Speculators Driving Up Commodity Prices? Hardly

By Matthew Hougan

The push to shut institutional investors out of the commodities market reminds me of the short-lived proposal for a gas tax holiday.

Remember that gem? Hillary Clinton and John McCain were going to fight high oil prices by eliminating the federal tax on gasoline. Because lowering the price of something always helps lower demand, right?

Ain't politics grand...

The flaws in Senator Lieberman's argument that commodity index funds are to blame for rising commodity prices are many, but let's start with this one: prices for commodities without an active futures market are rising faster than prices with an active futures market. Steel is the key example, but rice, potash and a dozen other commodities make the case too.

Remember that index funds holding commodity futures add nothing to demand for the physical commodity. They never take physical delivery - they simply roll their contracts forward each month. That may drive up the price for commodity futures, but for the underlying commodity, I'm not so sure. If I buy a lot of futures on General Electric, does that drive up the price of the stock?

In the end, it's supply and demand that matters.

Having said that, there are places where commodity investors are having a real impact on prices. Gold bullion is one example: the SPDR Gold Fund (GLD) holds $18 billion of gold bullion in a vault, mostly bought over the past two years. The ETF has become one of the largest purchasers of gold bullion on the planet, and you can bet that's influencing prices.

Similarly, ETF Securities has a physical platinum ETF in London that is contributing to a tightening of the platinum market worldwide. This situation is exacerbated by supply distributions in Africa, but it's pretty clear that the ETF is playing an important role in the upward movement of platinum prices.

Outside of these physical markets, the evidence that commodity index funds are influencing commodity prices is thin. Maybe on the edges of the agricultural markets ... maybe ... but the impact even there is both small and debatable.

There are two things driving the spike in commodity prices: increased demand from the developing world and the dramatic fall in the U.S. dollar. The solution is to strengthen the dollar, increase supply, develop new alternatives and conserve.

Comments

[Steven Thacker:]

Hold on. Buying futures DOES increase the price of the underlying stock or commodity. Lets say a very rich individual buys many millions of dollars of futures contracts for coffee, causing the price of the future to increase markedly. If there is any significant difference between the current spot price and the future price, then anyone could perform a riskless arbitrage by stockpiling the good or stock now and selling or shorting a futures contract. This would have the effect of increasing current spot price.

2008 Jun 16 03:57 PM

[zenalgorithm:]

So funds which have added almost triple the amount of equity to the entire commodities market, don't have an effect on the price?

Give me a break. The entire U.S. commodities market was smaller than MSFT, GE, or XOM.

The commodities market is broken. It's like putting a Ford Escort engine into a bus and pretending that it's going to keep on trucking.

Goldman is making a killing on rolling contracts through their GSCI index - it amounts to legalized front-running.

2008 Jun 16 03:57 PM

[TA:]

If I was running a large hedge fund, I would pay people to write articles like these to keep the game going as long as possible.

The short covering action in the oil market on June 6th showed the world the power that the huge money pools have over the commodity markets in no uncertain terms. There's no going back now.

2008 Jun 16 04:02 PM

[Francis Sch...:]

A lot of people find it extremely hard to understand the commodity markets are physical markets. Anybody buying a Copper contract, has either to sell it before the expiration date of the contract, or has to take delivery of the goods. For copper bars, I can understand and have known people taking delivery. However, I don't see anybody take delivery of an Oil contract. Assuming somebody would, one would need to have the proper infrastructure to do so. Hence speculators can only play a limited role.

2008 Jun 16 04:22 PM

[zenalgorithm:]

The commodities market is being manipulated and artificially inflated. Why did cotton skyrocket a few months ago - it wasn't supply and demand...?

I believe that the commodities market is a huge bubble that is going to eventually crash, but in the mean time, the manipulation is going to kill a lot of people in the third world. Energy and food can't be allowed to be potentially manipulated, they definitely need to be removed from the indexes and heavily regulated to stop abuses from the investment banks and hedge funds.

2008 Jun 16 04:36 PM

[oil myth:]

This article on bloomberg should dispel any doubts about speculations from the "investment banks".


Goldman, Morgan Stanley Profits Conceal Reliance on Commodities

By Christine Harper

June 16 (Bloomberg) -- On Wall Street, where just about everyone has lost confidence in financial assets, Goldman Sachs Group Inc. and Morgan Stanley are making money the old-fashioned way: Buying and selling commodities.

Goldman and Morgan Stanley are expected by analysts to report the best second-quarter earnings of the world's biggest securities firms this week, having limited their losses from the collapsing credit market. They also lead Wall Street in commodities trading, where crude oil futures doubled in the past year and the price of products from gold to corn soared to record highs.

Surging prices are attracting investors, as well as companies hedging their positions by buying derivatives. That's played to the strength of Goldman and Morgan Stanley, which dominate the market for commodity derivatives. The two New York-based companies accounted for about half of the $15 billion of revenue that the world's 10 largest investment banks generated from commodities last year, said Ethan Ravage, a financial-services industry consultant in San Francisco.

Commodity trading ``is very large for them, and that is even more important now given what's happening with the rest of the businesses,'' said Frank Feenstra, a consultant at Greenwich Associates, the Greenwich, Connecticut-based research firm whose survey last month found Goldman and Morgan Stanley were the preferred dealers of corporate users of commodity derivatives. ``There are more commodities used, more hedging by companies, and the investor population has increased significantly as well.''

Goldman probably will report a 32 percent drop in second- quarter profit tomorrow, and Morgan Stanley may say on June 18 that net income fell 59 percent from a year earlier, according to the average estimate of analysts surveyed by Bloomberg.

Blankfein and Mack

That's relatively good news for Goldman Chief Executive Officer Lloyd Blankfein, 53, and Morgan Stanley CEO John Mack, 63, when compared with the $2.8 billion second-quarter loss reported last week by Lehman Brothers Holdings Inc. Bear Stearns Cos. was forced to sell itself to New York-based JPMorgan Chase & Co., the third-biggest U.S. bank, after almost going bankrupt in March.

``Fixed-income is really, really tough right now,'' said Ralph Cole, a senior vice president of research at Ferguson Wellman Capital Management Inc. in Portland, Oregon, which manages $2.7 billion and holds Goldman shares. ``The two names that had so much trouble were big fixed-income shops, whereas Goldman obviously has commodities.''

Goldman, the only one of the 10 biggest investment banks to show a gain in its stock price last year, fell 17 percent so far in 2008, and Morgan Stanley tumbled 23 percent in New York Stock Exchange composite trading. By contrast, Merrill Lynch & Co. dropped 29 percent and Lehman fell 61 percent.

Commodity Cushion

The earnings declines at Goldman and Morgan Stanley will be driven largely by writedowns of real estate-backed securities and leveraged loans. Goldman probably will take $1.3 billion of such writedowns, and Morgan Stanley may write off $1.6 billion, said David Trone, a New York-based analyst at Fox-Pitt Kelton Cochran Caronia Waller, who has an ``in line'' rating on the companies.

Morgan Stanley has already taken $12.6 billion of such writedowns since the beginning of last year, compared with Goldman's $3 billion, data compiled by Bloomberg show.

Goldman and Morgan Stanley, the two largest U.S. securities firms by market value, don't report commodity revenue separately, lumping it instead into the same line as fixed-income and currency trading. That makes it difficult to assess just how much commodity revenue has cushioned earnings.

Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York, estimates that commodity trading accounts for more than 7 percent of revenue at Goldman and Morgan Stanley. That would have added up to more than $3.2 billion at Goldman last year and $1.9 billion at Morgan Stanley.

`Money Chasing'

Those numbers may be higher this year based on the strength of the markets.

``There's just a lot of money chasing these markets,'' said Peter Fusaro, chairman of New York-based Global Change Associates, which advises hedge funds on energy investments. The number of energy-related hedge funds his company lists has more than tripled to 634 in less than four years.

``I would assume, since those two have stellar people, they're doing phenomenal business now,'' said Fusaro, referring to Goldman and Morgan Stanley.

The Standard & Poor's GSCI Total Return Index, part of a suite of commodity indexes created by Goldman in 1991 and sold to McGraw-Hill Cos.' Standard & Poor's last year, gained 67 percent in the year ended May 30.

Food Prices

Global trading in commodity derivatives on exchanges rose 52 percent to 489 million contracts in the first quarter from a year earlier, according to data compiled by the Bank for International Settlements. Energy and agricultural products led the climb. In the over-the-counter market, the value of outstanding commodity- derivative contracts jumped 26 percent to $9 trillion in December 2007 from a year earlier, the most recent BIS data show.

Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather.

The dominance of Goldman and Morgan Stanley in commodity trading comes as a 60 percent increase in food prices over the past 18 months has sparked riots in 30 countries and as record oil prices have led to hearings in Congress on energy markets.

``We are facing a very dangerous situation caused by these tremendously increasing prices for commodities, food and oil,'' German Finance Minister Peer Steinbrueck told a meeting of executives and government officials in Russia this month.

Soros's View

While supply shortages and rising demand from emerging markets such as China and India account for much of the price gains, money managers such as Michael Masters at Atlanta-based hedge fund Masters Capital Management LLC say financial speculators and a shift of pension fund money to commodities are also responsible.

Billionaire investor George Soros has said commodity prices may be turning into an unsustainable ``bubble.'' Crude oil rose 697 percent since trading at $17.45 a barrel on the New York Mercantile Exchange in November 2001. That surpasses the 640 percent gain in the Nasdaq Composite Index before a reversal in technology stocks in March 2000 triggered a 78 percent decline.

Goldman's commodity business, J. Aron, dates from its 1898 founding as a coffee-trading company, according to Lisa Endlich's book ``Goldman Sachs: The Culture of Success.'' Goldman purchased the family-owned company in 1981, and the next year the division hired Blankfein, a metals salesman who has since become Goldman's chairman and CEO.

Mortgage Market

Morgan Stanley was founded in 1935 by a group of executives, including the grandson of John Pierpont Morgan, the financier who created the trust that controlled more than half of the U.S. steel market. It didn't get into commodity trading until 1982. Today it owns heating-oil storage terminals, and it bought fuel- distribution company TransMontaigne Inc. in 2006.

Some doubt that commodities can take the place of businesses like structured credit that are being shunned by investors after mortgage-related assets plummeted.

``It's hard for me to imagine that it could be the same scale of profits as what was being generated in the glory days doing structured credit, but that doesn't mean it's not big,'' said Brian Barish, president of Cambiar Investors LLC in Denver, which manages $8 billion and owns stocks in energy and gold companies instead of investment banking stocks. ``Even if one's made some money in commodities, and maybe a lot of money, it's tended to be overshadowed by problems in fixed-income.''

Risky Business

The commodities business is also risky. Amaranth Advisors LLC collapsed in September 2006 after trader Brian Hunter's natural gas positions lost about $6.6 billion in one month, the biggest loss ever by a hedge fund.

Commodities revenue can swing wildly. Morgan Stanley said in December that its fourth-quarter commodities revenue decreased 84 percent, without providing an actual figure.

The firm's traders were ``badly positioned in electricity, natural gas and oils,'' Chief Financial Officer Colm Kelleher told analysts on a conference call. ``It was poor trading; it is as simple as that.''

In the first quarter, Morgan Stanley said commodities revenue was the second-highest ever at the firm.

Asked last year about competition from Wall Street banks that have been building commodities divisions -- chief among them London-based Barclays Plc and New York-based JPMorgan -- Goldman Chief Financial Officer David Viniar warned about the pitfalls.

``A lot of very smart people have gotten into a lot of trouble or lost a lot of money by getting into the commodities business,'' Viniar said at an investor conference in February 2007. Goldman has a ``long history of watching our competitors get into the commodities business at the top of the market.''

Value-at-Risk

Goldman's value-at-risk in commodity prices, a statistical measure of how much it estimates it could lose in a day of trading, rose to $38 million in the first quarter from $26 million in the prior quarter, the firm reported in March. At the same time, it lowered risk in equities and kept it unchanged in interest rates. Morgan Stanley lifted trading VaR in commodities to $40 million from $34 million, while reducing the risk in equities and currencies, the firm reported.

Isabelle Ealet, a 45-year-old French woman based in London, took over management of Goldman's global commodities business last year. Ealet, who has been a partner at the firm since 2000, has two New York-based deputies: Peter O'Hagan and Jeffrey Resnick. Her business is overseen by four co-heads of global securities trading.

Rise and Fall

John Shapiro, 56, has run Morgan Stanley's commodities trading business from Purchase, New York, since March 2005. Olav Refvik oversees trading of crude and oil products, and Simon Greenshields manages electricity trading.

At New York-based Merrill Lynch, the third-biggest U.S. securities firm after Goldman and Morgan Stanley, President Gregory Fleming said the commodities boom could turn out to mirror the rise and fall of technology stocks in the late 1990s and structured-credit products between 2002 and 2007.

``I'm hearing a lot of talk about supply and demand in commodities is not necessarily what we should be looking at,'' Fleming said in an interview on May 29. ``Boy I've heard that twice before in less than a decade in two different markets.''

To contact the reporter on this story: Christine Harper in New York at [e-mail].

Last Updated: June 15, 2008 19:01 EDT

2008 Jun 16 04:59 PM

[Reinko:]

A lovely article from a dumb writer;

A few years ago the entire corn market could be chocked by only 3 large hedge funds, they did not do it in the past but now conditions are different.

A few years ago worldwide metal markets were nothing but a very average Nasday listing in terms of revenue...

And don't we have the Federal Reserve Bernanke telling explicit to long term investors like pension funds : Cash = Trash?
Because a 2% level is tale telling.....

Do these long term investors like to invest in US treasuaries?????

No, they have their future obligations to the pension folks so the flee these stupid US govenment bonds and invest in that what brings happiness in the short run.

2008 Jun 16 05:05 PM

[alexx:]

This article and many like it notwithstanding, the commodities futures market is BEING manipulated big time, and it has been going on for the past 4 years...the stream of $20-30 billion which became a $260 billion river owes its great success to the criminal negligence of our CFTC which has refused to enforce our nation's laws for the past few years which requires it to intervene in this fast growing casino and impose 50% and 100% margin requirements so that this manipulating money does not get out of control. As a matter of fact, all that is needed to break this bubble which is ruining millions of people and their jobs from airlines to auto plants, is an immediate directive to CFTC to enforce the law.Please remember there is no shortage of commodities (read the EIA.gov website on supplies in years past and now-no appreciable change...only prices are up 500% since 2002) and the only realistic reason for the commodities spiral is the Leverage in their trading. Take that away, this outrageous 20 to1, 30 to 1 leverage, and the bubbles go "pfttt...)All bubbles broke that way...

2008 Jun 16 05:16 PM

[raafat:]

the future market has always been casino speculation .To make it a reasonable investment play the margin requirement have to increase at least to 10% from the actual 3%

2008 Jun 16 05:23 PM

[Reinko:]

Nice info Raafat. 3% of margin call means leverages are above 33.

So it is not like on the currency markets where leverages could be above one thousand...

2008 Jun 16 05:29 PM

[Etf Planet:]

Your reasoning is flawed sir. Here's an example. An institution calls up the USO and wants to put 100B into their fund. USO says OK, and then goes into the market buying futures. No impact you say? Hardly. I understand what you are getting at, these funds dont take delivery, they do have to unload these contracts and roll into the next month, but they're unloaded them at an artificially high price that they influenced when getting in earlier in the month. Next month, repeat.

2008 Jun 16 05:54 PM

[Galex:]

What will happen to spot oil price, if hedge funds buy oil directly from suppliers, and store it somewhere offshore?

2008 Jun 16 06:58 PM

[Waiting for...:]

I agree with alexx... We should demand that the government who is there to protect the people do just that... If the fat cats loose their shirts for gambling then too bad. Win some loose some!!!!

2008 Jun 16 07:43 PM

[bds231:]

"prices for commodities without an active futures market are rising faster than prices with an active futures market. Steel is the key example, but rice, potash and a dozen other commodities make the case too."

This is potentially a very interesting angle. Do you have any data on hand you can share?

2008 Jun 16 09:25 PM

[fxtrader07:]

incredibly dumb article that is short facts and long opinion (which itself is based on thin air only)
many have already pointed out that a surging "paper" demand (e.g. futures contracts) of course do substantially influence the price for the real asset (i.e. the underlying). and 1 billion a day waiting to flow into commodities futures and index funds make for a huge surge in "paper" demand

on the other hand that often claimed "huge growth" in real oil demand by China, India etc. is largely a myth and WAY overblown. we are talking about high relative growth rates (starting from a very low base) which amount to very low growth in absolute terms , when compared to the size of the overall oil market. we are talking about a few hundredthousand barrels a day in a market of 88 million barrels a day! But yeah, right, that 0.5% increase in overall demand fully explains a 100% price increase over just 12 months, doesn't it?
the developed markets' demand is by far the bigger driver.
but of course, it is soo handy and easy to just repeat what is written allover the media everyday about emerging markets' insatiable appetite driving oil opprices higher. Why bother with the facts and the real numbers?

2008 Jun 17 05:50 AM

[junkyarddog:]

The opinions shared here are more educational and informative than the article itself!

Where does Seeking Alpha get such moronic, paid-for, sponsored spin writers? Or do they allow such idiocy to be written just to get readers going?

Matthew Hougan' article above is an insult to human logic.

2008 Jun 17 12:55 PM

[sudhir Agarwal:]

Steel is freely traded on MCX & NCDEX in India & on LME. The argument for rising steel prices is nonsense as its reflection of rising energy prices. Similarly numerous studies & even CFTC is of the view that futures drives spot. Its common knowledge that whenever futures rises beyond cost of carry, traders start buying from spot & selling futures till cost of carry return back to normal.

If index speculators are so bullish, why they are not operating on physical market.

To end my counter view, we vividly remember Hunt Brothers cornering Silver futures on COMEX in 1980 which drives the price to $40 per ounce & when the margin was raised it fell like house of cards.

2008 Jun 19 10:13 PM