Veteran oil trader Dan Dicker, whom we’ve cited previously, has some enormously interesting things to say about the wild ride in commodities and particularly oil:

The word “speculation” has been applied to the dynamics of oil and general commodity pricing, and when it is, the words “manipulation” and “bubble” follow them shortly after. Let me explain why these words don’t apply, and we’ll have a better idea of what levels oil and other commodities can reach.

First, we need to understand that commodity pricing is no longer being arrived at by the traditional users of commodity markets. In my first article, I described the nature of price discovery and talked about how legitimate buyers and sellers find each other using exchange contracts to arrive at fundamentally correct prices for corn, wheat, oil and other commodities.

In the last few years however, speculation, particularly indexed speculation, has swamped the volumes of legitimate participants and left them outside the system that was created for them. Farmers are less often utilizing the forwards markets, refiners cannot make a reasonable margin on $4-a-gallon gasoline, and OPEC ministers tell President Bush that there’s no one left to sell oil to, even if they agreed to increase supplies, and they’re not kidding…

if we come to the conclusion that traditional sources of price discovery have little influence on the markets, what is determining price? Everyone wants exposure to oil and other commodities as a better return investment to stocks and bonds today. And there are not many places to go if you want to be exposed to (long) commodities. The NYSE offers more than 20,000 issues if you want exposure to stocks, but there are only two major oil futures contracts being traded today: WTI on the New York Mercantile Exchange and Brent Oil on the Intercontinental Exchange. There’s a lot of fresh money showing up on these and other exchanges looking for exposure to commodities that until recently never looked for it before…

when I say exposure, I mean they are looking to buy and only buy. Much of this new money is coming from indexed futures funds, which try to represent a basket of commodities in one instrument that you can buy like a stock — although they are still biased toward the hotter commodities such as oil, metals and grains.

Mike Masters of MastersCapital has done extensive research on the rise and influence of indexed futures funds and commodity price discovery — he testified yesterday in Washington, and his statement is available here I recommend it as essential reading to all of you.

Indexed futures investing is not nefarious, in that there are no special traders looking to “fix” prices or manipulate prices upwards to get returns — the investors in these instruments are just like you and me, looking for another asset class that is outperforming the traditional asset classes they also hold. To put it simply, I am an oil trader, but my daily trading isn’t driving up prices in oil. However, my investment in the Pimco real return commodity fund, an indexed futures fund, most certainly is. There is speculation, but there isn’t any manipulation going on. If we’re really looking for someone to blame for rising commodity prices, we’re going to see far better candidates by looking in the mirror than looking at OPEC.

Futures on commodities also have one key difference from all other asset classes, and it makes this problem even thornier: open interest. If you want to buy a house — get long houses — you need to buy it from someone who has a house for sale. Similarly, if you want to buy a share of Citibank or Hewlett-Packard or Transocean, you also need to buy it from someone who owns a share already. I know this sounds simple and obvious except for this: This rule doesn’t apply to futures on commodities.

If you want to buy a contract of soybean oil for delivery in July, you can purchase it from someone who already owns a contract and is looking to sell, but you could just as easily buy a contract from someone who doesn’t own it at all and is willing to create a fresh contract for you to have in your portfolio. This is the idea of open interest.

Every stock offered on every exchange has a certain number of shares that are open for trade — a company can issue more or buy back some, but the number of shares stays pretty steady. Housing inventory can go up or down, but it also requires the involvement of principals either building or knocking down homes. However, anyone, and I mean anyone, can create a fresh contract of a natural gas contract for delivery in October just by finding a trade.

Let’s try to understand just how monumental this difference is in practice. If I am looking (like an indexed fund) to purchase baskets of futures, I don’t need to find already involved participants of the futures markets to sell contracts to me, because of open interest. If I can entice anyone who believes he can gain a financial edge by selling those contracts, he is as welcome as anyone to take the other side of my trade.

Now remember, I have to buy and buy today — money is pouring in, looking for exposure, and I must put it to work. The only way to drive a fresh participant — a hedge fund or trade market maker — into selling me that contract is through price. It may be a crazy price, a higher price, a price that no longer represents fundamentals of supply and demand.

On the other side, sellers of oil futures, for example, have tried to find fresh hedging and arbitrage opportunities to try and satisfy the appetites of these insatiable buyers — they’ve gone to buying drilling and coal stocks and other oil ETFs as well as other commodities against their oil shorts, and most have been hurt. The guys I worked with for 25 years on the floor have all gotten killed if they have relied upon their experience and training in trying to understand these oil markets and traded them the same way. The appetite for exposure is just swamping everything else that used to be important out there.

And commodity markets now swing wildly upon only financial rationales of capital entry and exit and less and less on fundamental factors. Wheat should be a good buy here, not because of any fundamental factors but because there will continue to be consistent buying pressure, and it has recently sold off a lot. I’ll admit it is a simplistic way to view a complex market space, but there is more than a little truth to it.

The most important takeaway from all this is that you cannot get a traditional “bubble” from this kind of market dynamic. Since you are not trading a known “market cap” in commodities as you do in every other asset class, there is no known or set “inventory” you need to have traded through to exhaust supply. In commodities, the inventory is not ever defined and can increase, at least in theory, forever.

Therefore, the only way to come to an end — or a bursting of a bubble, at least from a financial view — is to exhaust the appetite for exposure. And to me and to most other observers of the commodity markets, this is a meal still in its very early courses.

This entry was posted on Thursday, May 22nd, 2008 at 4:43 am and is filed under General, business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.