All this week, the Commodity Futures Trading Commission (CFTC) has conducted hearings investigating the role of speculation in the energy markets. And while the end results remain to be seen, one thing seems certain: Position limits are coming to an exchange near you - maybe even as early as this fall.

But position limits won't solve a thing, says oil expert Chris Cook. As the former compliance and market supervision director at the International Petroleum Exchange back in the 1990s, Cook is no stranger to market regulation or the often obtuse energy scene. And while many in Washington are pointing their fingers at commodities ETFs, Cook has taken the opposite stance, instead blaming the financial "middlemen," and accusing the market of having become "entirely sociopathic."

Earlier this week, HAI associate editor Lara Crigger chatted with Cook about how to best rein in energy speculation, including the relevance of the Brent Complex, the controversial "hedge exemptions," and the "submarines running the convoys."

Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): Many people in Washington are blaming speculators for the volatility in the energy markets, especially for last year's run-up. So are speculators to blame for high oil prices?

Chris Cook, former IPE compliance director (Cook): I'd say that speculators are to blame, but it depends on how you define "speculator." I don't regard the exchange-traded funds as speculators; I believe the real speculators are the middlemen who buy oil and sell it for profit, or who act as market markers in the derivatives markets with the view of making profits. Now, there's nothing wrong with either of those things, but it is inherently a speculative activity.

Crigger: Who are these middlemen, and how do they influence the markets?

Cook: You've got these financial institutions, the so-called Wall Street refiners, that really got moving in the early 1990s: Goldman Sachs, JP Morgan, Citigroup. Their participation is purely financial, and they're in the market to make a profit. They have a financial interest in volatility, as that's where they make their money. The more volatile the market, the more money they make.

The whole purpose of derivatives markets is to allow producers and consumers to hedge their price risks. Unfortunately, the volatility is so excessive. And it's not generated by the futures exchange. That's a big misconception: The futures exchanges are the visible tail; but the physical market, that's the dog.

That is, an exchange-traded fund is physically unable to make and take delivery. It's only the people who can actually make and take delivery who can affect the physical market price. That's what's being missed here. So the real problem isn't from exchanges. It's from this complex of contracts - the Brent Complex, the BFOE contracts.

Crigger: How do you mean?

Cook: Well, this month there's only something like 53 cargoes coming out of the North Sea for the BFOE. That's worse than it's been in years. So it only takes about $2 billion to buy them all and control them. So for someone like a BP or a Goldman, it doesn't take too many forward contracts to actually support the price.

Crigger: So is the Brent Complex still a relevant benchmark for oil pricing?

Cook: It's better than the alternative. North Sea oil has been in decline since I was on the exchange back in the 1990s. But the same is the case in Dubai and in the States (only worse). So the North Sea is the "less worse" solution.

Back in 2000, U.S. Senator Levin's Subcommittee on Investigations sent two staffers over to interview me about the Brent market. I think that not only should they dig that out again, but that the U.S. Senate and the House of Parliament should do a joint investigation of the Brent Complex.

Because what's going on right now is a waste of everybody's time. It's going nowhere, and if they do manage to limit exchange positions, it's just going to drive away people who should be on it.

Crigger: There was a recent report from the Financial Services Authority [Britain's financial regulatory body] absolving speculators of any blame for the high volatility in oil prices. What are your thoughts on that?

Cook: I think it comes back to defining what we mean by "speculators." The funds, the ETFs, the long-only people who've been in there all this time, like GSCI - those guys are not like the hedge funds. They're people who are genuinely interested in hedging inflation; they're prepared to take on energy risk and offload the risk of holding money, because they think money will depreciate.

To me, that's not speculation. That's the opposite of speculation. The true speculators are the middlemen who operate in the physical market. They're the ones causing the volatility.

Crigger: So if financial intermediaries are the ones setting oil prices, does that negate the effects of supply and demand?

Cook: Don't get me wrong: In the long term, supply and demand will set the market price. At the end of the day, you've always got producers selling and customers buying. So if the price goes high enough, demand destruction does set in, in the medium to long term.

But in the short term, like last year, we saw a bubble. Like all bubbles, it was driven by gearing, or borrowing by derivatives. My theory is that, over quite a few years, the bubble inflated through a lot of hype, by the likes of Goldman and others. And the funds came in. But essentially, what was happening was that money was being lent to the producers, who were in turn lending the oil. It sounds very odd to say, but that's what was happening. So the minute people started to pull their money out of the market, the market collapsed.

So we had a spike in volatility caused by speculation. But you're always going to get a reversion to supply and demand in the long and medium term.

Crigger: For years, investment banks like Goldman Sachs have operated free of trading limits. Should they be allowed to keep these hedge exemptions?

Cook: No, because what are they hedging? They're hedging a bet. It's not like they're hedging physical production, because they aren't producers. So, they're bringing onto the exchange this off-exchange risk. But it's still risk. It's a risk transfer mechanism, sure, but you've got to actually understand what the risk is in the first place.

BP and Shell have a nice big balance sheet. Not much risk there. But we've already seen what happened to Goldman's balance sheet, with the money markets going sour. I don't think people realize quite what could happen if they bring all these off-exchange contracts on exchange. It just concentrates more of the risk into a single point of failure.

Really, it shouldn't come as a surprise if the investment banks are quite happy about position limits on exchanges, because they know it doesn't matter a damn. Better than that, it even drives the big funds off the exchanges and into the OTC swap. It means they're going to make more money off-exchange. So it really suits them to operate that way. It might sound counterintuitive, but that's how it is.

Crigger: Should there be trading limits put in place for commodities?

Cook: For six years, I managed a gas oil deliverable contract, and I can tell you we never thought once about having position limits, because they're a total waste of time-in the energy market.

It's different in the metals markets or the grain markets, because what it comes down to is securing supply. Position limits in those markets have a role to play.

But a speculator cannot secure supply in the oil market without participating in the Brent Complex. And in some cases, like electricity - well, you can't store that at all. And natural gas isn't easy, either. Anything that's not storable, or where there isn't much storage, with position limits, you're pretty much wasting your time.

Crigger: Should ETFs have as large a role as they do in the energy markets?

Cook: ETFs are big, to be sure. They provide liquidity where it's needed. And provided an ETF can trade directly with a producer, they're both happy. They don't particularly want middlemen to get involved, because they're quite happy with the prices that they get.

Quite frankly, I think that's what the market is for: transferring the risk between someone who, long term, wants to offload it, and someone who, long term, wants to take it. It's the difference between investment and speculation. ETFs are more investment; they're not just looking for a transaction, whereas the speculators are looking for a transaction profit.

Crigger: So in your opinion, what can be done to restore sanity in the energy markets?

Cook: Within the conventional market structure, I don't think anything can be done. It's beyond help. Let me use an analogy: An investment bank is a little like a submarine. It's a beautiful piece of engineering, but its purpose is to sink ships, or in this case, make profit. And you don't let the submarines run the convoy. But that's what's going on. The submarines are running the convoys.

These guys do have a role to play as service providers. In my opinion, the market should be in the hands of consumers and the producers, with the middlemen acting as service providers. That's the architecture I'd like to see.

A good starting point would be to simply set up a global registry of transactions, so that every transaction, both on and off an exchange, should be registered with a database or a custodian somewhere. Then it would be available for regulators to look at, if they want to. It's a practical starting point, and a simple one too.