Analysis and recommendations regarding oil and the Index Speculators

Hedge fund operator Mike Masters’ Senate testimony on oil speculation, recommended for our review by Dan Dicker in the piece below, reads as quite an indictment of so-called Index Speculators. By the way, the Index speculators are “Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments” and other investors who probably thought that sub-prime was the New, New Thing a few years ago. They are by far the largest participants in commodities trading now, though they were a small fraction of trading only a few years ago:

Commodities prices have increased more in the aggregate over the last five years than at any other time in U.S. history. We have seen commodity price spikes occur in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo…unlike previous episodes, supply is ample…What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets…Index Speculators…distribute their allocation of dollars across the 25 key commodities futures according to the popular indices: the Standard & Poors – Goldman Sachs Commodity Index and the Dow Jones – AIG Commodity Index…

Demand for futures contracts can only come from two sources: Physical Commodity Consumers and Speculators. Speculators include the Traditional Speculators who have always existed in the market, as well as Index Speculators. Five years ago, Index Speculators were a tiny fraction of the commodities futures markets. Today, in many commodities futures markets, they are the single largest force. The huge growth in their demand has gone virtually undetected by classically-trained economists who almost never analyze demand in futures markets.

Index Speculator demand is distinctly different from Traditional Speculator demand; it arises purely from portfolio allocation decisions. When an Institutional Investor decides to allocate 2% to commodities futures, for example, they come to the market with a set amount of money. They are not concerned with the price per unit; they will buy as many futures contracts as they need, at whatever price is necessary, until all of their money has been “put to work.” Their insensitivity to price multiplies their impact on commodity markets.

Furthermore, commodities futures markets are much smaller than the capital markets, so multi-billion-dollar allocations to commodities markets will have a far greater impact on prices. In 2004, the total value of futures contracts outstanding for all 25 index commodities amounted to only about $180 billion. Compare that with worldwide equity markets which totaled $44 trillion, or over 240 times bigger. That year, Index Speculators poured $25 billion into these markets, an amount equivalent to 14% of the total market…

One particularly troubling aspect of Index Speculator demand is that it actually increases the more prices increase. This explains the accelerating rate at which commodity futures prices (and actual commodity prices) are increasing. Rising prices attract more Index Speculators, whose tendency is to increase their allocation as prices rise. So their profit-motivated demand for futures is the inverse of what you would expect from price-sensitive consumer behavior.

You can see from Chart Two that prices have increased the most dramatically in the first quarter of 2008. We calculate that Index Speculators flooded the markets with $55 billion in just the first 52 trading days of this year. That’s an increase in the dollar value of outstanding futures contracts of more than $1 billion per trading day. Doesn’t it seem likely that an increase in demand of this magnitude in the commodities futures markets could go a long way in explaining the extraordinary commodities price increases in the beginning of 2008?

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.

Masters’ recommendations to Congress are fairly sweeping:

Number One:…Congress should modify ERISA regulations to prohibit commodity index replication strategies as unsuitable pension investments because of the damage that they do to the commodities futures markets and to Americans as a whole.

Number Two: Congress should act immediately to close the Swaps Loophole. Speculative position limits must “look-through” the swaps transaction to the ultimate counterparty and hold that counterparty to the speculative position limits. This would curtail Index Speculation and it would force ALL Speculators to face position limits.

Number Three: Congress should further compel the CFTC to reclassify all the positions in the Commercial category of the Commitments of Traders Reports to distinguish those positions that are controlled by “Bona Fide” Physical Hedgers from those controlled by Wall Street banks. The positions of Wall Street banks should be further broken down based on their OTC swaps counter-party into “Bona Fide” Physical Hedgers and Speculators.

There are hundreds of billions of investment dollars poised to enter the commodities futures markets at this very moment. If immediate action is not taken, food and energy prices will rise higher still. This could have catastrophic economic effects on millions of already stressed U.S. consumers. It literally could mean starvation for millions of the world’s poor.

Some prefer a laissez-faire approach to market imbalances such as this. But it was the decoupling of futures markets from delivery acceptance obligations that caused tulipmania after all. Thoughtful regulation of futures markets is not in itself unreasonable, just as it is not in the stock market. Personally, we’d prefer public floggings of the offenders.

3 Responses to “Analysis and recommendations regarding oil and the Index Speculators”

  1. Lesley Says:

    Dear Mr. Risko,

    Thank you for linking Mike Master’s Senate Testimony. It would seem to me that our government would better off dealing with Index Speculators than suing OPEC. I genuinely don’t understand what Congress hopes to accomplish with an anti-trust suit.

  2. feeblemind Says:

    Thanks for the post. I had never heard of index speculators. I need to think about this.

  3. Janet Rose Says:

    Regulation of an investment like commodities results in behavior that obviates the regulation and makes the speculative activity more aggressive than it would have been without the regulation. Rather than regulate commodities, you might consider asking Ben Bernanke to reduce the massive money supply increases that he and Alan Greenspan have been pursuing. Blaming speculators for central bank incompetence is an old tactic. Any market can correct itself unless it has been artificially inflated by central bank policy. You are making the problem worse, not better. You might try an occupation different from economics. You are not very good at economics.

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