The same can be seen in the negative rent for gold. There are so many players going long without actually being able to securely store the stuff. They take care of it by paying somebody else for storing it for them.

Commodity lending is a kind of “virtual inventory”. When speculative hysteria goes to these lengths, the popping of the bubble can not be very far ahead.

Sorry that there is no link but from what Alan Heap, Global Commodity Research, Citigroup, wrote 25 January, 2006, the process began well before Sep last.

His report, co-authered with Thomas Price, was titled: Beyond fundamentals – the funds phenomenon, from which a few excerpts:

Long-only funds are joining hedge funds and CTAs – investing in commodity markets.

The increased fund investment and price increases are occurring against a fundamentally robust environment… (But Juan would mention that, even as global growth was fairly strong, China’s consumption of crude oil fell flat in 2005, picking up again in ‘06)

New players
Long standing investors in commodity markets (hedge funds, CTAs, etc.) are being joined by long-only funds (mutual funds, pension funds, etc.) who are implementing an asset allocation shift away from more traditional sectors.

Fund flows dwarf those of commodity markets Commodity markets are tiny compared to markets of conventional asset classes. Funds are making only small asset allocations (3-5%) into commodities, but much greater flows could occur.

And, apparently, greater flows did occur as trend following behavior and reallocation decisions became trend generating.

At that point in early 2006, A. Heap estimated a total of US$200 billion to be invested in commodity markets. Without checking, it’s my recollection that S. Briese and Bianco Research’s Greg Blaha speak of roughly the same amount today, not as a total but only the Index Fund portion, most all of which is buy side.

Sure they no doubt use different different methodologies, nevertheless…

http://theroxylandr.wordpress.com/2008/04/08/how-commodity-speculation-works/

Basically it suggests that when futures prices are higher than cash market prices (due to speculative interest), commodity buyers will simply buy the physical commodities early to lock in the price rather than buying the futures contract… which would contribute to closing the gap between cash and futures prices. If as Juan’s link suggests the prices have only been out of line with fundamentals since Sep 2007, this seems even more feasible.

The explanation seems logical, if not quantified. But I don’t know if those inventories would be counted among the inventories that Krugman claims just aren’t there. My apologies if this is not a valuable comment, I’m still learning this stuff.

Don’t know if you spotted this over at econbrowser, here’s the link:

http://www.econbrowser.com/archives/2008/04/commodity_arbit.html

Wonder what happened at the forum…

No, a futures contract does not require delivery; in fact, per ichabod’s comments above, only a subset of traders on the CBOT are permitted to take delivery. Most index traders are assumed not to take delivery.

An earlier NYT article discussed how disparities between futures settlement prices at contract expiration and cash prices in certain ag markets were a growing and perplexing phenomenon. That clearly can’t happen if enough players are arbitraging.

Thanks and you may also find this 8 February, 2008, article from AgWeb of interest:

The great wheat “squeeze” of ‘08.

http://www.agweb.com/Blogs/BlogPost.aspx?PID=b12091a2-0e10-4003-bd6b-ab24b1406077

That was enormously helpful. You ought to post the same over at Krugman, since he has some sway.

It also confirms my and others’ suspicions: some of the run-up in commodities is warranted, but a lot is due to people looking for an inflation/dollar collapse hedge. And the currency and bond markets are so much bigger than the commodities markets that parties fleeing the above for safety can create distortions pretty easily.

Once prices are disconnected from fundamentals, they can soar to astonishing heights, making those who sat it out look like morons. But mean reversion (more often, a correction beyond the mean) eventually prevails, and timing an exit is difficult. But then again, if your rationale is hedging, as opposed to speculation, that concern is less relevant.

These are significant [price] movements amounting sometimes to a 30% variation in a matter of few weeks.

Volatility generates uncertainty and uncertainty inhibits or confuses the investors.
(Does Oil Price Volatility Matter? June 2001)

‘The alleged economic rationale’ is an efficient market artifact which fails to hold and all the more so when, as Steven Briese has written, index traders are able to evade exchange and/or CFTC position limits through use of swaps dealers.

That this large, bullishly oriented group of funds is flourishing is partly a result of a regulatory anomaly. In recognition of the fact that the commodity markets are too small to absorb an excess of speculative dollars, the Commodity Futures Trading Commission, in conjunction with exchanges, imposes position limits on speculators. But the agency has effectively exempted the index funds from position limits.
[...]
The speculators, now so bullish, are mainly the index funds. To see how their influence on the market has become outsized, just look at how they operate. Nearly $9 out of every $10 of index-fund money is not traded directly on the commodity exchanges, but instead goes through dealers that belong to the International Swaps and Derivatives Association (ISDA). These swaps dealers lay off their speculative risk on the organized commodity markets, while effectively serving as market makers for the index funds. By using the ISDA as a conduit, the index funds get an exemption from position limits that are normally imposed on any other speculator, including the $1 in every $10 of index-fund money that does not go through the swaps dealers.

The basic argument put forward by the CFTC for exempting swaps dealers is that they, too, are offsetting other positions — those taken with the index funds.
( http://commitmentsoftraders.org/?p=32#more-32 )

Commodity prices have been financialized, i.e. have been disconnecting from fundamentals, something noted early 2006 by Citi’s Alan Heap but evident to all who cared to look.

This is no longer simply a broken system but one that, in its fashionable grubbiness, kills.

With all due respect, I take what regulators say in front of Congress with a handful of salt, as the recent testimony on the JP Morgan/Bear deal attests. They are always and ever doing a good job, and can always catch the bad guys.

In particular, I nearly gagged on the first page when Harris implied that CFTC supervision was able to prevent manipulation. John Dizard in the Financial Times has written of one known practice, “date rape” which the powers that be seem unwilling or unable to stop.

Per our comments on his story, which can also be found in a February 2007 post:

Dizard calculates the collective losses to investors (organizations like pension funds, endowments, and insurers) on the monthly roll of the GSCI (required because the index uses futures contract that expire every month) at 150 basis points on $100 billion of funds, or $1.5 billion. And who is on the other side of these trades? Dizard believes Goldman is at the top of the list.

Read that figure again. 1.5% a month. That’s massive. On a supposed low cost, efficient index, investors are incurring costs above what they’d pay to be in a hedge fund (and it would have to be a hugely successful one at that for them to face charges of that magnitude, while here, the costs are incurred, whether the investor profits or not).

And these frictional costs are on top of explicit management fees.

Commodities trading volumes are up considerably from a year ago, hence there is every reason to believe the magnitude of “date rape” and similar practices has increased correspondingly.

I will note that this sort of manipulation does not support the “speculative cash has pushed commodities well above their fundamental price” thesis.