Tuesday, May 27, 2008

Index investors driving commodity prices?

Recent surges in commodity prices have brought attention to the increased role commodity index investors have taken in the futures markets.

The upsurge in commodity index investing has led some observers to claim that commodity prices are being pushed higher due to the growing involvement of these long-focused funds, which buy and hold distant-month futures contracts in order to gain exposure to rising commodity prices.

Are commodity index investors to blame for higher commodity prices, or have they simply become the new scapegoat in the attack on speculators?

John Mauldin recently addressed this issue in a recent edition of his Frontline Thoughts newsletter.

In a section entitled, "Those Nasty Index Speculators", Mauldin looks at recent comments made by hedge fund manager Michael Masters on the issue of index fund involvement in the commodity markets, and offers a rebuttal to Masters' claim that index funds are a main factor driving higher commodity prices and the virtual stockpiling of much needed commodities.

Here, Mauldin quotes from Masters' testimony:

"There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.

"Index Speculators' trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits."

There is also the question of certain loopholes which allow investment funds to avoid position limits in the futures markets, an issue discussed in our recent post on food prices. Mauldin addresses this point here as well.

"What about position limits? Aren't there real limits to the amount of a physical commodity that a fund or speculator can accumulate? Masters points out that there is, but the CFTC has given investment banks a loophole, in that they can sell unlimited size positions in the OTC swap markets if they hedge the positions.

So, a hedge fund could buy $500 million worth of wheat, which would be way beyond the actual market position limit, through a swap with a Wall Street bank, without having to worry about position limits. And there is no doubt that large purchases of any commodity will drive up prices, at least in the short term.

What does Masters think Congress should do? Prohibit pension funds from commodity index buying, close the swaps loophole on speculative positions, and make the CFTC (Commodity Futures Trading Commission) provide more transparency as to who is buying commodities. That would stop those nasty index speculators from driving up food and energy prices. Prices would come back down and we could all go back to driving our SUVs without having to worry about the cost."

But, as Mauldin points out, there is more to the issue than that:

"It is not that simple. While there is no doubt that excess demand in the form of index buying can have a very real effect -on prices, it is not the whole story.

What an index funds does is buy a futures contract for a given commodity when money is first invested. Say that contract is six months out. When the contract is one month from expiration or delivery, the index fund sells that contract and buys another contract six months out. They sell before the contract could have an effect on the cash price of the physical commodity. The cash price is determined by supply and demand."

For more on Mauldin's (and Bob Greer's) take, read the whole article.

But the debate linking higher commodity prices to index investors and increased speculation does not end there. We have plenty more for you on the subject, with everyone from Tim Iacono to GaveKal research and FT Alphaville weighing in. Read on at the related links below.

"Fun with the Masters Report" - Mess That Greenspan Made

"More fun with the Michael Masters report" - MTGM

"Commodities spiral - are speculators to blame?" - FT Alphaville

"Government meddling on food prices" - Finance Trends Matter

"On agricultural commodity prices" - Finance Trends Matter

"Pension execs called on carpet" - Pensions & Investments