This post first appeared on May 9, 2008
The question above may seem foolish. Oil has just passed $124 a barrel despite improvement in the dollar. Commodities prices are moving less in lockstep than before (gold and wheat in particular have backed off significantly from their highs) suggesting that buying is not the result of the basic materials version of a land grab. Opinion among economists, at least those polled by the Wall Street Journal, is unusually united: 89% think that skyrocketing commodity prices are the result of fundamentals, not too much cash chasing too few raw materials.
Yet bubble-like enthusiasm abounds. Tim Iacono pointed to a Money Magazine cover as proof that the end of the commodities run was not too far away. However, we have yet to see the storied counter-indicator, a Business Week cover story. In fact, Business Week ran an op-ed by Ed Wallace, “There is No Gas Shortage,” that pointed out that inventories were growing, which in combination with rising prices, suggests some speculative hoarding:
Gasoline reserves on hand are at the highest levels since the early 1990s, which is remarkable considering the nation’s refineries have been cutting back on the production of gasoline because their margins have declined. In fact, average gasoline reserves on hand have risen since this past October, while oil reserves in this country have gone up virtually every week this year—and only fog in the Houston Ship Channel that kept oil tankers from unloading their crude one week kept it from being every week…..
In January of this year, the U.S. used 4% less petroleum than we did a year ago. (Oil demand was down 3.2% in February.) Furthermore, demand has been falling slowly since July of last year. Ronald Bailey of Reason Online has pointed out that worldwide production of oil has risen 2.5% in the first quarter, while worldwide demand has grown by only 2%. Production is expected to increase by 3.3% in the second quarter, and by as much as 4.1% by the third quarter. The net result is that the U.S. daily buffer for oil production against demand, which was a paltry 1.5 million barrels as recently as 2005, is now up to 3 million barrels in excess capacity today…..
“The [oil] fundamentals are no problem. They are the same as they were when oil was selling for $60 a barrel, which is in itself quite a unique phenomenon.” — Jeroen van der Veer, chief executive officer, Royal Dutch Shell; Washington Post, Apr. 11, 2008.
But what is intriguing is that commodities veterans are distressed by recent market action. They seem more inclined than outsiders and newbies to point to the role in the bull market not of fundamentals but of new cash and perhaps more important, new vehicles, such as ETFs.
Reader Michael e-mailed us an paper and a series of posts by Michael Frankfurter, a commodities industry analyst (the article was co-authored with Davide Accomazzo of Pepperdine). The posts are broader in focus and discuss the “financialization” of commodities. As we will see soon enough, this development has worrisome parallels to recent history in real estate, with an asset intended primarily for use increasingly treated as an investment vehicle.
An old Wall Street saw illustrates the dangers of this approach:
On a slow afternoon, trader A decided to open a market for a can of sardines. Bidding started at $1. B bought it for $2 and sold it to C for $3. D and E decided to get into the act, with the result that E became the owner for $5.
E decided to open the can and discovered the sardines had gone bad. He went back to A to get his money back, protesting that the sardines were rotten. A smiled broadly, and said, ” You don’t understand. Those were trading sardines, not eating sardines.”
The paper, “Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures,” has some disconcerting findings from the standpoint of investors. It says that the normal risk/return paradigms of securities markets do not operate in commodities markets, nor do the pricing models for commodities offer an adequate substitute:
Our research indicates that these models have inherent shortcomings in being able to pinpoint a definitive source of structural risk premium within the complexity of the commodity futures markets. We hypothesize that the classic arbitrage pricing theory contains circular logic, and as a consequence, its natural state is disequilibrium, not equilibrium. We extend this hypothesis to suggest that the term structure of the futures price curve, while indicative of a potential roll return benefit, in fact implies a complex series of roll yield permutations. Similarly, the hedging response function elicits a behavioral risk management mechanism, and therefore, corroborates social reflexivity. Such models are inter-related and each reflects certain qualities and dynamics within the overall futures market paradigm.
With respect to managed futures, it is an observable materialization of behavioral finance, where risk, return, leverage and skill operate un-tethered from the anchor of an accurate representation of beta. In other words, it defies rational expectations equilibrium, the efficient market hypothesis and allied models – the CAPM, arbitrage pricing theory or otherwise – to single-handedly isolate a persistent source of return without that source eventually slipping away.
The article provide a nice survey of the issues surrounding CAPM and its successors, and then reminds us of why commodities are traded:
The secondary benefit provided by the futures market is that it functions as a mechanism for transparent price discovery and liquidity, which therefore mitigates price volatility. The primary benefit provided by these markets, however, is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge. This reduces the risk of adverse price fluctuations that may impact business operations, which in turn theoretically results in increased ‘capacity utilization.’
And bear in mind, there are more prosaic reasons to be cautious about commodities. From the first in a series of three posts by Frankfurter,
Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated.
Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While, there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, the same cannot be said about commodities.
With that as a backdrop, let’s then turn to Frankfurter’s third post, “The Mysterious Case of the Commodity Conundrum, Securitization of Commodities, and Systemic Concerns.” His case is straightforward: financialization of commodities, including the growth of OTC markets, is pushing prices well out of line with fundamentals (note I have excerpted his key points; the piece provides far more evidence):
Rising prices and a widespread bull market in commodities should indicate that there is a growing scarcity of hard assets. However, traditional forces of supply and demand cannot fully account for recent prices.
To be precise, the normal price-inventory relationship has been altered. This is the assertion of an expanding list of bona fide hedgers, commodity professionals and economists. Specifically, dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has been causing a self-perpetuating feedback loop of ever higher prices.
That means a bubble. Back to Frankfurter:
In a statement to the CFTC, Tom Buis, president of National Farmers Union, testified, “If [farmers] can’t market their crops at these higher prices, we’ve got a train wreck coming that’s going to be greater than anything we’ve ever seen in agriculture.” Billy Dunavant, head of cotton merchant Dunavant Enterprises, was more blunt, “The market is broken, it’s out of whack—someone has to step in and give some relief.”
Even CFTC Commissioner Jill Sommers acknowledged charges that speculators are skewing the market, in an apparent turnaround from the CFTC statement of April 21st which implied that commodity markets are functioning properly…..
the predominant view is currently biased to commodities as an investment hedge against inflation and speculators as an easy scapegoat for all the world’s commodity woes.
Unfortunately, this thinking is a self-fulfilling prophecy which ultimately may feed into a negative economic cycle where legitimate commercials are squeezed out of business thereby reducing supply, protectionism gains traction, trade breaks down, hoarding ensues, riots occur and wars erupt over access.
This may sound alarmist, but industry insiders are not buying into the one-size fits all answer that emerging economies are the primary factor driving up prices from the demand side, reinforced by supply-side shocks and peak production fears. In a slowing global economy hit by a major credit crisis and reeling from a falling dollar, it is likely that money flows seeking safe haven in hard assets is the key driver of recent volatility…..
Even if one accepts all the arguments that there is an economic shift in fundamentals which has resulted in rising commodity demand in emerging economies, as well as arguments that there are supply-side constraints bottle-necking commodity production, it is imprudent to deny that this perfect storm has been accompanied by a paradigm shift in how the commodity markets have historically operated.
We’ve been hear before… Economic problems related to OTC derivatives first occurred n 1994 which included the bankruptcy of Orange County , in 1998 with the collapse of Long-Term Capital Management, then during the California electricity crisis of 2000 and 2001 due to market manipulation by Enron, and most recently the credit crisis as a result of mortgage securitization repackaged into complex derivatives.
This history should not be misconstrued, however. Derivative products in themselves are not necessarily the problem. Rather, it is the unregulated environment in which such instruments are traded, and the lack of a cohesive infrastructure to manage the trading, clearing and mark-to-market pricing of such instruments. The regulated futures industry, on the other hand, provides a robust alternative model for trading derivatives.
An aside: perhaps I have been asleep at the switch, but aside from a mention in a New York Times article of a AIG, which manages commodity funds, entering directly into a contract with a farmer, I have not seem any mention in the mainstream media about OTC commodity trading, yet Frankfurter indicates this is a significant and growing factor. I wonder if this oversight is leading to incomplete analysis.
Back to Frankfurter:
Unfortunately, the most important tool of the CFTC to monitor potential market manipulation and excessive speculation, the Commitment of Traders (COT) report, was materially impacted by the CFMA [Commodity Futures Modernization Act of 2000]. In fact, this cornerstone of market surveillance has been so severely damaged as to make reliance on it nearly useless, and those who cite COT as justification for a balance between speculators and hedgers, not credible…..
The CFTC’s ability to monitor the commodity markets was further eroded when the CFTC permitted the Intercontinental Exchange (ICE) to use its trading terminals in the United States for the trading of U.S. commodity futures contracts on the ICE futures exchange in London . Subsequently, ICE Futures allowed traders in the United States to use ICE terminals in the United States to trade its synthetic futures contracts on the ICE Futures London exchange. This allowed unregistered funds to effectively bypass registration.
According to the U.S. Senate Staff Report, “Despite the use by U.S. traders of trading terminals within the United States to trade U.S. oil, gasoline, and heating oil futures contracts, the CFTC has not asserted any jurisdiction over the trading of these contracts. Persons within the United States seeking to trade key U.S. energy commodities… now can avoid all U.S. market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.”……
In addition to the issue of index funds accumulating long positions and thereby imputing an upward bias to commodities, there is another opportunity for market manipulation with respect to the construction and rebalancing of prominent commodity benchmarks such as the Goldman Sachs Commodity Index (GSCI).
As reported by the New York Times on September 30, 2006 Goldman Sachs significantly readjusted in August of that year the GSCI’s gasoline weighting. Index products tracking the GSCI, and representing an estimated $60 billion in institutional investor funds, were forced to rebalance their portfolios resulting in an unwinding of positions. Originally, unleaded gasoline made up 8.75 percent of the GSCI as of 6/30/2006 , but this was changed to just 2.3 percent, representing a sell-off of more than $6 billion in futures contracts.
As a result, gasoline fell 82 cent in the wholesale market over a four-week period, an unprecedented move; and crude oil, which in July 2006 traded over $79 per barrel for August delivery—at the time an all-time record—subsequently fell to around $56 by January 2007.
Many at the time argued that these moves were due to fundamentals, but… it should also be noted that the U.S. was in the midst of mid-term elections with Republicans facing a major fight to retain control over both Houses. According to a Gallup poll at the time, 42% of respondents thought that the Bush administration “deliberately manipulated the price of gasoline so that it would decrease before the elections.”
We’ve also discussed other games Goldman plays with the GSCI, most notably “date rape“, which costs investors in that index a stunning 150 basis points a month.
There are, however, three concerns as a result of the securitization of gold, which can also be applied to commodity-linked ETFs generally:
The first is that increasing gold prices act reflexively upon investor sentiment as an indicator of inflationary pressures, therefore resulting in more gold accumulation and dollar dumping—a vicious feedback loop.
The second concern, while an indirect case in point, is that the securitization of gold bullion demonstrates how easy it is for a cash commodity to be hoarded, effectively taking the supply of that hard asset off the market. Theoretically, forward contracting by investors is causing the perception of inadequate supply due to perceived increase in demand…
Third, the StreetTracks gold ETF broke the mold and open the floodgates for additional securitizations of commodities in the U.S…..these vehicles ended up doing an end-run around the CFTC by exploiting the loopholes in the CFMA.