Institutional speculation fuels commodity boom: Expert

(June 2008) Large institutional investors are fuelling the commodities boom, pouring vast sums of money into long-only positions, with actual demand playing a much smaller role in the current market, according to a well-known commodities expert and trader. If they change their minds, the market could be in for a huge correction.

In an interview with Advisor.ca, U.S. commodities commentator Steve Briese, the editor of www.commitmentsoftraders.org and an advisor for JovInvestment Management’s Horizons Global Contrarian Fund, says the regulation already exists to solve speculation. The problem is the U.S. Commodity Futures Trading Commission (CFTC) has flagrantly ignored its own rules limiting who can speculate in the market.

The result is an unprecedented amount of investing taking place by massive institutional investors, such as pension funds and sovereign wealth funds, which have an almost unlimited supply of capital at their disposal to pour into the commodities.

Both houses of Congress have set up committees to find ways to curb speculation in the commodities market in order to rein in prices, with a specific focus on oil. Last week, Joseph Lieberman, a well-known independent U.S. senator from Connecticut, said he would be looking to find ways to increase regulation in order to ban institutional speculators from the market.

“In Washington, a big fuss is being made at various senate committees and house committees at the CFTC [about] whether the commodity index traders are responsible for high prices and high volatility or whether it’s fundamental demand from India and China, which has been the rallying cry of commodity bulls for several years,” Briese says. “The only group that is allowed an exemption from the speculative trading limits are bona fide hedgers — people who are involved in the cash business as producers and manufacturers. If you’re not actually handling the product, you’re not entitled to an exemption. This is very clearly stated in the law; it’s stated on the CFTC’s website.”

Briese says the problem is that the CFTC has been acting beyond its authority to increase the circulation of commodities. Exemptions have been extended to commodity index funds, which invest in a benchmark index that tracks a certain commodity market, the most popular being the Standard & Poor’s Goldman Sachs Commodity Index (S&P GSCI). Large institutional investors are piling into these index funds to increase their exposure to commodities and diversify their holdings.

This wealth represents billions of dollars, so it drives prices up, and Briese says when you have that level of wealth pouring into the market, the investments become a self-fulfilling. More fuel is poured on the fire as more investors pile in.

“These exemptions to the larger swap dealers that the CFTC has allowed are illegal,” he says. “All you have to do is allow the CFTC to enforce their current law in order to resolve the problem with commodity index traders. I don’t think there is a valid argument that commodity index traders are not responsible for a great deal of the excess price in commodities.”

He adds, “What happens are pension funds, or funds such as the Yale Endowment Fund, go to one of the large investment banks on Wall Street and arranges a swap so that it has a return on an index of commodities — the most popular of these is the S&P GSCI. The swap dealer in turn goes to the very pits and buys futures contracts from the commodity indexers.”

Briese says right now it’s difficult to assess how large their position is in the market.

“In Chicago or New York, the markets don’t know if the buying is coming in from India and China or from a commodity index fund. All they know is that substantial buying is coming in,” he says. “You have buying coming in to the point where some of these funds are holding about a third of the long open-interest and up to 60% in some markets, like wheat. You can’t accumulate that size position and become the largest player in the long side of these markets without raising prices dramatically.”

The more problematic question is at what point do they stop buying?

“The indexers themselves want to invest in something that has a low correlation with stocks and bonds, real estate and the other things they are already invested in. Commodities fit the bill,” he says. “Commodity index traders through these swap dealers have unlimited exemption. It’s really unknown how much of that money is available. They have never been involved in this before.”

Briese says there are signs from the investment banks and producers that the volatility is getting out of control and the risk too high.

“We haven’t had a commodity boom bull market since 1973 that hasn’t retraced. Commodities have always been cyclical. These players that are long-only certainly don’t have a view towards a bear market. When excess buying came in to overshoot irrational prices on the way up, that money will be forced out the market when prices start going down,” he says. “Prices will then overshoot on the downside. Producers are getting hurt on both ends of the deal.”

Both the banks and producers recognize that this risk is already making hedging almost impossible for those directly involved in commodities production.

“Producers initially like the long-only money coming in [and] raising prices, but then they found out the volatility was so high, their bankers would not fund future positions so that they can lock in these high prices,” he says. “Many of the producers are not able to hedge at these high prices. They are susceptible to a downswing too. The lower prices will hurt the producers significantly.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(06/18/08)

Mark Noble