Rayden's  Instablog

"It's not the things you don't know what gets you into trouble. It's the things you do know that just ain't so" -- variously attributed to Will Rogers, Mark Twain or Yogi Berra

The effect of commodity index funds on commodity prices has been a hot topic lately: from congressional hearings, to proposed tougher CFTC regulation and hearings going on right now, to breathless articles in Rolling Stone.

The popular wisdom is that commodity index fund investors, being long-only, tend to drive prices higher, that they raise the price level far above what it would be otherwise, both in the long and the short term (a view well represented by, for example, Jeffrey Korzenik).  The popular wisdom also holds that commodity index fund investors generally increase volatility, ie they buy high (and cause prices to rise even higher) and sell low (and cause prices to fall even lower).  Certainly, the huge increase in popularity of commodity ETFs and index funds over the past few years, combined with the historically high commodity prices and extreme volatility of commodities over the same period, would seem to support this view.  Just because two things occur at the same time, however, doesn't mean that one caused the other.

I will use data from the United States Oil Fund ETF (USO), which is the largest futures-based (as opposed to physical) commodity ETF.  USO holds assets that have recently ranged roughly from 1 to 4% of total open interest on the major oil futures contracts (NYMEX, WTI, Brent).  As a player in the global oil market, USO is huge; yet it is far from being the largest single player, and definitely not enough to move the market by itself.  USO is more likely to be used as a vehicle for small/individual investors, rather than institutional investors (who might prefer an index fund such as PIMCO Commodity Real Return, or using futures to track GSCI directly).  It is nevertheless a reasonable assumption that the type of investor behavior seen here would be representative of commodity index fund investors in general, both large and small, in oil and in other commodities.

Without further preamble, here is the monthly data on USO total holdings (red line) and unit price (blue line; tracks front month oil futures), since the fund's inception in April 2006:



The presented data utterly refutes the hypothesis that commodity fund speculators as represented by USO had anything to do with the oil price spike in mid-2008.  The USO holdings at the time when oil prices peaked, in June-July 2008, were 7.6 million units, less than at the beginning of 2008, and three times less than at the beginning of 2007.

We can break down the behavior of USO investors into five periods, as follows:

1. April 2006 to January 2007: prices falling, USO investors are net buyers
2. January 2007 to February 2008: prices rising, USO investors are net sellers
3. February 2008 to June 2008: prices rising even further (this is the infamous oil spike), USO investors net neutral
4. June 2008 to February 2009: prices fall (by 76%), USO investors are net buyers (holdings increase by 17x, yes seventeen-fold)
5. February 2009 to May 2009: prices rise, USO investors are net sellers

This illustrates that over periods on the order of months to years, USO investors consistently act to stabilize prices: they buy into falling prices and sell into rising prices.  Another name for that behavior, of course, is "buy low, sell high".  There is no evidence whatever to link USO investors with the oil price spike of 2008.   They wre net sellers of oil during the initial part of the price spike, and stayed on the sidelines during the later part.  After the spike, during the period June 2008-February 2009, the data suggests that USO investors prevented an even greater crash in oil prices; in fact, at the low point of oil prices in February 2009, USO held more than 4% of the total oil futures open interest in the world. 

There are excellent theoretical arguments for why commodity index speculators cannot directly affect the overall price level.  In a nutshell, they never take delivery, and hence have no effect on supply and demand.  By investing in the front month(s), and having a predictable roll, they can encourage front-running which can indirectly steepen the contango curve, thus making storage profitable.  This makes sense on an intuitive level: the strategy that index speculators are trying to reproduce using futures is simply holding the commodity itself, and so inevitably their participation in the markets makes it profitable for someone else to physically store the commodity.  But that has associated storage costs, and the index fund investors end up paying for those through a negative roll yield.  The footprints of index speculators in the market can thus be seen not in higher prices, but in a steeper contango curve, and beyond a certain point in physical inventory buildups.  Inventory buildup can affect the overall price level; but that is the only link between index speculators and overall prices.  In order to prove that index speculators drive up prices, one has to show inventory buildups; and then the effect of index speculators is only as large as the effect of any inventory buildup they can be shown to cause.

As predicted by this theoretical discussion, the futures curve did change from backwardation to a steep contango during the period (July 2008-February 2009) of post-spike falling prices during which USO total holdings increased seventeen-fold.  Again as predicted, at the same time the oil storage trade (ie: buy physical oil and store it, sell futures) became really popular, even leading to floating oil storage (exemplified in these articles: [1] [2] [3]).  By indirectly causing a steeper contango and an inventory buildup, USO investors probably did cause higher oil prices; but they did so in February 2009, not in July 2008; at the bottom, not at the top.

In the interest of completeness, there is exactly one instance in the available data of USO investors not acting so as to stabilize prices: in October 2009, there was significant net selling into falling prices.  Considering the environment of absolute panic in the commodities markets at the time, it is understandable that some USO investors lost their nerve.  They were buyers the previous month, and resumed buying en masse the next month, however.

The inevitable conclusion is that restricting this type of speculation will increase volatility in the commodities markets.  As a trader, I would certainly benefit from this; but as an impartial observer, I have to conclude that the proposed CFTC position limits and other restrictions on commodity index speculators would have precisely the opposite of the intended effect.

Disclosure: oil futures position equivalent to a long straddle; no position in USO.

Michael David White gave us an outrageous proposal for how to end the finacial crisis, "Plan Orange".  I will respond to some points of his proposal and throw down a Swiftian counter-proposal, named "Plan Black".  The chosen color is black because it will put most people "in the black", but also because it spells a R.I.P. to those entities responsible for the crisis; you see, it's not exactly a very nice proposal.

In a nutshell, Mr White's idea is to "Pay down mortgage debt of all property owners to 80% of today's value."  There are three key questions to be asked of this and any other proposal: 1) Who should pay?  2) Who gets paid?  and  3) Why would we ever want to do that?  Who pays is of course the government, ie the taxpayers.  Who gets paid is precisely the "property owners" which in the case of mortgages is the banks, ie the bank bondholders, stockholders, and owners of securitized instruments; and not the homeowners, as one might naively assume.  So, Mr White's proposal decoded is "the taxpayers should pay down mortgage debt held by the banks".  This is wealth transfer on a massive scale, from those most deserving to those least deserving.  It is a giant theft, pure and simple; hugely unfair, immoral, unprincipled, and corrupt.  Clearly there are excellent reasons not to do this.  As to any reasons in favor... Mr White does not say, besides that we "must" and that it will be "fast" (it won't).

Mr White also talks about a "debt destroyer".  He is quite correct that debt will be destroyed, that appears inevitable at this point; but it will be destroyed through default (mostly) or repayment (much less of it).  His proposal is not a "debt destroyer", it's a debt transfer.  Instead, why not actually accelerate the inevitable debt destruction, and make sure it happens in an orderly fashion? 

That is the idea behind "Plan Black", which is basically a plan to do nothing:

 

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In the past two weeks, the Brazilian government sold at auction to farmers put options for 3 million bags of coffee (roughly 10000 NYBOT coffee "C" contracts) with a strike of $1.18/lb, and it is expected to sell another 3 million in upcoming auctions.  This is fully 20% of this year's projected Brazilian arabica coffee crop.  All puts offered were sold; the bidding was very heavy in the first auction and somewhat lighter in the second.  Based on previous experience with similar interventions (last seen in 2002), the government will not keep this coffee off the market, if the puts are exercised against them they will simply turn around and sell into the cash market, so this does not affect supply directly.

While at first this may appear bullish ("putting a floor under the market"), this development is actually intensely bearish.  Remember, the government is not trying to make money here, they are deliberately giving money away.  So instead of being a mildly bullish trade, this implies the government is concerned that coffee can/will go a lot lower, and that they feel farmers are under sufficient pressure to require an intervention.  What do the farmers know that we don't that makes them jump at the chance to lock in that price, even at the cost of paying substantial cash up front?  Why does the government feel the need to do this now, and why do they call it a "coffee crisis"?

The answer is simple: the cash price for current crop coffee in Brazil has imploded, from $1.35/lb earlier this year to recent prices as low as $0.95/lb.  While Brazilian arabica coffee is not deliverable on NYBOT, it is often interchangeable with that grade as far as end users are concerned.  Typical differentials are stable at around 10 cents.  Thus, the implied NYBOT coffee "C" cash price based on current Brazilian cash prices is around $1.05.  Ouch.  The main drivers behind this are (a) the largest off-year crop ever at 39 million bags, and (b) no buyers!  There are lots of players (commodity funds, etc) who want to buy coffee futures, but really not many people who want physical coffee at the moment.  That is not a sustainable situation, and it will be resolved with the futures price converging towards the cash price.

Bear in mind also that world stocks are relatively quite high, and that next year's Brazilian crop is likely to be a mega record-breaker at over 50 million bags, possibly as high as 60 million with good weather, as the trend of increased production accelerates.  Brazilian coffee alternates high and low yield years, and on top of that there is a lot of trees planted years ago which are now maturing so there is a trend to larger crops, corresponding to an increase of around 4 million bags per year.  The sequence of crops in millions of bags from 2003 to 2008 has been 28, 39, 32, 42, 36, 46, with the current year predicted at 39 and next at 50+.  As everyone is anticipating this, players in the market will be drawing down stocks substantially this year.

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