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Hedge fund manager, Michael W. Masters, testified before the Senate earlier this week (PDF File). He highlighted one of the main trends impacting the commodities markets today:
“What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.”
Armed with a significant amount of data Mr. Masters fired that the ‘demand shock’ from what he calls ‘Index Speculators’ is the primary price mover of energy and food commodities today. Some interesting statistics were used to help drive this conclusion home:
“In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculators demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!”
While Mr. Masters isn’t exactly saying anything new – when tiny markets attract huge amounts of investment dollars underlying prices tend to rise – what he does do is add color to the discussion Gene Epstein (WSJ) helped kick start back in March. For those in need of a refresher:
“Index funds offer investors an easy, inexpensive way to gain exposure to a segment of the commodities markets or a broad-based basket of commodities. Result: The funds have drawn many private investors who have never ventured into futures, along with pension funds and other institutional players looking to diversify. But for all the virtues that the funds hold as a way of spreading bets across commodity markets, they take only long, or bullish, positions, avoiding short-selling. In other words, they trade on the naïve and potentially fatal assumption that commodities have the same tendency as stocks to rise over the long run.”
But while Epstein remained relatively neutral to the potential consequences of the “Index Speculators”, a sharp rally in energy and food prices since March compelled Masters to paint a significantly more ominous picture. In fact, Masters hints that action is needed right now to avoid a catastrophe.
“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.”
The ‘immediate action’ Masters is calling is as follows: Congress should immediately stop pension funds from investing in commodities and close the “Swaps Loophole” (which allows Index Speculators to circumvent position limits), and the CFTC should offer more transparent COT data. Given that the CTFC recently held a fruitless roundtable discussion relating to position limits and Congress doesn’t seem at all interested in taking Masters’ advice, investors are left to anxiously await another end to the commodities boom. That being, when investment demand for commodities dries up.
The Herd May Continue To Run…
With crude oil only recently going ‘contango’ and other investment alternatives (i.e. stocks and real estate) no longer attracting the hot money crowd, the argument can be made that commodity prices will continue to attract investor interest over the near term. As Masters noted and bubblelogic confirms, “one particularly troubling aspect of Index Speculator demand is that it actually increases the more prices increase.” Nevertheless, basing an investment on excitement and the greater fool theory can be dangerous, let alone when there is there is some logic at play:
Unless we are peak-everything the U.S. led slowdown (assuming it persists and/or resumes at some point in the future) should materially damage the demand side of the commodities equation.
In other words, unless the history books are being rewritten by the emerging market miracle currently being discussed ad nausea, major commodity price swings lower will eventually coincide with disruptions in global economic activity. Seemingly obliviously to this threat the herd of commodities investors continues to grow.
“Assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March 2008, and the prices of the 25 commodities that compose these indices have risen by an average of 183% in those five years!”
..Until It Meets The Cliff
There is an actual place in Alberta Canada – home to Canada’s oil sands – called Head-Smashed-In Buffalo Jump. As Wikipedia notes, “The buffalo jump was used for 5,500 years by aboriginal peoples of the plains to kill buffalo, by driving them off the 10 metre high cliff.” As Wall Street increasingly touts the diversification and ‘safe haven’ tributes of commodities to an accepting crowd, the image of Buffalos being corralled and directed to their eventual demise can easily be conjured up.
“If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged.
Why is there not outrage over the fact that Americans must pay drastically more to feed their families, fuel their cars, and heat their homes?”
Needless to say, when theorizing about a Buffalo Jump end for many commodity participants it may be worth remembering that commodity prices have rallied more strongly and for longer than most thought possible. Perhaps instead of showing why he thinks prices are essentially being rigged higher, Mr. Masters actually pinpointed why prices must and will continue to move higher forever? Thanks to insatiable investor/Chinese demand this time things really could be different, couldn’t they?
In a word, no. Rather, the contrary conclusion to unprecedented flows into commodities is that when the music stops many naïve investors will be smashed. As for the ‘timing’ of this event, as early as 1996 U.S. stocks were showing signs of being in a mania, the U.S. and global real estate bubble was clearly brewing as early as 2002, and legitimate commodity bubble concerns have been making the rounds since at least 2005. In other words, there is no ‘timing’ mechanism that can predict the end of ‘bubbles’ before they burst, especially when rising prices themselves start to make more and more people think that no cliff rests beyond the horizon (as seems to be the case today in many commodities). I wish there was a more helpful way to frame today’s commodities bubble, but unfortunately there is not.
Incidentally, and on a seemingly completely different note, the inevitable demise of the U.S. dollar (i.e. all unbacked paper money eventually fails) has been anticipated for a lot longer than the commodities bust. A dollar bust would seriously complicate the commodities bust theme given that most commodities are priced in U.S. dollars. So many Buffalo Jumps so little time...
BWillett@fallstreet.com
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