A quick recap of Soros’s prepared remarks at the Senate hearings on energy market manipulation, which I watched just now.
The billionaire said that he had a view of bubbles that departed from conventional wisdom about financial markets. They start with a trend but the dymamic becomes self reinforcing and increasingly disconnected from reality.
For oil, Soros said that the price appreaciation resulted from four factors:
1. Declining productivity of existing fields and increased cost and difficulty of finding new oil fields
2. Backwards sloping supply curves in supplier nations who deem it attractive to defer development of oilfields when prices are high and appreciating
3. Increasing demand from countries such as China and India which are growing rapidly but also subsidizing the price of oil and thus not presenting buyers with true costs
4. The role of index investors
Soros stressed that there would have been increases in oil prices without speculative factors, which are acting on top of an upward sloping curve. While he said that curve had become parabolic, which was a sign of a bubble, he said he did not expect prices to fall soon (although he did say that when bubbles break, the reversion is sharp). He mentioned softening demand from emerging markets as a possible trigger.
He also said that index investors had initially helped producers, since backwardization of commodity futures prices was an inefficiency and they helped alleviate that. However, unlike investments in stocks and bonds, which help promote economic activity, index fund investments in commodities do not aid the real economy and are not an appropriate use of capital.
Soros cautioned against regulation, since it might simply lead investors to move to unregulated commodities markets, such at OTC trading. He recommended first trying moral suasion, to persuade fund managers that investing in commodities was a violation of the prudent man rule. if that failed, ERISA investors could be prohibited from investing in commodity futures. He was cautious about raising margin requirements, but said that tool should be used more actively. He did not elaborate, but appeared to allude to financial regulatory proposals to implement pro-cyclical capital requirements.
It is noteworhty that the committee members seemed far more eager to take aggressive action than Soros appeared to be.
index fund investments in commodities do not aid the real economy and are not an appropriate use of capital
This is theoretically true, but it is dependent on a currency that maintains its value and can be relied on as a store of value.
In the absence of a stable dollar, investors want something that will act as a store of value. Hard assets, such as oil, are not bad choice in that regard.
I notice Soros did not include the weak dollar in his four factors. He is missing the boat. You can not have a reasonable discussion of “the appropriate use of capital”, when the default choice, cash, is declining and unstable.
Using commodities as an inflation hedge IS speculation. And last I checked, we all live and eat in the real economy, so all these benefits to investors have a cost to everyone in the real world. Having Wall Street be more important than Main Street is what got us into this mess in the first place. That’s why Greenspan kept money too cheap for too long.
And not having heard the testimony, aren’t those index investors often seeking an inflation hedge?
I tend to agree with his inclinations; any sort of major regulatory action will only distort the situation further and increase the chance of further price increases. Minor regulatory action to get pension funds out of the pool (who have no business being there when you think about it) would help, but beyond that, not much the government can do on the regulatory side.
What it can do is defend the dollar and raise interest rates, which would cause a massive reversal in the commodities markets as inflation hedges unwind. It’s not likely to do that anytime soon, unfortunately.
More notes re: testimony:
It looks like Sen. Cantwell was hinting at tapping the FTC to go over the head of the CFTC.
Sen. Dorgan made the ominous statement about US regulators that don’t believe in the mission of their own regulatory existence – they pose a huge cost/threat to the US economy. And he made direct reference to Walter Lukken and Bart Chilton of the CFTC.
Dollar devaluation is a very significant contributor to the run up in commodity prices. People are desperate to protect their savings from inflation and currency devaluation. Housing market fiasco has already swallowed a big chunk of their wealth (yes, they want to leave something to their children). Many feel that in the environment where the strength of the economy is highly questionable the equities will not do the job of wealth preservation. If not for the investment restrictions imposed within 401(k) and 403(b) plans, there would be even more run up in commodities. Dollar is quickly loosing its property as a store of value. The search for a replacement will continue creating new bubbles.
It is strangely contradictory for Soros to recommend government prohibition and enforcement of speculation in commodity contracts…what would his attitude have been if 28 years ago someone had suggested that hedge funds be prevented from shorting the British Pound.
Mark Thoma over at Economist’s View posted this recently:
“Dallas Fed president Richard Fisher reminds us that bubbles are nothing new (suggested by email):
Listening to Washington Irving, by Richard Fisher, Dallas Fed: There is nothing “unprecedented” about the situation we find ourselves in. To illustrate the point, I want to read a passage from Washington Irving’s 1819 essay on the Mississippi Bubble. For those of you who think the recent housing bubble and the ensuing financial imbroglio are “unprecedented,” listen to these words penned almost 200 years ago:
Every now and then the world is visited by one of these delusive seasons, when the ‘credit system’…expands to full luxuriance: everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open…. Banks…become so many mints to coin words into cash; and as the supply of words is inexhaustible, it may readily be supposed what a vast amount of promissory capital is soon in circulation…. Nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital….
Now is the time for speculative and dreaming or designing men. They relate their dreams and projects to the ignorant and credulous, [and] dazzle them with golden visions…. The example of one stimulates another; speculation rises on speculation; bubble rises on bubble…. No ‘operation’ is thought worthy of attention, that does not double or treble the investment…. Could this delusion always last, the life of a merchant would indeed be a golden dream; but it is as short as it is brilliant.
And to think, Washington Irving had never met a subprime mortgage, or a CDO, a CLO, an SIV or a credit default swap…”
Worth a read to compare to Soros’s analysis of bubbles and see how little some things change.
Also, when China and other countries currently subsidizing oil prices and their citizens have to pay the market cost for gasoline, I believe we will see a fairly steep drop in demand. The gradual runup of gas prices here in the US has been painful, but the fact that the increase has been fairly gradual has mitigated the unrest. Imagine if the price had gone from $2 a gallon to $4 in a week; there would have been serious trouble.
“Using commodities as an inflation hedge IS speculation.”
It is monetary speculation. However it is constant value in terms of the underlying asset. If you plan to eventually spend 15% of your retirement account on energy, then putting 15% of it into energy now simply locks you in at that percentage. If the sticker price of energy falls 50% due to technological discoveries, you will take a hefty monetary haircut, but your access to real economy energy is less affected. Price is not value.
Which is the whole point of banning retirement funds and the like from commodities. By destroying old folks’ hedges, they will have to slash consumption and/or go back to work. The Wall Street-Beltway complex shivers with anticipation.
“And last I checked, we all live and eat in the real economy, so all these benefits to investors have a cost to everyone in the real world.”
Commodities investment is not a zero sum game. Technological improvements in agriculture, prospecting, extraction, and recycling directly and materially benefit the real economy.
Flawed logic. Hot flows of money into commodities increase volatility. Volatility discourages investment. Soros understands that, which is why he is sounding warnings, but even he doesn’t have a good answer.
Try telling “commodities is not a zero sum game” to people who recently could support themselves and are now starving. If 60-75% of your budget is food, you can’t take a 50% increase in food prices. Myron Scholes has warned that the increase in food costs in some developing nations will lead to malnutrition, which will hurt the physical and mental development of children. But no, your inflation hedge is more important than other people’s survival.
Increases in food prices and energy, if continue, will destabilize a lot of political regimes. Even in the US we are not immune. At some point, to protect themselves politicians will have to do something for the people. Soros understandably does not want that to happen, as he learned how to rip profits from the existing system. He is hardly an advocate for the middle class. When he speaks, he advances his own interests.
that was a lousy hearing, the sound of one hand arguing. At one point I wondered if soros was worried that he was guilty of the very techniques being debated. I thought he mumbled his way through the day.
I used to be a hill staffer and I’ll tell you what I was thinking…It was a lousy day for the swaps market. If what those witnesses were talking about was accurate we’ve got one hell of a problem out there. I do not accept the 40-40-40 characterization, but I’m not sure what the committee thinks. You must remember that most Senators and their staffs don’t understand these issues as well as they should. This hearing does not help the debate.
Speculation encourages not just investment, but overinvestment. Speculative bubbles by definition result in a volcano of overproduction. All volatility does is scare a little sense into the bubblers, keeping the overproduction from being even worse.
People are suddenly starving because China’s new middle class is buying up food and feeding it to pigs. This is not speculation, this is a fundamental shift in demand, and an appallingly sudden shift at that. Manipulating the risk/reward curve for commodities would make the starvation problem worse, by damaging the profit to be made by supplying the poorer economies. With investment hamstrung, suppliers would concentrate on the proven profitable Chinese (and Brazilian, and Indian, …) market.
The other side of the sudden shifts in demand is the central banks, who imposed gigantic distortions on the risk/reward curve during the Developing Country Middle Class Boom. Those distortions are now breaking down and the money will start flowing to its natural destinations, so we can expect more sudden, gigantic changes in the flow of money. Those flow changes will leave many poorer countries high and dry. Unfortunately the pent up monetary pressure can not be contained by any possible intervention. The dam is bursting and the water will find its natural level. The only opportunity is to facilitate the necessary investments to build new supplies.
You guys are blaming the speculators on commodity, while the culprit is the electronic printing press. You guys are blaming helicopter Ben, while the culprit were million of brave Americans who signed under the dotted line. You guys blame those bankers who spins all the time until the music stops, while some guys told you that 19 arabs made WTC 1 2 and 7 falled with Newton’s Apple speed.
Clueless and cowardice in the face of lies and malice.
To Anonymous of 2:57, oh _please_, Beethovan’s Opus 95 sounds much better set strings. Very few of those having any impact on commodity prices via index funds figure to be lower tier folks with an underwater mortgage making early withdrawals from their 401k to play with soybeans. Most of those pushing the indexes around are big, big money whose holders have, yes, lost beaucoup on MBS bad bets and are looking to recoup any old way and the devil take the calorie-short. All of _these_ speculators AND their offspring could live mighty comfortably—far more than I—on a _tenth_ of their net worth as of a year ago. Please, weep not for these who go lame now where once they ran (amok). It would be a wonder and a blessing if these folks speculating ON THEIR OWN BEHALF in commodities would think a tad more about collective action and responsibility and a whole bunch less about personal balance sheets as of today, ’cause they more they try to secure ‘their future’ the more then end up costing all of us, including themselves.
To Daniel Newby: Oil refiners have their margins collapsing as we speak, and significant producers are actually quitely cutting production. Your comments are but dust and tow: look at the world as it is. This commodities spike is spurring neither production, innovation, nor long-term investment. It is a speculative parabola—Soros is totally correct on that—which has no productive function , huge interim distortions, and ends in major financial losses for most players and all end consumers.
Housing 2001-07 was in no way unprecedented. The 1817-19 bubble is a very good comparison, but the best one in American history is the property spec bubble of the 1830s; huge, huge, huge, with a massive bust afterwards. The solution to it?: “Go west, young man” ’cause opportunity in Gotham is an unclaimed corpse in the morgue. Take a look at Thailand in 1996; there’s a pretty property spec bubble for yah. Unprecedented NOT.
And I’m glad to see Dorgan and Cantwell talking tuff. It’s only for the tube at this point, but as things worsen the public will turn to those who want something done that counts. The idea that ‘nothing can have any impact’ is totally bogus. If government and capital fight, who wins? Crack yer history books, fella, vol. 20th century. Governments can’t call all the shots, and shouldn’t really, but if they want capital out of something or into something, they have the oomph and the stick to get it pretty much done. When they have the will, which as we see isn’t just yet. Government intervention is to this point a blunt instrument; it would be much bette if the market was open to suasion and stopped thinking about it’s own lower half and more about its continued health. This is why Senators are bloviating now; the markets won’t listen, naw. But watching capital put itself first in a big way when push has come to shove is an excellent tutorial for the public at large.
I’m sorry, but I see the words: “prohibit” and “Commodities speculation” in the same sentence, and I start getting really, really nervous. Even if it is to the ERISA – which as I’ll get to – is a probelm. And George is smart enough to know what the result is if you try to control the price in the futures markets.
Soros cautioned against regulation, since it might simply lead investors to move to unregulated commodities markets, such at OTC trading
That’s the polite way of saying: We’d be on our way to a black market for oil. When are people going to get it through their head that free markets find a way. They will always find a way, because they are too powerful a force. People want their stuff, for the price that can negotiate for it.
Although, I do agree an extremely forceful talk with the fund managers is in order. If I hear one more person say: I’m going to invest in Commodity Oil Prices, I think I’m going to scream.
It IS ZERO SUM. IT’S NOT INVESTING. BUT IT IS AN ECONOMIC BENEFIT. The futures markets are for small speculators (Who have been keeping downward pressure on the Oil market during this runup by a net short position as shown by the COT Report), large traders (who need a severe talking to) and the Commercials (Who need the stuff). Any improvements in technology cannot be implemented in a crop before the contract expiration comes due, and the contract comes due. Each position has an opposite position. It’s zero sum, and the free market portion of futures speculation (Which I engage in, and have for 12 years) needs re-enforced to the people that have been slamming their money into those markets. You’re not investing in oil. You’re trading in oil; negotiating the most fair price given the economic fundamentals.
It is not completely true that “speculators” increase volatility. By quickly raising the prices they are causing the world to react: invest more in oil esploration, venture capital for green technology, government guidelines on fuel consumption, Electric Vehicles etc. A “parabolic” volatility is much better than the Hockey Stick volatility we would have not acting and realising one day out of the blu that oil supply is no more enough.
Then, if only the governments had acted with a more strategic long term view imposing very high taxes on gas, we would have had the same results without the money outlow. But that is dreaming …..
Going through Mike Greenburger’s testimony, i thought this was intersting (he is an ex-cftc director of trading):
“NYMEX President Newsome has further opined that ―[t]he reports on the role of speculators on oil prices are grossly exaggerated. If you look at the data on who is actually trading, the level of commercial participants remains 70 to 72 percent. Of course, as Michael Masters recently explained, Dr. Newsome‘s calculation treats investment banks and hedge funds laying off the risk of their off exchange swaps transactions on NYMEX as the same as a heating oil dealer using the WTI contract on NYMEX to hedge his business risk. If those banks and hedge funds were properly classified as speculators, about 70 percent of the trading on NYMEX would be speculative – not commercial. And, if you were to add all of the WTI trading on NYMEX, ICE, and the Dubai exchange, speculation might very well approach 80-90 per cent of the WTI trades executed by U.S. owned exchanges. By any objective assessment, the crude oil market is now overwhelmingly dominated by speculation, most of which is not subject to the age old controls imposed upon speculators in these markets.” (emphasis added)