Commodities Boom... and Bust?

June 2008 Salvatore Ruscitti

he doubling of oil prices in the past year has seemingly defied logic. The most commonly offered explanation for rising oil prices is one of demand outstripping supply. However, rising demand from countries like China is hardly a new concept. Chinese oil consumption has surely not doubled in the past year. Subsidized oil, another popular explanation, has also been around for a while. With regards to the supply side of the equation, high oil prices are slowly beginning to prompt producers to increase production. For instance, new capacity from Saudi Arabia is expected to come on line shortly as are new refineries. O.P.E.C. has been adamant that the oil markets are well supplied. Strangely, the spike in oil prices has occurred despite expectations for slower global economic growth and rising future production, with the latter albeit at a diminished pace than in previous oil price cycles.

If supply is not the issue and demand does not fit with a near tripling of prices in the past five years, what is going on? The oil markets and commodity prices in general are likely being distorted by increasing exposure to these assets by institutional investors. We are not focused on the hedge fund community here but rather on pension funds, endowments, and other institutional investors allocating funds to commodity index replication strategies based on the Goldman Sachs Commodity Index or the Dow Jones-A.I.G. Commodity Index.

In recent years, it has become increasingly common for institutional investors to hold a portion of their portfolios in commodities as a means of achieving diversification and hedging against the risk of inflation. These investors and the consultants who advise them have come to view commodities as a separate asset class because they tend to be inversely correlated to equity markets. Investors who decide to allocate a percentage of their portfolio to commodities do so by investing in a commodity index replication fund, which in turn goes out and buys commodity futures. These replication funds have in effect become major new buyers of commodity contracts on futures markets over the last couple of years.

According to a recent study by Masters Capital Management LLC, assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March of this year. During that period, the prices for the 25 commodities that comprise the above noted indices have risen by an average of 183%. Demand from commodity index replicators differs significantly from traditional commodity speculators in that it is not sensitive to price. These are purely portfolio allocation decisions based on investment committee and pension consultant recommendations for asset class diversification. Moreover, commodity index replicators never sell. They buy futures and roll the positions. In fact, as their portfolios grow in size, they need to buy more futures contracts to maintain their relative allocation proportions.

In 2004, the average daily dollar value of open interest for all 25 index commodities was $180 billion. Positions from commodity index replicators accounted for $25 billion or 14% of the total market. This year, the average daily dollar value of open interest for these 25 commodities has reached nearly $700 billion. In just the first 52 trading days of this year, it is estimated that index replicators poured $55 billion into the market or just over $1 billion per day. At this rate, index replicators will account for almost 40% of open interest or nearly as many commodity contracts as real buyers and sellers.

These developments will ultimately catch the attention of regulators and government officials. In fact, we expect that we will begin to see policy responses shortly. Aside from the obvious economic consequences of high food and energy prices, there are important human tolls around the world in less developed countries.

Free market proponents will bristle at the notion of tighter regulations in the commodity futures markets. They should take some time to look at how the growing institutional demand for index products has distorted price discovery in a number of commodities.

The futures markets were originally intended to allow buyers and sellers the opportunity to hedge the price of underlying commodities. Today, however, many buyers and sellers are being shut out of the market. As more money has flowed into commodity futures contracts, volatility has increased, thereby raising the cost of hedging. For example, in the corn market, the cost to hedge the price on a delivery of corn for the end of the year is three times higher than it was one year ago. The result is that traditional hedging market participants such as farmers and grain handlers have stopped using the futures market to hedge pricing. Consequently, these parties are finding it increasingly difficult to protect themselves against potential losses.

In the oil markets, speculative action is also squeezing refining margins to the point where processing crude has become uneconomic for refiners. Crack spreads or the theoretical margin earned by a refiner compressed to nearly zero for a brief period a couple of months ago. Can you imagine the value of a processed product being equal to or less than the value of a crude product? Is it any wonder why refiners are pushing back O.P.E.C. to not supply more oil or why refinery capacity utilization as per the weekly petroleum industry reports is running at such low levels?

To make matters worse, consider that the Commodity Futures Trading Commission (C.F.T.C.) several years ago granted swap dealers like investment banks an exemption from speculative position limits which were put in place to prevent speculators from roiling the markets. Banks are exempted from position limits when they hedge over-the-counter swap transactions, effectively creating a loophole for unlimited speculation. Under the current rules, a large institutional investor wanting to achieve exposure to a particular commodity can do so by entering into a swap transaction with a bank. The bank can then turn around and buy the position in the underlying commodity without transgressing the position limit.

If these types of speculators are so involved in the commodity markets why does this not show up in the C.F.T.C.’s weekly Commitment of Traders Report? According to the C.F.T.C., all index speculators accessing the commodities market through the above swaps loophole are categorized as "commercial" instead of "non-commercial" (i.e. speculators). It is estimated that approximately 85-90% of index speculators access the commodity markets through commodity index swaps.

The issue of commodities speculation is not to be taken lightly because of the way in which futures markets work. Unlike stocks, commodities have no income stream, and hence no intrinsic value per se. The value of a stock is based on the future cash flows generated by the underlying business over many years discounted to the present. We are not suggesting that stocks always trade this way, but at least there is a guidepost or a concept of intrinsic value. With oil, for instance, what is the intrinsic value of a barrel of petrol? It could be $10 or $1000. Who is to say? It is determined by how much buyers are willing to bid it up and how much sellers are willing to offer it for. Theoretically, there is no limit. This, by the way, is why most successful commodity investors are trend followers.

In recent months, the buyers of oil in the futures markets have been overwhelming the sellers. This is what makes commodities speculation so dangerous, compromising not just the properly functioning of the marketplace, but also in the process threatening economic health. Oil at these levels is an absolute killer for the economy. It is a zero sum game!

The tripling of oil prices in the past five years has occurred with little impact on the global economy. This fact has rendered many observers complacent about its potential negative drag on growth. Such complacency is misplaced. Unlike at any moment in the past five years, the global economy has been substantially weakened by credit market losses. As a result, it has become much more vulnerable to energy and food price shocks.

Inflation is normally a lagging variable and as such it should moderate as prices catch up to slower global growth. However, if speculation is allowed to drive oil prices to $150 or even $200 per barrel, then all bets are off. The equity market has recently begun to exhibit concern about the consequences of spiking oil prices. This is not surprising given that inflation has a tendency to compress stock market multiples.

Extreme price volatility in the commodity markets has already begun to mobilize lawmakers and regulators into reining in speculation. Recently, Congress and the C.F.T.C. have heard complaints from various market participants. Legislation tightening oversight of commodities trading is in the works. The C.F.T.C. has committed to review trader reporting and classification and is co-operating with non-U.S. exchanges to monitor large non-commercial positions. In short, the pressure to take action is mounting. There is little choice. With worldwide institutional assets approaching $29 trillion, and pension consultants regularly advocating allocations of between 5% and 10% to commodity assets, commodity index replication could eventually top $1 trillion. This type of buying power could easily drive commodity prices higher, thus further disconnecting from the fundamentals.

Whether from a stronger U.S. dollar, slackening global demand or tougher legislation, the headwinds against higher commodity prices are beginning to stiffen at a time when the consensus has accepted that higher food and energy prices are here to stay. On the policy front, we would look for two important changes. First, is the implementation of more strict margin requirements for futures contracts, thus making speculation more costly for market participants. The current margin requirement for an oil futures contract is approximately 7%. This means that a large speculative fund can achieve almost $3 billion of notional exposure to crude with just $200 million (provided of course that the fund is deemed to have sufficient liquidity to meet margin calls). Second, is the elimination, in whole or in part, of the above noted swaps loophole. U.S. regulators have already been blindsided by the use of financial swaps in the housing debacle. We doubt that they will want to be seen as letting another swaps market grow uncontrollably during their watch, especially as this one has more direct economic linkages via higher food and energy prices.

We have been experiencing parabolic moves in many commodity prices. To be sure, the developing world is growing rapidly and for several years the resources sector was starved of capital, thus not enabling a more rapid supply-side response to the recent expansion in global demand. However, there are no fundamentals that can justify the recent price action in commodity markets. At the end of last year, the New York Mercantile Exchange reported a 25% increase in the daily volume of contracts versus 2006. In January of this year, volumes increased 6% over January 2007. In February, the year-over-year increase was 28%; by March, it had surged to 62%! This is the kind of data that has all the earmarks of big institutional money flows!