An early June edition of the German newsweekly Der Spiegel said it all: “Angriff auf den Wohlstand – Attack on our Wealth and Well-Being,” and below that: “How speculators are making life ever more expensive.” Illustrating the story: a two-page image of the CME Group’s trading floor, and the following explainer: “After high-tech shares and real estate debt, the hoards of speculators have discovered the commodities market. Their billions have pushed prices to astronomical levels, with grave consequences for the lives of men and the global economy.”
The sentiment was echoed by India’s ruling socialist government, which promptly banned four more futures contracts in June, bringing to eight the number of products that can neither be hedged nor speculated there.
Indeed, every nation on earth seems to be responding to a different aspect of the global commodities bull market. In the United States, the focus is on oil, while in the developing world, it’s on food. And the culprits vary as well. For some, it’s speculation itself; for others, it’s the new-fangled long-only index funds; and for still others, it’s misguided government policy. Somewhere in there, you find references to supply and demand and the weak dollar.
THE FUNDAMENTALS
In testimony before the U.S. Congress, Daniel Yergin was among those emphasizing the underlying economy. The author of “The Prize” and chairman of Cambridge Energy Research Associates, he presented some fairly straightforward math.
“In the five years between 1998 and 2002, world oil demand grew at an average annual rate of 1.1%, for a total absolute growth of 4.2 million barrels per day,” he said. “In the five years between 2003 and 2007, world oil demand grew at 2.1%, for a total absolute growth of 8.2 million barrels per day.”
And suppliers, be they drillers or refiners, have not been able to get up to speed. “As a result, the balance between supply and demand has tightened,” he says. “One major reason for the slow supply response is limitations around the world on access to areas for development. A second is uncertainty about investment, fiscal and regulatory regimes. Both of these are global questions. So is the third reason: the shortage of people, equipment, skills and commodities.”
SCAPEGOAT OR CAUSE?
The U.S. Senate has been trying to take it all in – a bit too theatrically for some. When former psychiatrist Henry Jarecki (see Trader Profile) watches the endless hearings, he recalls something doctors wrote on prescriptions: “UAF.” It stood for “ut aliquot fiat,” or “in order that something be done.”
“If it was colorful medicine, you would write ‘UAFV,’ or ut aliquot fiat videatur, ‘in order that it be seen that something is being done,’” he says. “That meant you would do something dramatic for that purpose.” And that, he says, is the prescription some members of Congress seem to be following as well. “In reality, you have a whole series of supply shortages and demand increases and they’re going to deal with it by doing something,” he says.
Anne Berg agrees – to a point.
An independent consultant and former director of the Chicago Board of Trade, she says the Senate hearings are a bit heavy on posturing, but she doesn’t let speculators off the hook. Instead, she says unchecked and poorly regulated speculation is just one of many distortive forces driving markets higher than they would go if supply and demand were the only factors, but that government efforts to rectify those forces often create more distortion. She points out, for example, that India, Pakistan, Ukraine and Kazakhstan banned the export of domestic wheat in the past year, and Russia imposed a 50% tariff on its own wheat products being shipped out of the country; all in an effort to keep supplies high and prices low at home. Those measures worked, but they also reduced local farmers’ incentive to plant food crops and created a concentration of demand in the global reference price.
“Demand got funneled into the U.S.,” she says. “That put the price
on fire.”
Then, as African governments sought to protect their consumers from high prices, they also reduced the incentive for their farmers to meet demand. Interestingly, the UN’s Food and Agriculture Organization, not always perceived as a great proponent of free markets, has been one of the few entities to avoid speculator bashing. And, in the United States, there’s the new Energy Bill and its effort to promote the use of biofuels.
“The mandated diversion of foodstuffs into fuel bears an eerie similarity to Mao Zedong’s directive to farmers during the late 1950s to build backyard pig-iron furnaces across China’s agricultural regions,” says Berg. “The Great Leap Forward turned farmland into steel mills, and 20 million people died.”
“Once the government steps in, they bollocks things up so badly you can’t see straight,” says Berg, who points out that the price of rice in India has roughly tripled since India banned futures on rice, wheat, tur and urad early last year. This may be a cautionary tale for U.S. politicians regarding what heavy handed government intervention can do to prices as they demonize speculators. They should take note that rice is not represented in any significant degree in the indexes the offending funds are replicating.
“Wheat production in India has stagnated over the last decade, while their potato production has gone up tenfold in four decades – because potatoes have not been subject to government intervention,” says Berg, lamenting the June decision by the government to ban futures on potatoes, along with chick peas, rubber and refined soya oil.
But it is the U.S. Senate that is getting the bulk of attention stateside, after holding multiple hearings to answer the question: “Are institutional investors contributing to food and energy price inflation?” Among those answering “yes” is Michael W. Masters, who runs the long-short equity hedge fund Masters Capital Management LLC.
“What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: institutional investors,” he told the senators. “Specifically, these are corporate and government pension funds, sovereign wealth funds, university endowments and other institutional investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.”
He pointed to the group that has easily become the most common culprit presented by critics:
THE INDEX INVESTORS
Trillions of investment dollars are looking for a home, and one place they’ve found it is with so-called “index speculators,” who follow a simple strategy. Rather than trying to pick and choose and time their trades and play both sides of the market like commodity trading advisors (CTAs), they make a passive long-only investment in a basket of commodities, in the belief that it will add overall performance and reduce risk.
Such funds took off after the dot-com bubble burst, pushing investors to look for returns non-correlated with equities – and, says Masters, have become virtual hoarders of commodities.
It’s clear that the amount of money allocated to index trading has surged over the past five years – from $13 billion at the end of 2003 to $185 billion as of May, according to S&P GSCI. Masters estimated the size at $260 billion as of the end of the first quarter.
The large divergence in estimates has to do with the recent controversy and the evolution of the indexes themselves that are now being split by individual sectors. One method of measurement is to conduct surveys of industry participants, while Masters uses existing data plus an extrapolation from CFTC data. The CFTC’s Commodity Index Trader (CIT) supplement to its Commitment of Traders report was launched in January 2006, and includes reported positions of index speculators in 12 commodities. Getting an estimate of the entire size of money benchmarked to indexes involves looking at how each commodity is weighted in the various indexes, using the known data from the CIT, and estimating the size of the other (energy) commodities. From there, you can figure out how much open interest on futures exchanges is related to index funds.
“Index speculators have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum,” Masters says. His analogy is somewhat dubious though, as index funds do not hold physical commodities and sell contracts as they enter the spot month.
OVERSTATING THE IMPACT?
As critics like Masters and others called for the CFTC to reel in its controls on speculators, defenders like Barclays Capital say the numbers are being interpreted all wrong.
In a June report entitled “Investment flows: Headlights through the fog,” it said the blame for high commodity prices essentially lies with four factors: surging demand from China and India, supply glitches, geopolitical concerns and the weakness in the U.S. dollar (see “Dollar’s impact”).
Rather than try to extrapolate the size of the market analytically, Barclays (which is a major participant in commodity indexing itself) surveyed industry participants and came up with figures showing indexes with a much smaller share of the overall market than when they attempted to estimate using the CIT data (see “How big are index funds?” ). They say that index investors are buying a less diverse basket of commodities than analysts generally postulate due to the indexes being marketed down to the individual sector, which ends up giving the indexes blame for all commodity price rises, even when participation is limited. They make a solid argument, as six months ago many analysts saw much more upside potential in agricultural markets than energies and metals, which already had seen significant gains.
THE CFTC RESPONDS
Former CFTC Chairman Jim Newsome and current CFTC Acting Chairman Walt Lukken also chimed in. Newsome, who now runs Nymex Holdings Inc., used the chance to once again call for more disclosure of positions held on Nymex’s London competitor, ICE Europe, and Lukken used his chance to reiterate that the CFTC had already reached an agreement with London’s Financial Services Authority (FSA) to get just that and to justify more funding for the CFTC so that it can expand its market surveillance program. He also addressed the difficulty of quantifying the index speculators’ net impact on markets.
“Most (index) investment comes through major Wall Street swap dealers (who) then are exposed to commodity price risk as a result of aggregating these transactions and must utilize the futures markets to manage their own remaining residual risk,” he said. “This ‘netting out’ of risk by swap dealers before coming to the futures markets makes it difficult for regulators to determine the total amount of index trading occurring in the energy markets.” He said the CFTC is in the midst of reviewing data from index dealers and will provide a report to Congress by Sept. 15.
As the idea of investing in commodities has evolved, money began flowing into structured products that can invest at the sector or individual commodity level. And, says Barclays, although the value of money in commodity index products has surged this year, the bulk of that (about 80%) is the result of rising asset values, and not of new money flowing into the market.
What’s more, they say that long-only funds tend to reduce their stakes as values rise to maintain diversity.
OPEN INTEREST AND CASH
And then there’s the core of the debate: to what extent can we equate open interest with a massive cash position?
Barclays finds it dubious to use futures’ market open interest as a proxy of actual size, preferring to compare the size of these funds to the actual cash market and noting that in that light, it is a drop in the bucket (see “Market share”). But Berg, a passionate defender of well-run markets, says index investors can’t be let off the hook completely. She believes the massive open interest positions being rolled forward each month are damaging the markets.
“In the wheat market, the index funds own 40% of the long interest,” she says, citing the CIT report. “They’ve put permanent contango in the market, and we no longer have true price discovery. I know someone who is buying cash wheat at $1.30 below futures and delivering in Chicago – and making a consistent bundle.”
While a growing contango in various markets creates a costly hurdle for these funds, Berg says the situation will not self-correct under current circumstances. Instead of advocating tighter position limits as some have done, however, she believes the exchanges should impose monthly cash settlement or compel any takers of delivery to load the delivery stocks out at expiration instead of rolling the contracts over, a so-called mandatory load-out.
“If someone takes delivery when the futures are at $9 and the best bid they can get in the cash market is $7.60, they won’t do that too often, and the market will converge,” she says. “Or they can settle every month with compulsory load-out, which is what the Indians do.”
Indeed, before the ban India’s futures markets were the envy of the developing world, having been designed to replicate the success of U.S. markets while learning from their mistakes.
HEDGE EXEMPTION
Another sticking point with Berg, Masters and others is the decision to exempt some index funds from speculative position limits. Such limits have been imposed for decades to prevent speculators from cornering or otherwise manipulating a market, but bona fide hedgers are exempt from speculative position limits – and the swaps dealers on the other side of these huge positions qualify as bona fide hedgers based on their short cash positions. The CFTC further granted no-action letters to a couple of index funds and proposed a broader exemption last year, but recently pulled that proposal under increased pressure from Congress. Those no-action letters still are valid however.
Lukken says hedge exemptions aren’t granted across the board, but are instead determined on a case-by-case basis. While the expansion of hedge exemptions directly to index funds has been pulled off the table, notwithstanding the no-action letters, what gives these funds the ability to grow exponentially is a previous CFTC decision that allows a hedge exemption to cash swaps dealers. A reexamination of that decision would probably be more appropriate than some of the draconian measures currently being bandied about Congress.