NEW YORK (MarketWatch) -- Goldman Sachs Group, already under fire for reaping record trading profits in the aftermath of the financial crisis, is now fighting to defend one of its biggest sources of revenue -- commodities trading -- with regulators considering setting limits on Wall Street speculators.

Representatives of the firm, along with those of other big investment banks, are scheduled to appear at a series of hearings held by the Commodity Futures Trading Commission starting Tuesday -- part of the Obama administration's biggest move yet to clamp down on commodities speculation, which has roiled the prices of everything from oil to corn and wheat in recent years.

At issue for Goldman Sachs GS, +2.32% is a major exemption it enjoys from limits on trading in certain types of agricultural commodities. Such an exemption is usually reserved for traders classified as "hedgers," such as farmers or food producers who depend on stable prices for their businesses.

Goldman opened the door for investment banks to apply for a similar status when it won the first exemption 18 years ago to help its big institutional clients in commodity-index trading, or investment in a range of commodities by tracking a major index.

The result, according to some members of Congress, has been a surge in all commodity speculation in the past few years, pushing oil prices near $150 a barrel and gold prices above $1,000 an ounce.

Speculators' index trading is "creating price disruptions for producers and consumers," said Sen. Carl Levin, D-Mich., late last month after the release of a 247-page report documenting how index traders have made large purchases on the wheat-futures market in Chicago and pushed up futures prices over the past few years.

It's time for regulators to "change course, rein in commodity index traders and clamp down on excessive speculation that is disrupting commodity prices," he added.

Besides considering removal of the special exemption, the CFTC, the U.S. futures market regulator, is also thinking of adopting position limits on all commodities, not just in agriculture. The move could curb the growth of some major commodity exchange-traded funds.

The CFTC "must seriously consider setting strict position limits in the energy market," said CFTC Chairman Gary Gensler, who worked for Goldman for nearly 20 years before being confirmed in May as the new head of the CFTC. He added that he has called his staff to research and outline "every authority available to the agency" to protect the markets and the public." See related story.

The commission has planned to hold three hearings, including the one Tuesday. Representatives from Goldman and J.P Morgan Chase & Co. JPM, +1.01% , the two biggest holders of derivative assets, are scheduled to attend the second hearing on Wednesday.

“ Goldman opened the door for investment banks when it won the first exemption 18 years ago to help its institutional clients in commodity-index trading. ”

'Unintended' consequences

Goldman argues that any new limits will severely impact liquidity in commodities markets, hurting both large and small investors by reducing their access to these markets. The bank derives almost half of its revenue from trading commodities, currencies and bonds. (It doesn't break out commodities by themselves.)

"Attempts to regulate volatility have rarely -- if ever -- succeeded," said Steven Strongin, a Goldman managing director, in testimony delivered last week to a Senate committee regarding Levin's wheat report. "Yet they often have unintended and significant consequences."

Brad Hintz, analyst at Sanford C. Bernstein & Co., estimated that commodities trading accounts for about 8% to 9% of Goldman's revenue. While the percentage is not as big as fixed-income trading, it's an important sector for Goldman because "there are only a handful of major players."

"It's a powerful, powerful piece of the firm," said Hintz.

The CFTC's rule-making process is still in its early stages, and it's not clear whether the hearings will ultimately lead to the adoption of new rules. Michael Duvally, a spokesman for Goldman Sachs, declined to comment.

At the crux of the debate are the so-called commodity index investments, the total value of which has been estimated by MarketWatch at about $150 billion. See earlier story on the analysis.

The business started in 1991, when Goldman advised a big pension fund to invest $100 million in commodities by tracking the widely followed GSCI, as the Goldman Sachs Commodity Index has come to be known.

The swap

The investment was essentially a bet on the index: If the index rose, Goldman would be required to make payments to the pension fund. To protect itself against the risk, Goldman, through its commodities-trading arm J. Aron & Co., planned to establish similar buying positions in commodities futures markets.

If commodity prices rose, Goldman's gain in futures markets would offset the payments it had to make to the pension fund.

The so-called swap plan had a major obstacle. Federal rules limit the number of positions a trader can take in some agriculture commodities, such as corn, wheat and soybeans.

While no limits were set in other commodities, the agricultural limits would sabotage the whole swap plan, since index investment covers a range of commodities and a limit in one represents a limit in the whole investment plan.

J. Aron applied for exemption, arguing that the firm should not be treated as a speculator but as a "bona fide hedger" -- a classification usually reserved for farmers, processors or food producers who enter the futures market to hedge their risks in physical commodities trading.

The CFTC, in a letter to J. Aron dated Oct. 18, 1991, granted J. Aron the exemption. A copy of the letter was obtained by MarketWatch. See the CFTC letter.

Similar exemptions were granted to other swap dealers, most of them big investment companies.

With the help of swap dealers, more institutional investors have diversified their portfolios into commodities to hedge against inflation and a weaker dollar. Their positions have grown so large that legislators and analysts said the trend was pushing commodity prices to levels that couldn't be justified by fundamentals. See earlier story on passive investment.

In a statement released earlier this month, CFTC Chairman Gensler said the agency is considering "applying position limits consistently across all markets and participants, including index traders and managers of exchange-traded funds."

Goldman's Strongin, in testimony before Levin, said passive investment in commodity markets is "a crucial source" of market liquidity, and it was "inappropriately characterized as speculators with no real economic interest in these markets."

Strongin, who had served as a member of the policy committee for the GSCI index, said index investors "rarely invest based on short-term speculative market views" and "aim to earn a reasonable long-run return."

Setting limits

While the CFTC is considering withdrawing the exemption, it's also considering whether to expand speculation limits to cover all commodity futures, such as oil, metals and natural gas.

Such limits in all commodities could pose another blow to Goldman, which makes billions of dollars in direct commodities trading.

Goldman's revenues in fixed income, currency and commodities trading stood at $6.8 billion in the quarter ended in June, or nearly 50% of the quarter's total revenue.

Setting rules on commodities speculation is "certainly not good news for Goldman," according to Jeffery Harte, analyst at Sandler O'Neill. "But the devil is in the details. How are you going to specifically define speculators? We just don't know yet."

The impact of expanding speculative limits to all commodities would jeopardize the unlimited access to futures markets that some popular commodity exchange-traded funds now have. The United States Oil Fund USO, +2.23% and the United States Natural Gas Fund UNG, +0.54% , the two biggest energy ETFs, hold significant positions in energy futures.

Putting position limits on energy futures could also hamper the ability of producers and refiners to hedge their risks. Energy users and retailers sometimes go to a swap dealer to make customized trades, instead of using a standardized futures market. The swap dealer will then go to the futures market to hedge its own risk.

"I will be concerned about artificially limiting the size of positions," said Jeffrey Mayer, chief executive manager of MXenergy, one of the biggest independent retailers of natural gas in the U.S. "The CFTC should make sure all positions are reported and the categories be broken down more carefully to sort out speculators from commercial hedging interest."

The CFTC had said it will enhance its weekly Commitments of Traders report to separate and categorize swap dealers. The improved COT report also will distinguish professionally managed market positions, such as those of hedge funds.