New CFTC Rules May Be a Boon to Commodity-Related Stocks and ETFs

Saturday’s Wall Street Journal carried a story (subscription required) on the potential for proposed new CFTC rules to restrict issuance of shares of commodity ETFs. The withdrawal of earlier grants of rule exemptions has already led certain ETFs to suspend new share issuance. As the Journal story notes, this has driven UNG, the natural gas ETF, to trade to a 16% premium to net asset value.

There is clearly an increased focus at the CFTC in protecting market integrity through the imposition of position limits, rules which restrict the amount of interest in a market for any non-commercial entity. To date, most of the truly effective ways of implementing this (e.g., extending the restrictions to the OTC swap market and international regulatory coordination) are still on the drawing board. However, if the CFTC does move forward in this direction there will be significant investment implications.

While the Wall Street Journal focused on the loss of investment opportunities, this is not necessarily so. From a trading perspective, demand for a commodity ETF whose new issuance has become restricted might offer existing shareholders the opportunity for valuation expansion similar to what has already happened with UNG. But such premiums are fickle and fleeting. Investors with long memories may recall the spectacular valuation expansion of the closed-end Germany fund whose market price soared to double its net asset value in early 1990 in the wake of the fall of the Berlin Wall. Then, as likely now, such premiums are unsustainable as lookalike products flood the market with new supply, or investors assess the risks created by such premiums. For ETFs this is particularly problematic, since one of the key selling points of this structure is the elimination of discount/premium valuation worries.

The most likely long-term outcome of any robust CFTC position limits will be a reevaluation of the entire commodity-as-asset-class story at both the retail and institutional levels. As noted in an earlier post, this has always been a suspect concept, more a creation of Wall Street’s salesmanship than reality. Those same product pushers are likely to rediscover that which has always been true — certain commodity related equities offer similar or superior portfolio characteristics to the underlying commodities.

In this regulatory scenario, we may well witness a surge of interest in commodity related equities, assuming of course that the bullish case for commodity prices (primarily emerging market demand and weak dollar) remains intact. Morgan Stanley already created an index of 20 commodity related equities: AA, ABX, ADM, APA, APC, BHI, BHP, CAG, DVN, FCX, GG, HES, IP, MRO, NEM, POT, SLB, TSN, WY, X. Such names may benefit not only from generic interest in commodity related equities, but from specific products, yet-to-be-created, that are linked to this or similar indices.

Interest in energy-linked stocks both on individual merit and as part of packaged index vehicles may well lead the way. Contrary to the claims of the marketers of futures-linked product, energy stock indices correlate well to energy prices, provided you use the right index, such as the Dow Jones U.S. Oil Equipment, Services & Distribution Index. Another index that correlates well to energy prices, the Dow Jones U.S. Oil & Gas Producers Index already has an ETF, IEO.

Strict CFTC limits will indeed close off some avenues for investors. Those funds have been sitting in markets ill-designed for such purposes (see the dangers of this here). However, this will also open the door for inflows into appropriate vehicles in the equity markets, which were designed for just such investments. Investors who can look beyond any new restrictions will recognize some new opportunities.

Full Disclosure: Neither the author nor his clients have any direct positions in the securities mentioned in this piece. Both may or may not indirectly hold these securities through third-party managers.

Comments

[apppro:]

ALL ETF's, not just commodity related ones have not accomplished their initial intention: to act like a mutual fund, but with day-long access and liquidity.
Add to this the horrible abuse by some short funds and the manipulation of the 'ultra' funds has created an industry that desperately needs adjustment.

Why not just try to get all these ETF's BACK to what they were supposed to be and to mimic a mutual fund:

1. Have the ETF's trade on 20 MINUTE DEALYED quotes.
2. Can't buy at open. Starts trading at 9:40.
3. Absolutely NO premarket.
4. All trades after 3:40 are market on close orders.
Just to suggest a few.

Aug 25 07:14 AM

[a guy in Ch...:]

I never understood the appeal of commodity ETFs over commodity futures. Futures have good liquidity, longer trading hours, there are no restrictions on short sales. Most trading is on the screen now, and you can trade a broader variety of markets than the ETFs cover. It's a matter of educating yourself.

Aug 25 09:45 AM

[Kinabalu:]

"The most likely long-term outcome of any robust CFTC position limits will be a reevaluation of the entire commodity-as-asset-class story at both the retail and institutional levels."

This would be a, most definitely, favorable outcome. The only losers would be the dealers that are pitching assets allocations of as high as 20% for commodities, a non-earning asset that only realizes any value in its ultimate consumption.

Aug 25 02:13 PM

[The Greates...:]

It is like the Fox watching the hen house.

Aug 25 02:24 PM

[Kinabalu:]

Just read the authors linked post at Inefficient Frontiers on The Emperor Losing His Clothes and agree 100%. It's an excellent and succinct description of the problems of Commodities-as-an-Asse...

inefficientfrontiers.w.../

Aug 25 02:25 PM

[The Greates...:]

We can all blame Phil Graham with the Commodity Futures Modernization Act passed in 2001. That 262-page bill led to the Enron mess, the sub-prime lending disaster, and opened the door to the “Dark Energy” speculation trading.
For some good reading on this subject check out this site.
Global Research.
www.globalresearch.ca/...

Also read more about it at this site:
losangeles.injuryboard...

Aug 25 03:05 PM

[The Greates...:]

Here are a few fun facts:
By 2008, a barrel of oil was traded 27 times, on average, before it was actually delivered and consumed.
To see how your Representative is doing in relation to Oil and gas lobbyist in 2009, go to
www.opensecrets.org/in...
The current level of employment in the United States has now returned to the levels of June 2000. Enough said.
There are more apartments for rent today then in the last 20 years.
America is losing about 450,000 jobs a month.
American families are putting school supplies on lay-way.
Earlier this week, the U.S. government reported that crude in storage, which had been building for weeks, fell by a surprising 8.4 million barrels as refiners cut back on petroleum imports. Crude prices jumped sharply.
Not because of any recovery, and Congress needs term limits.

Aug 25 03:14 PM

[Pi106:]

The world and most of you folks have gone quite mad.
Now we are to believe that commodities are not an asset class?
Commodities are of course, the original asset class.
From the first storage of grain by farmers, agricultural commodities and their trading for gold are the origin of human commerce and storage of wealth.

Aug 25 05:22 PM

[Value Added:]

CFTC limits make sense to protect businesses that depend on physical commodities, to protect them from manipulation. Nevertheless, since I'm currently holding a few commodity ETFs, my feelings are somewhat conflicted - I'll be glad to see the premium kick that will occur if/when stricter limits are imposed, yet I won't like being closed out of other ETFs that I might find appealing at a later time. Nevertheless, for the sake of protecting genuine commerce, I am in favor of *some* limits being strengthened.

Aug 27 07:05 AM

[CC_Gold:]

Let's use GLD and SLV as an example. Do you really think they actually hold all the physical Silver and Gold that they claim? Look at the COT report. The commercials hold an unprecedented, concentrated short position. What are the commercials really hedging? FRN notes?

Aug 27 08:00 AM

[djj420:]

I've used this strategy for some time. IYM or XLB gives you a basket of mostly non-energy materials companies. The choices for ETF's of energy-related companies are virtually endless.

Aug 27 08:15 AM