Cezary Salad

This is the last of a three-part series of posts reflecting on what’s really driving the price of oil in today’s markets. Last Thursday’s post focused on the role of dollar depreciation. Then, on Saturday I reflected on the tightening outlook for global supply and demand. Today’s post will examine the impact of commodity price speculators.

The third - and definitely the most controversial - long-term trend that has put upward pressure on oil prices is increasing commodity price speculation.

Under most circumstances, financial theory would dictate that the inflow of speculative capital can’t have an outsize effect on a market as large, open and actively traded as oil futures. That’s because such a market is bound to have a large variety of participants - technical traders, physical hedgers, fundamental investors, passive investors, mean reversion traders - all following various objectives and trading strategies that can’t really have a measurable impact on it.

However, this fails to hold true if there’s so many participants all following the same strategy that they do in fact move the market by creating an imbalance between the number of buyers and sellers, resulting in either a spike (via excessive buying) or a crash (via excessive selling).

And, by the looks of it, that’s precisely what’s going on in the oil futures market right now. Over the past five years, an influx of new investors have flooded the commodity markets with speculative capital, much of it following the same strategy - go long and hold - which helped to create a spike in oil prices.

Big money, big market

Let’s start with the numbers. In May, Michael Masters, manager of hedge fund Masters Capital Management, estimated that assets allocated to commodity index trading have risen twenty-fold from $13 billion at the end of 2003 to $260 billion as of March 2008. Fair disclosure: his hedge fund stood to lose a lot of money with rising oil prices, so he had an interest in arguing for greater regulation of the commodity markets. Moral hazards aside, though, in early July, CNNMoney.com reported that the International Energy Agency had came up with nearly identical figures: $15 billion in 2003, growing to $260 billion by 2008.

Where did all this money come from? The inflow of speculative capital was enabled in large part by an innovation in the world of Exchange-Traded Funds (ETFs), which track indexes but can be traded like stocks. Since 2005, when Barclays Global Investors created the first broad-based commodity ETF, commodity ETFs dedicated to tracking the performance of futures commodity indexes like the Dow Jones AIG Commodity Index (DJAIG) or the Goldman Sachs Commodity Index (GSCI) have mushroomed. This empowered investors worldwide to participate in the commodities bull market like they never could before and naturally led to a huge influx of capital - and not just from hedge funds. In late 2006, for example, CalPERS - one of the largest U.S. public pension schemes - announced that it would earmark $500 million for a pilot commodities investment program. And CalPERS definitely wasn’t alone. By 2008, Masters estimated that investors bet nearly $1 billion per day on commodity indexes in the first 52 trading days of the year.

But it is important to view these numbers in context: there are trillions of dollars’ worth of commodities contracts traded every day (New York Times business columnist Joe Nocera puts the figure at $5 trillion). In this light, a couple hundred billion worth of speculators’ capital can only have a material impact if their positions are so concentrated on any one strategy that a large-scale retreat from or a run to that position reverberates through the market.

Crowded investment strategy

To see how this can happen, it’s important to first draw some distinctions. The Commodities Futures Trading Commission (CFTC), the regulatory body tasked with overseeing the commodity futures markets, distinguishes between two types of participants: commercial and non-commerical. Commercial participants are those who have a legitimate commercial reason to hedge their exposure to a given commodity - such as a grain farmer or an oil refinery - whereas non-commercial participants are those who participate in the market purely for financial gain (i.e. speculators). Both, however, act in the same global market and therefore answer to the same oil prices. Furthermore, there are two types of trading strategies of interest in examining non-commercial participants’ impact on the market: long and short. Long positions bet on rising prices and therefore their accumulation tends to put upward pressure on prices; short positions bet on falling prices (by borrowing shares, selling them high, repurchasing when low, returning them to the borrower and pocketing the difference) and therefore their accumulation tends to put downward pressure on rising prices.

Armed with this knowledge, let’s look at the trends. Last year, the same Congressional committee that Masters testified in front of tasked Edward Krapels, manager of the gas and power practice at consultancy Energy Security Analysis, Inc., to answer essentially the same question: what is the effect of index speculators on oil prices? To answer the question, Krapels examined the difference between non-commercial speculators’ long and short positions on West Texas Intermediate (WTI) crude oil from 1986-2007. What he found was that, with some exception, between 1986 and 2002 non-commercial investors were net short on oil. Between 1992 and 2001, they oscillated between net long and net short interest. But between 2002 and 2007 - a period which saw WTI rise from $20 to $100 - the non-commercial investors were usually net long. For the sake of convenience, below I’ve reproduced the charts that Krapels uses to illustrate these trends (sorry for the bad resolution):

If anything, after Krapels’s testimony in December 2007 we can only guess that this trend continued to snowball. The public spotlight on the tight global supply and demand conditions as well as the plunging dollar gave non-commercial commodity investors few reasons to go short - an indication of how inter-connected these three trends really are. And again, the credit crunch stands out as the common element because in its wake, with the debt markets frozen and the equity markets in disarray, commodities indexes stood out as the only relatively safe place for skittish investors to park their vacant capital. The result? More capital chasing futures contracts using predominantly the same strategy: go long and hold.

Material impact on price

Now, keep in mind that futures prices are driven by expectations. As I argued in my last post, worries about fundamental supply and demand are already putting upward pressure on futures. But this effect is exacerbated by specualtors’ increasing net long interest in oil futures contracts because as more index speculators wishing to go long and hold crowd the market, the marginal futures contract becomes more expensive to purchase, which bids their prices even higher.

Here it is crucial to point out that commodity futures contracts expire every month, which forces their holders to either take the physical delivery of the commodity or to sell the contract. In practice, only about 5% of futures contracts ever result in physical delivery, and this figure isn’t any different in today’s market than in years past. So critics argue that non-commercial commodity investors cannot possibly be bidding up the price of oil since they are not removing a single drop of oil from the market (this is a point espoused by New York Times columnist Paul Krugman); they simply use calendar swaps to sell the contract to someone else before it expires and physical delivery is ultimately accepted by a commercial market participant. Thus, were non-commercial interests bidding up the price of oil, we would see huge pile-ups in oil inventories thanks to the likes of Goldman Sachs and JPMorgan, which is not the case.

But this line of reasoning misses the point. It is not the physical delivery of oil today that determines its price. Instead, it is the futures markets that are at the very front and center of how oil is priced since - as I explained in my last post - oil is priced over a futures benchmark.

Mixing water with oil

This distinction helps explain why comparisons to other commodities markets which are not as heavily traded as oil but are nonetheless surging in price - such as the global market for iron ore - are off the mark.

Yes - by all measures, prices for iron ore globally are booming thanks to growing demand from China. And because this is a market in which the only market-making activities are individual contracts between buyers and sellers, there is no room for speculative influences. Ergo: fundamental demand must be driving iron ore prices, not fundamentals.

Fair enough. But to point to this and to say it this is evidence that oil must also therefore be booming purely because of fundamental demand brushes over several crucial differences that don’t make this an apples-to-apples comparison:

• Oil pricing is benchmarked off of futures contracts. Iron ore pricing is based on spot contracts between individual market makers
• Oil has far more sophisticated market mechanisms that allow for greater price discovery (exchange-based trading, swaps, futures). Iron ore doesn’t
• No one market participant is large enough to significantly impact the price of oil. Conversely, the market for iron ore is dominated by big players who have significant control over price; when Brazilian miner Vale announced in February that it would sell iron ore to South Korean and Japanese steelmakers for 65% more than its 2007 prices, that deal effectively set the price benchmark for the whole industry
• The price of oil is growing by leaps and bounds. Iron ore is experiencing a more modest price escalation. Even a 65% year-over-year increase isn’t bad compared with the more-than-doubling of oil over the last year

Clearly, this well-intended comparison mixes water with oil.

Stormy outlook

Considering all of this, it is difficult to argue that speculators aren’t having any impact on the skyrocketing price of oil. Rather, the appropriate questions are: how much of an impact and how big relative to the other two trends. This is difficult to quantify, but estimates such as 50% of today’s oil price being caused by speculation - as offered by Masters during his testimony - don’t pass the smell test and only galvanize those who wish to keep speculators’ hands clean (in which case, rather than focusing their efforts on rebutting Masters’s testimony point-by-point, critics should try to deconstruct the much more balanced analysis offered by Krapels).

At the same time, though, it is important to remember that any price tag that we apply to speculation’s share of a barrel of oil would not be as high as it is without dollar depreciation and concerns about tight supply and demand since the three are very closely interconnected. As Krapels put it, “it would be naïve to expect any sustained causation between trading strategies and prices,” but “there are, nevertheless, several areas where causation should not be dismissed, all of them consistent with normal economic analysis,” among which he names:

1. Perfect storm episodes: there are likely to be periods of time when the condition of the physical energy market and trading strategies of financial market participants are in such good alignment as to produce “herding” and “bubbles” or their opposite, crashes
2. Variations on the market power syndrome: It is possible that the positions of some market participants - index funds as one example - are so large as to constitute witting or unwitting market power. A large-scale infusion or retreat from any of the various positions very large index funds might have price effects

By the looks of it, we are currently experiencing both situations: the mixing of these three trends has indeed created the perfect storm, and the resulting influx of long-and-hold speculators helped to grow it into the hurricane that it is today.

It’s no news that energy and commodity prices have been rising at breakneck speeds; just look at the Dow Jones AIG Commodity Spot Index - which tracks commodity price levels and is up nearly 40% over the last nine months. Instead, the $126/barrel question that’s stirring up controversy and making news is: why?

There seems to be broad agreement among economists as to who the culprits are: rising demand from countries like India and China for food and energy (exacerbated by a weak dollar), weather-related crop shortfalls reducing supply, speculation in the commodity markets and - perhaps most controversially - the use of corn crops for biofuels.

There is broad disagreement, though on which one of these structural/speculative factors is most to blame, and the tug-of war is just beginning. On Friday, the Wall Street Journal reported that 51% of economists in its latest forecasting survey said that demand from China and India was the prime factor in soaring energy pries, and 41% said that demand was the chief contributor to food costs. Perhaps most strikingly, only 11% saw a bubble developing due to speculation.

Now, no one can deny that growing demand for a refrigerator in every Chinese kitchen and a car in every Indian garage isn’t a powerful driving force behind commodity demand for everything from grains to metals to petroleum. However, looking at the timing of this latest explosion in commodity prices, one is tempted to give the speculation thesis a bit more weight in this debate.

Last week, the U.S. Joint Economic Committee on the Economy held a hearing on precisely this issue, with Tom Buis, President of the National Farmers’ Union and U.S. Department of Agriculture Chief Economist Joseph Glauber leading the testimony (watch the C-SPAN video here). About the first hour was good old-fashioned political grand-standing and speechmaking, but the last hour contained a few excerpts worth sharing:

[1:37:23] Rep. Carolyn Maloney (D-NY): According to the New York Times, commodity-exchange traded funds, which was developed barely 4 years ago, have grown nearly seven-fold since 2005, and to what extend are higher food prices being driven by speculation in commodity markets?

[1:37:42] Tom Buis: I appreciate that question because this has been a big concern. [. . . ] It’s something we’ve been hearing in farm country for quite some time is we can’t capture this price as I mentioned before this futures market has which markets have counted on forever has been eliminated and part of the reason is because the speculation into the market price has caused the market to explode. In the case of wheat, they reached contract limits day after day and, well, when you do that, that country elevator or that farmer has to pay a margin call and one country elevator I talked about that had pre-bought wheat for fall delivery had a million bushels and the price of wheat was going up 60 cents a day. Nothing was changing in the fundamentals at that point. There was lot of speculation, export markets coming in, that was costing him 600 thousand dollars per day to meet the margin calls and as a result he hit his credit limits. Hitting those credit limits forced him to cut off buying that grain from the farmer. So we raised these concerns and we were told nothing extraordinary was wrong except they could not explain: cotton. Cotton - we have a huge surplus of cotton, we had a great crop, it’s all over the country, you can’t hardly give it away and cotton prices spiked upon speculation. Now, when they went up, every farmer’s hoping that they would be able to get that price but weren’t able to. There’s explanations that need to be made. I think its similar to some of the other bubbles we’ve seen recently, and it could be the biggest train wreck we ever see.

[A quick primer on margin calls: let's say I own a grain elevator. The way I make money is basically via a broking business: buy grains low, sell high. To enhance my returns, I may buy grains on margin, meaning that I borrow funds to make the purchase. If my margin limit is 50%, then that means that I must keep my equity at least at 50% until I sell the grains and close my position. So if I buy $100 worth of grains and the price goes up, say, 20%, then I get a margin call from my lender asking me to deposit an additional $10 of equity to meet my 50% margin limit (which went from $50 to $60 as a result of the purchase.]

Long story short: if you are grain elevator posting margin and are locked-in for future delivery via a futures contract, then your short-term liquidity dissipates and you don’t have money to purchase additional grains - even if your grain elevator is just sitting there half empty. If this is indeed what’s happening in farm country right now, then this may indeed be a train wreck waiting to happen since it means that speculation in grain commodities is essentially causing a bottleneck in the supply chain: grain elevators are being maxed out, but not by fundamentals like overproduction but by speculation.

So what impact does this have on the commodities markets? To check it out, I took Buis’s example - cotton - and plotted a USDA-published index for U.S. cotton production alongside a middling index for average U.S. cotton prices on a relative scale starting in July 2007 (see below):

By any standard, this does not look like a healthy price vs. production index graph, where you expect the two variables to move in opposite directions. From August through September, and from November through December, cotton prices actually increase at a faster rate than production (to compare this with price vs. production curves I ran for other commodities on Bloomberg, click here).

Sure, it could be because of higher demand, but the timing here makes me think otherwise: money seems to be pouring into the market about the same time that the credit crunch hits - August - and comes back with a vengeance - November. That it could be dislocated money from the credit crunch looking to find a new home - especially in the midst of a Fed easing cycle - is not entirely implausible.

Granted, so far this amounts to nothing stronger than a hop-skip from correlation to conviction. But when you combine it grain elevators being effectively maxed out due to margin calls, a sharper image starts to take shape. As Buis notes in his written testimony (see below), “with stocks and bonds in turmoil as a result of the mortgage crisis, investment firms seized opportunities in the commodity futures markets. Billions of dollars from pension and other investment houses poured into the hot commodity markets. As a result, many commercial entities of farm commodities have faced skyrocketing margin calls on hedge contracts which have for a long-time been a financial risk tool for farmers and grain elevators.”

Granted, Buis lists higher energy costs (to which food prices are very highly leveraged due to transportation), weather-related supply shocks and the weak dollar and export demand as his top three reasons for hot commodities (ethanol - as expected from a farm man - is not the culprit).

But if this disturbing scenario is indeed playing out in farm country right now, then the bubble which economists seem to be hitherto dismissing - while not the main culprit behind hot commodities - could be far uglier, far larger, and far more damaging than we currently acknowledge.

* * * UPDATE: After I wrote this post, a friend alerted me to an article on the the impact of margin calls on grain elevators from the April 2 edition of the Wall Street Journal. Check it out to get a better understanding of how this all works, and what the potential consequences may be.