"Driving from bank to bank, a man has got to be careful nowadays, for at the price of gas he will burn up more gasoline trying to get a loan than the loan is worth."
Will Rogers (May 17, 1931)
Last week we decided that the supply and consumer demand of oil is just fine. There is no shortage of oil, no lines at the gas pumps. Prices are going up. OPEC wants it up. Domestic Big Oil wants it up. OK, we know that.
The world-wide production of oil has averaged about 85 million barrels in each of the past three years. Demand now is in the vicinity of 95-97 million barrels. It is expanding steadily in the emerging economies like India and China, pretty much offsetting demand decline in the major economies like ours. However, India and China cannot afford higher oil prices. (Neither can I, can you?)
So is Big Oil lining its own pockets gouging consumers? OK, well yes, but that's NOT the only thing driving up the price of oil.
There is an artificial profit-generator that Wall Street has created that is also responsible. It is the massive buying of oil futures by a new category of buyer-institutional investors-the giant pension funds and university endowments, investment banks, hedge funds- in search of more profits. Some call them index speculators, but actually they are institutional commodity indexers, and they are HUGE buyers of commodity futures. They are creating "demand shock" market factors using new investment techniques with consequences unimagined by the regulators. The commodity futures market is under the auspices of the Commodity Futures Trading Commission (CFTC), a group as hard to find as the Illuminati.
In 1936 the commodities market (CFTC) was created to provide consumers of commodities (i.e., buyers of actual barrels of oil like Rocky Mountain Power), farmers who buy and sell wheat, hogs, beef cattle, corn, and all that with a mechanism to hedge the prices they may be expected to pay for the commodity in the future. There were limits imposed which did not allow speculators to dominate the market. For decades, futures contracts were mostly traded by commodity consumers, agreeing to a price today for a commodity to be delivered in, say, two months as a way to smooth out price fluctuations for those supplies. A hedge if you will.
Since becoming a for-profit entity the CFTC now allows virtually UNLIMITED access to institutional speculators. Speculation has always been a force behind commodity prices, but traditional consumer speculators buy and sell to hedge their commodity purchases. Institutional speculators are driving demand in an unprecedented manner. This new breed treats commodity futures as an asset class. Their buying and holding for investment purposes means they consume liquidity and hoard it while providing no benefit to the futures market.
Let's look closer:
Institutions allocate billions of dollars to this "asset class" and they buy to their limit, insensitive to the actual price. They're not making an investment decision; they're making an asset allocation decision. Since the commodity futures markets are much smaller than the capital markets, when the billions pour in, the impact is higher. In the first 52 trading days of 2016 it is estimated that more than $100 billion poured into commodity futures. By contrast, in 2003, institutional investors put $13 billion in commodity futures.
Approximately 88% of pension funds have an allocation to commodities, albeit a small allocation: the largest among the pension giants is 13.6%. Just as a point of reference, the largest public pension fund in the world is the Stichting Pension Fonds of the Netherlands at $473 billion, $150 billion more that the largest US pension fund, CalPERS (California Public Employees). The Netherlands fund owns commodity futures. Social Security has $2.837 trillion, all in US fixed income.
Institutional investors now compose a larger share of outstanding futures contracts than ANY OTHER market participant. When they place 1 or 2 percent of their huge portfolios in commodities futures, they drive the spot price of the commodity UP. Period.
And it gets worse. Index speculation increases the more the prices increase as more and more speculators are attracted. It's the herd mentality-"Have you seen CslPERS (California Public Employees) is up 137,000%? We need to be there." Their financial advisor helpers tell them they need to be there. Following their financial helpers' advice they hoard assets while the price has to go up as a self-fulfilling prophecy.
There are more ways to rein in commodity trading than you can imagine, including limiting how many contracts speculators can hold and closing loopholes that allow them to skirt regulations. Fuel consumers like airlines can lobby their customers to lobby their congresspersons. You would think there should be some kind of controls, but that is unlikely. Sometimes Congress surprises us and passes timely legislation that makes sense, is adequate and actually works. Mostly they do not.
Pension funds say the risk is that if the remarkable run-up in oil and other futures markets reverses course, billions of dollars of retirement benefits could be wiped out. The worry is that if the market does not continue to go up artificially, then pension funds will be in a freefall when there's a downturn. All those of you who have a real pension fund-a defined benefit from your company-not a 401(k) or IRA, raise your hands. That's what I thought. A lot of the USA pension money is held by public employees-like government workers and teachers. As far as I'm concerned, let the teachers keep what they have.
The commodity markets themselves are shrouded in a unique lexicon, like "rolling returns," "spot price vs collateralized," "negative roll yield." Any two analysts will reach different conclusions based on the same statistics no consumer understands. Markets are broad, liquid and move at light speed. You have to be glued to the machines. It is the most misunderstood asset class in investing. There is no transparency. Actual ownership of futures contracts is often hazy and obscured. Unlike oil, itself, you can't drill down.
Now there are commodity mutual funds and commodity ETFs, even leveraged ones. And, new on the scene, commodity RoboAdvisors to pick your investments for you, and to make it easier to take your money. Want to play in the commodity futures game? There are trading systems you can subscribe to.
Just like any other investment strategy, if you, the investor, do not know exactly what you're buying into, how it works, what are the downsides and where your money is going, you may as well come to Wyoming and go to a bull auction (the analogy works). I went to one once as a spectator, and when I reached up to take off my Stetson, I was the new proud owner of an $18,000 bull. Don't play in this sandbox. It's for the experts, whoever they are. I know some of them are here on SA. If you want to know more, please find them and ask them.
John Lohr resides in Buffalo, Wyoming and can be reached at firstname.lastname@example.org
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: John Lohr and team present retirement, investment and fiduciary original content on their subscription site, somebodyelsesmoney.com