Friday, January 26, 2007

How speculators exploit commodity markets

I use the word "exploit" because it was part of the original title of John Dizard's recent Financial Times article on speculators gaming the commodity markets.

Specifically, the charge put forth by Dizard's article is that locals on the exchange floors have been betting against commodity index funds by taking advantage of their need to roll contracts over in a timely and predictable manner. This, the article shows, costs money for investors in these types of funds. Says Dizard:

Speculators on the floors of commodities exchanges have been called many things, but sensitive, or solicitous of the interests of public investors, are not among them.

So it shouldn't be surprising that one of the ways they have of profiting from the passively investing public is called "date rape". In the pits, physical or electronic, that means betting against the certainty that commodity index investors' positions are rolled in a mechanistic manner every month, in known patterns on particular days. The phenomenon could be called index roll congestion, or some other euphemism, but as we noted, these are not people who worry about your feelings.

Are speculators unfairly squeezing investors, or are they simply acting out their part by exploiting (in the sense of taking advantage) a telegraphed signal from their counterparty?

Read, "How the speculators profit from investors in commodities", and this response letter, and decide.

The next article from FT's Jeremy Grant also falls in the area of "gaming the trade". His recent report, "Flame blame: how traders may distort energy costs", focuses on the idea that traders in the over-the-counter energy derivatives market are manipulating prices for energy through their low-visibility dealings.

In the following excerpt, Grant explains why American utility groups are upset over the influence OTC traders have on energy prices.

"Over-the-counter" markets have become a powerful feature of the way energy is traded globally - anything from petrol and petroleum futures or natural gas and gas futures to more complex derivatives such as energy swaps. Unlike on the New York Mercantile Exchange, the world's biggest market for oil and natural gas, OTC trading is not conducted in a pit where traders shout orders back and forth and the exchange reports their trades to the Commodity Futures Trading Commission (CFTC), the US regulator empowered to oversee on-exchange energy futures.

Instead, participants anywhere in the world negotiate specially tailored contracts with each other - linked by a telephone or computer screen connected to a special platform such as the Intercontinental Exchange, which operates a rapidly growing electronic crude oil futures trading business out of London.

Such ventures have become a popular forum for global trading and account for up to 75 per cent of energy trading in the US - larger than the energy derivatives markets on regular exchanges. Traders are investment banks or, increasingly, hedge funds. But - to the alarm of the Iowa utility group and others - OTC markets have been only lightly regulated since their emergence as a force in energy dealings. Regular exchanges such as Nymex are fully regulated.

Groups like the Iowa utilities and the public gas association are increasingly worried that this means the government is virtually blind to how the OTC markets are operating - and that the prices that consumers pay for energy could be artificially inflated by anonymous traders who operate in cyberspace.

These utility groups are hoping for more regulation over the OTC derivatives markets in the hope that "transparency" might be achieved.

Growth in the over-the-counter derivatives market has been staggering. The print edition of this article was accompanied by an interesting little graph showing the growth of OTC derivatives markets in relation to exchange-traded derivatives. If memory serves, the OTC derivatives market surpassed its exchange-listed counterpart in the early 1990s and has far outpaced it since.

Here is a (PDF file) table from the Bank For International Settlements that gives a snapshot of the OTC derivatives market as of June 2006. The notional amount of all contracts for this period was around 369.9 trillion dollars.