Regulators need to weigh impact on oil market liquidity

TOKYO Fri Feb 26, 2010 5:47am EST

TOKYO (Reuters) - Regulators would have to walk a fine line between increasing oversight of oil markets and making new rules so tough they chase investors away, the IEA and a Japanese government-affiliated energy agency said on Friday.

U.S. regulators want the right to peer harder at often opaque energy markets, part of broader reform moves after the financial crisis sparked a global recession and brought Wall Street into the political spotlight.

"There is a very fine balance to be struck by regulators between the need to take measures preventing manipulation and not choking off liquidity in markets," David Fyfe, head of the oil industry and markets division at the IEA, told a two-day oil forum in Tokyo.

The U.S. Congress was expected to pass a regulatory reform bill this year that would include giving the top futures watchdog the Commodities and Futures Trading Commission (CFTC) clout to regulate the $300 billion U.S. over-the-counter (OTC) swaps market, CFTC Commissioner Scott O'Malia said on Thursday.

But if energy market regulation was too tight it could backfire, deterring companies from hedging their oil exposure and send investment elsewhere.

Liquidity and the ability to manage risk "could be impaired if incoming regulation is applied in too stringent a manner," the IEA and the Institute of Energy Economics Japan cautioned in a joint statement after a closed-door workshop on oil price formation on Thursday.

O'Malia was aware of the risk, and said on Thursday he wanted to keep markets liquid. The U.S. was talking to other regulatory bodies worldwide to prevent investors simply moving money from tightly regulated exchanges to those with looser rules, he said.

"We just hope that regulation will create good conditions for operators to invest," said Dario Speranza, vice president of strategies and development at Italy's ENI (ENI.MI).

Some blamed excessive speculation for oil's climb to above $147 in 2008 and subsequent five-month slide of over $110, while others pointed to lack of spare capacity and tight supply.

The CFTC aims to limit the size of the bets that investors can take in the oil market in an effort to rein in speculation.

"There is always a risk that not getting the regulatory balance right removes participants who have added liquidity and that may reduce some of the future oil industry investment by making it harder to hedge," said Lawrence Eagles, global head of commodities research at J.P. Morgan.

ECONOMY

The biggest challenge to the oil market this year would be the economy's performance, Eagles said.

"It is impossible to say with certainty how long the global economic recovery will continue," he said. "The length of the business cycle and how strong the upswing will be depends on yet-to-be -made political decisions."

The strength of oil demand depends on the speed of recovery.

The end of huge global stimulus packages enacted by governments worldwide was a potential risk to demand growth, the IEA's head Nobuo Tanaka told Reuters.

Tanaka said there was more risk on the downside for oil demand in 2010 than on the upside.

In its monthly report in February, the IEA forecast oil demand would grow by 1.6 million bpd this year, the first expansion in three years, as the economy recovered. But slower economic growth could lop 400,000 bpd off demand, the IEA said.

Volatility could return to oil markets this year if growth eats into spare capacity, Tanaka said.

Uncertainty over future environmental policy could add to future volatility as oil producers were left second-guessing how much future demand would grow, he said. This made it difficult for producers to plan the huge investments needed in expanding capacity.

"It is very difficult to map out a clear and certain path for the market due to the uncertainty of economic growth and of polices," he said.

While regulators attempt to shine a spotlight into oil markets to dampen volatility, forum participants said another area needing illumination was data on supply and demand from emerging markets.

Emerging economies would pass industrialized nations in demand growth mid-decade, Tanaka said. Yet data from many emerging countries were incomplete, he added, making it difficult to accurately gauge supply and demand.

"Better data is a tool against volatility," said Paul Horsnell, head of commodities research at Barclays Capital. "But of course it does not necessarily mean low prices. It can mean you realize how strong demand is."

(Additional reporting by Osamu Tsukimori and James Topham; Editing by Chikako Mogi and Ramthan Hussain)