When food prices hit their previous peak in 2008, there were riots on the streets of 30 countries, with the poorest including Haiti and Bangladesh the hardest hit. With the media blaming “speculators”, the US Commodities Futures and Trading Commission, launched an investigation into commodity traders, aimed at measuring the impact of the so-called financialisation of commodities trading over recent years.
In late 2009 the CFTC launched its new disaggregated measure of traders' commitments, and the results confirmed what many had suspected -- the number of commodity futures and futures options contracts had grown five-fold over the previous 10 years. Financial players had become dominant traders, the CFTC said, outnumbering traditional market users by a ratio of three to one on exchanges, even without the larger over-the-counter positions taken into account.
Behind the rise in financial institutions’ participation in commodity markets is an explosion in commodity indexes, exchange-traded funds, quant funds and other investment vehicles. Over the past 10 years, there has been a 50-fold increase in dollars invested in commodity index funds, analysts estimate.
Commodity investing through tracking indexes such as Standard & Poor’s Goldman Sachs Commodity Index (SP-GSCI) and Dow-Jones UBS Commodity Index (DJ-UBS) rose to $376 billion by the end of 2010, according to Barclays Capital, triple the amount in 2005. Commodity index returns were accessed using index swaps, medium-term notes and commodity exchange-traded products (ETPs).
With low interest rates and slow economic growth dampening demand for equities, appetite for commodities has surged in recent months. Commodity ETP assets rose by a stunning 11.4% in July, reaching 44.3 billion euros, according to Deutsche Bank. At the same time, commodities passed fixed income to become the second biggest ETP asset class after equities, registering a 17.9% share of the $171 billion market.
The most popular investment in the recent period has been gold and ETPs now hold a record 2305 tonnes of gold, according the World Gold Council, compared with 1649 tonnes two years ago.
The impact of the influx of cash, regulators suspect, is that commodity prices are no long driven by macro-economic supply and demand, but by futures markets betting on price action months, or even years, down the road.
Chicken or the egg
The truth of that assertion is predicated on the following dilemma – are prices rises causes by the chicken that is predominantly long positions on futures contracts, or the egg that is higher demand in the real economy.
Proponents of the former argue that futures should trade at a discount to spot markets, because commodity hedgers are effectively paying a premium to lock in future returns. However if futures are more expensive than spot then hedgers will simply buy more commodities than they need, pushing up prices in the physical market. In this way the “inflow” of investment money into commodities leads to rises in prices.
The opposing argument is equally as compelling. Macro economic factors such as weather-related crop losses, export restrictions, and a depreciating U.S. dollar are fueling price rises, it says. The world’s population is growing, boosting demand for food and materials. In Asia, for example, it is estimated that 75% of land that could be used for crops is already under cultivation. In India that rises to 95%. China has lost 9% of its arable land in the past 10 years.
“It’s difficult to say whether the market has become more volatile because of money flow or because we are in a much more volatile global environment,” said Kamal Naqvi, Head of Institutional Commodity Sales at Credit Suisse in London. “The investor base is much bigger, buts also much better educated, meaning stories are priced much more quickly and much more aggressively.”
The prima facie evidence is equivocal, with net longs on commodities such as wheat and cotton sometimes accompanying price rises, and other times not appearing to do so
Caught between the rock of speculation and hard place of rising demand are policy makers, charged with doing something to offset the devastating effects of runaway price rises on the world’s poorest populations.
The UN’s Conference on Trade and Development believes commodity derivatives markets need international oversight, transparency and intervention to offset speculation.
The wall of money flowing into commodities has encouraged “herding behaviour” and creates bubbles, it said in a report published in 2009.
“Market participants make trading decisions based on factors that are totally unrelated to the respective commodity, such as portfolio considerations, or they may be following a trend,” the UN agency said. “The price discovery mechanism is seriously distorted.”
Food prices in recent months seem to support that theory, with maize up 84% in July from a year ago, sugar up 62%, wheat 55% and soybean oil 47%. Amid pressure from farmers unions and politicians to impose position limits on trading, CFTC chairman Gary Gensler on June 10 suggested he agreed with the United Nation assessment that speculators were to blame,
The fact that some 90% of wheat futures contracts and derivatives on the Chicago Board of Trade currently trade long, Gensler said, suggest they are bought and sold by speculators with no connection to agriculture or food production and distribution.
According to the CFTC’s monthly index investment data report, the notional value of long commodity positions on US futures and related markets in June was $321.9 billion, while notional shorts totalled $94.2 billion, leaving an overall long position of $227.7 billion. The biggest long positions were in gold, gas, soya beans and oil.
Officially the CFTC has not launched any investigation into commodity speculation. However, Gensler’s description of commodity market dynamics was not an isolated outburst, and the CFTC in February outlined rules to modify position limits and accountability rules applying to some commodity contracts.
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) requires the CFTC to establish federal speculative position limits for both “exempt commodities” (including energy and metals products) and “agricultural commodities”.
A key new provision will bring the over-the-counter markets into the regulations, making them subject to margin requirements, increasing the cost of transacting and, according to opponents, reducing liquidity.
The proposals also include modifications to the “bona fide hedging” exemptions in current limits, including for swaps dealers, as well as provisions for more position visibility and aggregation requirements.
The rules are expected to be enacted some time in 2012, but not surprisingly have elicited howls of indignation from the derivatives industry, which insists that the regulators have fundamentally misunderstood the difference between high volumes of futures activity and gains in spot prices.
Contango vs backwardation
The central argument is whether the shape of the forward curve, a function of trading in the derivatives markets, leads the spot price or vice versa. The forward curve is said either to be in contango, trading above the spot price, or backwardation, below the expected spot price at maturity, and it is the interpretation of that relationship which is the root of the debate over the impact of derivatives on prices.
Some analysts argue that commodity forward prices should be in contango, as they include the so-called cost of carry – the cost of storing a physical commodity purchased today on the spot market.
In a basket of 24 commodities referenced by London-based ETF provider Source, six are in backwardation and 18 are in contango. In the oil markets, Brent Crude is in backwardation while West Texas Intermediate (WTI), also known as Texas light sweet, is in contango.
“The analysis we have done suggests that what drives the shape of the forward curve is fundamentals,” said Roxana Mohammadian-Molina, commodities research analyst at Barclays Capital.
“For example, if a market is in backwardation it means current supply/demand, driven by fundamentals is tight, meaning the price now is high compared with the forward price. This suggests buyers are worried that in, for example, three months the price will be higher, so they want to buy today and are willing to pay a premium.”
A contango market, on the other hand, suggests current supply is sufficient, meaning there is a lower likelihood of higher prices in three months time, and suggesting buying futures will be cheaper than buying spot and storing.
One group that does not buy the explanations offered by the financial institutions is the airline industry, which has launched a vociferous campaign in the US for legislation to limit derivatives activity in the oil industry.
The Stop Oil Speculation Now coalition, led by airlines such as Delta, which uses 95 million barrels of jet fuel, or 4 billion gallons, annually, and the Air Transport Association, are calling for curbs on financial players in the oil markets.
The huge inflow of investment money into oil amounts to a self-fulfilling prophecy, the coalition claims.
"Given how much trading there is today in commodities, it warrants as much attention and scrutiny as the stock market gets, and deserves some checks on the power of any individual player so as not to unduly influence" pricing, John Heimlich, the Air Transport Association's chief economist told McClatchy Newspapers in August.
Groups such Stop Oil Speculation Now have powerful allies in Washington, where there is widely-held suspicion over the impact of derivative markets on commodity prices. A US Senate Permanent Subcommittee on Investigations report in 2009 said that dramatic index investment flows had distorted prices, and that the activities of index traders comprised “excessive speculation”, in particular in the case of wheat markets.
British peer Lord Meghnad Desai has also claimed that oil prices are speculative and appear to be in a bubble, while academics Peter C. B. Phillips and Jun Yu reached the same conclusion econometrically.
The position was succinctly put in a Bank of Japan report published in March:
“Thus, the increasing share of investors who are less concerned about the fundamentals of each commodity has diluted the link between the return on commodities included in the major indices and supply-demand fundamentals. Given such evidence, the financialisation of commodities has caused commodity prices to diverge from the level explained by fundamentals,” the bank said.
“Index investors in commodity futures markets are characterized by their long-only positions and their dominance in the market. These characteristics of index investors seem to impose upward pressure on commodity prices, which can be augmented by trend-following momentum strategies...”
Speculation or diversification
On the other side of the argument a raft of financial papers, including one from the OECD, come to the opposite conclusion. In a study entitled ‘Commodity Index Investing: Speculation or Diversification” academics Hans R. Stoll and Robert E Whaley found little to complain about.
“We investigate this claim and conclude that there is little or no association between the trading
of index investors and the prices of commodities,” the academics said. “The surge in prices appears to be the result of other factors, principally expectations about inflation and future demand..”
Stoll and Whaley base their conclusions on three observations. First that returns of commodity futures contracts contained in indexes exhibit low levels of correlation, second that futures prices are not substantially impacted by the huge amounts of money settled and reinvested during index rolls, and lastly that new inflows into commodity index do not have a significant causal relationship with commodity prices.
One of the arguments made in mitigation of the commodity market’s impact on spot prices is the fact the futures contracts consistently converge on spot prices as they near the strike date. Any failure to do so would create simple and lucrative arbitrage opportunities for producers.
Short-term volatility, however, is a different matter and there are corners of the financial markets which recognise that futures trading can increase short term variations in price.
“Where the size of the futures market is large in comparison to the physical market you may see short term impact,” said Barclays Mohammadian-Molina.
“In the medium term however, price trends revert to fundamentals – in other words supply and demand dynamics.” Some studies note that the annual volume of CME wheat trades is 46 times the size of US production (2008 data).
Indeed, some analysts say there is even a negative correlation in the longer-term between index positioning and commodity prices. That is because of the smoothing effects of index rebalancing, when long positions are decreased on commodities that have seen the biggest increases and increased on those where prices have moved least.
In a paper entitled “Pipes, not punting” published in August, analysts at JP Morgan suggested that commodity prices are around half way through a 25 year super-cycle, and that marginal production costs are among the most powerful drivers of prices.
Nowhere in the existing literature, the authors say, “do we find the asking or the answering of the essential business question: how long is the pipe?”
In addition, the bank claims, annual Sharpe ratios for the S&P GSCI and DJ-UBS indexes since 1996 show that on a risk-adjusted basis strong performance years are becoming progressively less strong, while weak performance years are becoming progressively less weak. That suggests rising investors participation is aligning realised rewards toward fundamental risks. In other words that investors are making the markets more efficient.
As the debate continues to rage, food prices are set to rise further. The World Bank said in August that “global stocks remain alarmingly low”. Still, the CFTC may not complete limits on commodity speculation until the first quarter of next year, according to a filing on the agency’s website. No wonder then that Goldman Sachs in August reiterated that investors in commodities should stay “overweight”.