'Index Speculators' Hoarding Commodities

Includes: CME, OIL
by: Craig Jones

I took time today to read the Michael W. Masters Senate testimony in regards to commodity futures and “Index Speculators” and was immediately struck by several key points.

Firstly, what are we doing having an offshore hedge fund manager presenting testimony related to the trading of commodity futures before the Committee on Homeland Security and Governmental Affairs?  Aren’t they supposed to be protecting us from terrorist threats?  I believe that the Department of Homeland Security, in conjunction with the Patriot Act, have the potential to be the most long-lasting detrimental consequences of the George W. Bush administration.

Next I would say that Mr. Masters either has an agenda, the purpose of which is yet to be known, or he is a simpleton when it comes to Economics.  Yes, I know, he is a successful hedge fund manager.  That doesn’t though, preclude the possibility that he does not really understand economics nor free-market dynamics.

The assertion that “index speculators” have assumed a huge role in the trading, and even in the direction of prices, in the commodity futures markets, is mostly inarguable.  We have all known, for quite some time now, that the presence of long only capital has been on the rise.  We all know that institutional investors have been participating in these markets and that they have an appetite for non-correlated investment vehicles.

 To this I say, “So what?”  It is inappropriate to pronounce that the sky is falling at the sign of large sums of money chasing somewhat smaller pools of assets.  This has been at the heart of the boom bust cycle since time began.  Institutional investors establish long positions and they want to stay long so as to participate in the rally in hard assets.  Where’s the sin? 

The law of supply and demand, though it can be pushed around in the interim, has an incredible tendency to throw its weight around sooner or later.  Producers will produce and consumers will consume so long as the price for each equates to some semblance of balance that produces trade.  Once the price of a commodity, any commodity, moves to a point so high that it weighs on demand, pricing pressures will ensue.  We don’t know how long this will take.  We don’t know were price “X” is that will trigger changes in demand.  And we don’t know how individual market participants will respond.  We do know that the role of pricing in the free market is to allocate scarce resources and, I propose, that is exactly what will happen in every market in due time.   To suggest that there should be governmental action as a means of dissuading institutional investors from allocating funds to commodity futures markets is wholly anathema to what we are supposed to believe as American investors.

Mr. Masters’ assertions as they relate to the institutional “hoarding” of food and energy products through the stockpiling of futures contracts ring, in my ears, as hollow as the rest of his arguments.  Futures contracts, at their core, are synthetic investments that represent rights to purchase or sale.  Obviously, these contracts can assume intrinsic value and they possess the ability to be converted to physical, whether in the form of the underlying or some cash settlement calculation.  This conversion factor, while it has given rise to fear and the perception of hoarding, also allows for the solution to this “problem” in that it facilitates arbitrage.  Should the institutions gain too large a position at too high a price is not at all unreasonable to believe that any number of the major commercial market participants would be willing to deliver to them.  Indeed, at this point the indexers may in fact hold such a large position that it might approach “hoarding.” 

Consider, though, that they would be hoarding largely perishable “assets,” in the case of foodstuffs, and assets that have a high cost of carry in the case of energy and metals.  Doubtful that many institutional investors who are simply trying to index to a non-correlated asset want to become commodity merchandisers.  The point is, when the price reaches the right number, the traditional participants won’t be there to take the other side of the trades; who are they going to sell to when they roll?  And, on this hoarding note, the pharmaceutical example is off the mark.  Should an institution attempt to hoard important drugs, the price point would be such that new supply would come from the woodwork.  These products, unlike commodities, are not as dependent on finite resources (land, water, proven reserves, etc.) as are commodities and it should prove rather simple to ramp up production.  This analogy was nothing more that a means for Mr. Masters to insert more emotion into his argument.

As for commodity prices rising more in the last five years than at any other time in history, this too calls for further inspection.  While rises of late have been sharp, these rises should be put into context.  Until recently, commodities as a whole have grossly underperformed other assets and have, in fact, failed to keep pace with the US Consumer Price Index over the past twenty plus years.  The case lately seems more of an awakening of a sleeping giant than a demand side squeeze.

Finally, I would propose that Mr. Master’s need look no further than his markets of choice to make the case for “index speculators” manipulating prices.  Witness the enormous increases in volume and market capitalization that has taken place in international debt and equity markets.  The rise of the mutual fund, hedge fund, sovereign wealth fund, public pension fund and very large scale global financial institution has created a demand for financial assets that far outstrips what might otherwise have grown organically.  You don’t see FCMs, IBs, CTAs or CPOs advertising to consumers on television.  How many Schwab, Merrill Lynch, Fidelity and E-Trade ads have you seen? And this hyper activity within the financial instrument sector has real effects on Main Street. 

The increase in personal equity, or perception thereof, created when demand for stocks and bonds outstrips supply, and financial assets rise accordingly, leads to the much heralded “wealth effect” that so much has been made of over the past decade.  The increased perception of wealth results in increased consumer spending which results in higher consumer prices for goods and merchandise which results, ultimately, in inflation as well as a widening divide between the affluent, who own financial instruments, and the poor, who are simply left to pay the new, higher prices for the goods they need to survive.  The only difference in the case of commodity inflation vs. stock market inflation is that no one seems to care much (in fact, politicians are pleased) when the cost of a new car doubles in price, while everyone seems to panic when the price of the fuel that runs the new car does the same.

I’ll lose no sleep over index speculators running amuck.