.5 trillion after reckless speculation on OTC financial derivatives. Ignoring the threat this posed to financial stability, Congress passed Rubin’s legislation in October 1998. In June 1999 Born retired. “She just asked questions,” observed one of her critics, “and she was crushed.” William Rainer, her successor and a financier friend of Clinton’s, was appointed to further reduce the CFTC’s efficacy by removing all jurisdiction over OTCs and to sponsor the Commodity Futures Modernization Act 2000, liberating commodity traders from most meaningful controls. By 2000, the worldwide OTC derivatives market was notionally worth $105 trillion. The agency’s staff was reduced to 500, and its budget cut. Effectively, traders and speculators were handed control of the market.
The new Bush administration’s approval of unregulated OTC trading encouraged the major traders’ desire to trade “swaps” electronically 24 hours a day, a facility Nymex could not provide. Their solution in 2000 was the Intercontinental Exchange (ICE), invented to enable them to trade on their own terms using a computer housed in Atlanta. Authorized by the Commodity Exchange Act, ICE’s traders were required to keep records, but were exempt from the CFTC’s supervision. To guarantee payment and cover any losses, traders deposited funds in a clearinghouse. Every day the clearinghouse collected the “margin” or losses on each contract from the exposed traders. If necessary, the “losing” trader was then required to deposit more money, or to increase the margin call to cover any future loss, protecting both parties from default. Haphazardly, the unregulated OTC market using ICE and the futures trade on Nymex converged, and, unseen, was exploited by Enron’s traders, harming the integrity of the whole market.
The rising price of oil and the ease of investing in it through swaps and ICE attracted the managers of savings and hedge funds, who after 2000 became disenchanted with shares. Oil and other commodities were pounced on as a profitable safe haven against inflation and the weakening dollar. The number of energy hedge funds grew from 180 in 2005 to over 500 in 2006. By 2006, America’s trade in commodities on overseas markets had grown sixfold. “Growth in our industry,” admitted Jeff Sprecher in 2006, “is certainly exceeding the ability of the regulators to get their heads around it.” Since 2000, the volume of commodities trading had risen fivefold, to three billion contracts a year, worth about $145 billion in 2006. The explosion had spawned a hybrid of over 1,000 different types of contracts. The CFTC, unable to supervise the market except notionally to prevent fraud, had ineptly lost a battle to prevent the reduction of its own budget. ICE’s 13 founding members — the banks, oil companies and major traders — were the protectors of the entire OTC market’s integrity. Despite that self-interest, after pushing aside smaller shareholders and buying London’s International Petroleum Exchange, Sprecher lobbied the CFTC in January 2006 to allow ICE to trade oil futures in America from London, although the British FSA and not the CFTC would be the only regulator. The combination of poorly regulated trading in London and the rise of oil prices in April 2006 from $66 to $70 aroused an outcry among some politicians.
Motorists were complaining that prices of gas at the pump had soared — in America again passing $3 a gallon — while the oil majors simultaneously announced record profits and ran a multimillion-dollar advertising campaign in spring 2006 opposing a windfall tax. Even Bush’s administration was uneasy about such contradictions. The previous year Congress had passed the Energy Policy Act, granting oil companies $2 billion in tax breaks to encourage exploration, yet Lee Raymond had received $398 million as a retirement payoff. The latest energy bill, badly drafted and unscrutinized by the politicians, appeared to allow the oil companies to pocket between $7 billion and $28 billion over the following five years by avoiding royalty payments on oil and gas produced in the Gulf of Mexico. Amid renewed suspicions of Big Oil, price gouging and rumors of an impending scandal, Bush urged Congress to revoke the $2 billion allowance. The oil majors were disdainful. Only the independents, anonymous spokesmen sniffed, would need the subsidy. To appease public irritation, on April 25, 2006, Bush announced at the Renewable Fuels Association an instruction to the Justice Department and the CFTC to investigate “illegal price manipulation” by the oil companies. Before either could report, the Senate Permanent Subcommittee on Investigations began examining whether speculators were influencing the steep price increases.
There had been previous well-known conspiracies to control markets. Secret manipulation of vast paper positions by traders had devastated Sumitomo in 1996 and Enron in 2001, while reckless trading had destroyed Metallgesellschaft, Barings bank in 1995 and Long Term Capital in 1998. After each collapse, politicians and regulators spoke of lessons being learned and laws being tightened to prevent a recurrence of the abuses. Experience showed, however, that no regulations could ever prevent questionable speculation, especially if at the time it seemed to be reasonable. Nevertheless, basic facts about oil prices provoked questions. In 1998, oil was $15 a barrel. Since 2000, prices had risen from between $25 and $30 to between $60 and $75. The reason was unclear. Increasing demand had been matched by more production, and 347 million barrels of oil were in storage, an eight-year high. Yet prices continued to rise. The only reason, the committee surmised, was speculation. Over the previous three years, between $100 billion and $120 billion had been invested in energy funds. Oil had become an investment, and like gold, which does not rise in price because jewelers need more of it, oil prices were rising because of hype, political instability and speculators stoking misconceptions, not least about shortages. Philip Verleger, a veteran oil-market expert, compared the 19,624 very-long-term contracts held at the end of July 2001 with the 125,546 very-long-term contracts held at the end of July 2005. The proportion of long-term futures contracts favored by speculators had risen from 4.5 percent to 15 percent of all contracts, which, said Verleger, had added $25 to the price of a barrel. That speculation, he concluded, created additional demand for oil, which the speculators, rather than selling, had placed in storage. Faced with that vicious circle, the Senate committee concluded there was “a need to put the cop back on the beat.” The “cop” was needed because indisputable evidence of manipulation was missing. The committee’s investigators had failed however to prove how speculators had doubled prices. The shortcomings of their report were highlighted in September 2006 by the collapse of Amaranth, a gas trader, after losing $2 billion on mistaken speculation. Throughout their inquiries, the congressional committee’s staff had no inkling that between 2002 and 2005, traders and utility corporations had manipulated the natural gas market by providing false prices to Platts and the National Gas Intelligence; the worst offender was Amaranth.
Amaranth had been founded in 2000 as a routine hedge fund. Investors had received annual returns of up to 29 percent, but in 2004 the fund’s performance dipped to minus 1 percent. In response the managers hired Brian Hunter and other former Enron traders. Overnight the fund became an energy trader, and its fortunes were transformed. Hunter, lauded as “a one-man industry” in a “lops
ided game,” delivered 21 percent profits in his first year, and personally earned about $75 million.
In 2005, in the aftermath of Hurricanes Katrina and Rita, Amaranth traders were betting on continuing gas shortages and price rises. By early 2006 those bets appeared doubtful. January was the warmest on record, and the restoration of oil supplies from the Gulf of Mexico guaranteed ample reserves for the following winter. Amaranth’s traders, using their $8 billion fund, nevertheless continued to bet on a shortage. Tilting the market amid huge volatility, the future price of natural gas rose. Asked for an explanation, officials at Nymex and CFTC denied that speculators were influencing prices or stability. Although five years earlier, in 2000 and 2001, Enron’s traders had created California’s energy crisis by transmitting power out of the state and selling it back to it at higher prices while celebrating the high life in Houston’s steak houses and nightclubs, the regulators assumed that hedge funds made the market transparent and honest. Their complacency was surprising. Usually, any trader dealing over 12,000 natural gas contracts in one month would be subject to investigation; but during 2006 Amaranth held 100,000 short contracts in one month, representing 5 percent of all the natural gas used by the US in a year. The Amaranth fund, owning 75 percent of the outstanding futures contracts for November 2006, dominated the futures market, causing prices to rise. Each variation of 1 cent tipped the company’s profits or losses by $10 million.
In August 2006, the regulators reexamined Amaranth’s activities. Purchasers of natural gas for delivery in winter 2007 were paying high prices although there were ample supplies. Amaranth’s control over the natural gas due to be consumed by American homes in January 2007 had clearly influenced prices. However, rival traders, judging the price to be too high, refused to buy Amaranth’s contracts. After spotting the distortions, Nymex’s officials ordered Amaranth to reduce its stake. The fund obeyed but, unknown to the regulator, after withdrawing from Nymex the fund managers sold 100,000 contracts short on ICE, assuming that the squeeze would push prices higher. By moving from the regulated to the unregulated market beyond Nymex’s supervision, Amaranth’s managers secretly owned about 70 percent of the speculative positions on the market, making them confident that their manipulation would be successful.
In September 2006, although the fundamentals of supply and demand had still not changed, gas prices soared. “Boy, I bet you see some CFTC inquiries,” e-mailed one Amaranth trader to another. “Unless they monitor swaps,” replied the other, “no big deal.” ICE, he knew, was not regulated by the CFTC. Then suddenly the volatility collapsed. The price on Nymex of natural gas for delivery in October had been falling from $8.45 in late July, but the 50 percent crash in September, to about $4.80, the lowest “spot” price in two and a half years, was unexpected. Simultaneously, prices for 2007 fell by 75 percent. Brian Hunter and his traders were staggered. Rival traders, they realized, including many from the Enron diaspora, had held back in order to remanipulate the market against Amaranth. Hunter lacked the finance to cover the margin calls, and Amaranth’s portfolio was liquidated. Hunter was again unemployed. American consumers, all of whom had paid too much for natural gas, had been the victims of a squeeze. The culpable included the CFTC’s officials. The report assessing the agency’s antiquated technology, shrinking staff and flat budget condemned “a broken regulatory system that has left our energy markets vulnerable to any trader with sufficient resources to alter energy prices for all market participants.” Four years later, the Federal Energy Regulatory Commission (FERC) castigated Hunter, and the CFTC investigated him and others involved, including Coral Energy Resources, a Houston subsidiary of Shell, for manipulating natural gas prices in 2001–02 by passing false information and dozens of false trade reports to Platts about prices in the western USA. Five other traders were fined, and one was convicted of manipulation of prices in Houston in November 2007.
The regulators’ fumbling was exacerbated by the discovery during those same months that officials in the federal Department of the Interior had concealed their own mistaken payment of billions of dollars to the oil companies. The roots of the duplicity had grown since 1993. To encourage exploration in the Gulf of Mexico, the Clinton administration had granted a tax holiday on the exploration of about 1,000 offshore leases on federal land, especially in the Gulf. By mistake, government officials had omitted the right to levy royalties on oil extracted from those areas. Oil companies, silently noting the error, were not incentivized by Clinton’s tax holiday, but relished pumping oil and natural gas from federal land without paying royalties. In 2000, federal officials spotted their blunder but made no public announcement. Instead, they quietly inserted royalty payments into future leases, to be paid when oil hit $34 per barrel. In 2004 oil prices passed that mark, but the department’s officials again failed to charge royalties, and the historic oversight remained unrevealed. Johnnie Burton, the female director of the Minerals Management Service, was told about the lapse, but, it was later revealed in an official Department of the Interior report, “did not remember putting a great deal of thought into the matter.” By 2006, $65 billion of oil and natural gas had been produced without any royalties being paid. Inquiries into her department revealed that unqualified officials, using inaccurate data supplied by the oil companies, had tolerated cronyism and cover-ups of major blunders. Those investigating what Bobby Maxwell, the Department of the Interior’s auditor, called the “underpayments and outright cheating by companies that drill on property owned by the American public,” estimated in 2006 that the corrupt relationship between the department and the oil companies had cost the US government as much as $10 billion over five years. While BP and Shell volunteered to repay the royalties, Exxon insisted on abiding by the law, and refused.
Exxon’s defiance was followed by that of Anadarko, an independent oil company that had bought Kerr-McGee, the initiator of the action against the government. In successive trials and appeals in 2008 and 2009, judges in Louisiana decided that, despite the politicians’ claims, the law did not authorize the Department of the Interior to collect royalties on the oil.
Bobby Maxwell alleged that the law had been undermined by corruption among government officials. Senior officials, he said, had blocked his attempts to recover hundreds of millions of dollars, ordering, “Don’t bother the oil companies.” Those officials, said Maxwell, enjoyed consultancy deals with the oil companies or romantic relationships with their employees. Politicians searching for other evidence of price manipulation in late 2006 were frustrated by dishonest government officials and by ineffective CFTC staff, still hampered by the restrictions imposed by Clinton’s legislation in 2000. Their anger was somewhat assuaged by the CFTC accusing Marathon Oil of manipulating WTI prices at Cushing on November 26, 2003. Traders were always subject to scrutiny as to whether they had influenced the prices on Nymex by controlling the amount of oil being sold from the storage tanks in Cushing. On that occasion Marathon’s directors were baffled by the CFTC’s accusations. Marathon Oil, like BP and Shell, had lost money in the Platts “window” — the thirty minutes of trading to set prices — on that day. Careful scrutiny of the trades, confirmed by Platts, suggested that Marathon was innocent. But sensing that the CFTC needed a scalp, Marathon paid $1 million to get rid of the issue, exciting a residue of anger and “paranoia” about the government. Marathon was a minnow compared to BP, America’s most powerful oil trader. In that year, the annual value of global oil transactions — physical, futures and OTC — was estimated to be $40 trillion. The key benchmark was the price of WTI in Cushing, which still appeared to be dominated by BP. There was a hunger among lawmakers and their agencies in New York and Washington to find a culprit.
Vulnerable after the disasters in Texas City and Alaska, BP’s managers did not welcome the congressional reexamination of an incident that had taken place in 2002. The allegation was that prices had risen in New York Harbor because BP refused to supply additional oil down the pipeline from Cushing — a classic
squeeze. In its defense, BP explained that in a tight market, the corporation was obliged to supply existing customers despite others suffering expensive pain, and dismissed any notion of squeezing the market. In 2003, after investigating the OTC trades on that day and BP’s management of the oil in its storage tanks, Nymex’s regulators had concluded that BP had probably manipulated prices in so-called “roundtrip trading” or “wash” trades and swaps for WTI futures contracts on crude on 10 occasions. BP was fined $2.5 million without admitting liability. After further investigation, the CFTC discovered that on six occasions between April and June 2000 a BP trader in Houston had executed prearranged trades at identical prices on an electronic exchange and then neutralized the sales by executing identical trades. The purpose of these so-called “wash sales” had been to fix a recorded price in the market to influence the payment of a real contract. BP was fined $100,000. In November 2006 the CFTC reopened the New York Harbor case, and warned BP it was taking action about the trade of gasoline futures contracts in 2002. The scope of the investigation increased after congressmen discovered that the CFTC had completed an investigation of BP’s manipulation of the market in propane, a heating gas widely used in rural American homes.
Based in Houston, BP’s propane traders under Cody Claborn operated independently of the oil traders in Chicago. Claborn and Mark Radley, his senior dealer, had plotted during 2003 to corner the market by buying more propane than would be produced for delivery in February 2004. On January 8, 2004, Radley told his subordinates that propane was “vulnerable to a squeeze.” On January 13 he repeated that the market was “tight enough that if someone wanted to play games with it, potentially they could.” Under Radley’s direction, BP bought excessive amounts of propane, but to his misfortune, at the beginning of February the market turned. Supplies of propane increased, and Radley noted that “prices have been dropping like a stone.” Potentially, BP was losing money. To rescue the company’s position, Radley ordered BP’s traders to buy as much propane as possible. His intention was to create a shortage on the market, keep the price high and force other traders (who were “short”) to pay excessive rates to BP for propane to fulfill their own contracts. In the event, as fast as his traders bought propane, warm weather was reducing prices. Concerned that prices would fall further, Radley ordered his traders to buy yet more gas. Across the industry, BP’s bid to squeeze the market became common gossip, and was reported in trade newspapers. By February 24, the squeeze was working: despite rising prices, rival dealers started buying. On March 1, the buying stopped. Prices slumped, and did not recover. BP’s losses were not revealed.