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Commodity Speculation: Not just fun and games, its far reaching ramifications



May 21, 2008 – Comments (4)

Below is the best and most important (at least as far as the economy is concerned) article I've read in some time. Commodity markets are theoretically created to promote an efficient market between buyers and sellers. A wheat farmer can sell his produce, via a commodity futures market, months before the wheat has grown. This allows the farmer to lock in a price (and hopefully profit) and allocate his/her farming expenses and budget accordingly. On the other side of any commodity trade is the futures purchaser. For example: a bread company. By purchasing the wheat future the bread company now has a known quantity of a key component of its product set to arrive on a certain date. The bread company can then budget and set its product prices accordingly. Efficient and theoretically less volatility for the price of wheat. The buyer and seller have hedged their risk of future wheat price swings by locking in a known price the day of the futures trade.

Where is the problem? Remove the above “commercial” wheat company and enter the “non-commercial” institutional investor. Armed with almost free money from the Fed the same individuals whose actions almost imploded the world banking system (and they still might: CDOs held inside money market accounts? So far there have been no noteworthy failures but things could be chaotic if institutions cease to cover the losses from their own mistakes. For example Legg Mason continues to cover its money market fund losses. What happens when there is no longer sufficient capital available to these already cash strapped institutions? Rant complete) are looking for a new playground. Well maybe they are looking for a way to make a few quick bucks because their balance sheets desperately need some assets that actually exist to compare against liabilities whose existence has yet to be announced.

Whatever the motivation, institutional involvement in the commodity markets is creating an inflation time bomb. To date inflation has been absorbed in large part by the middle man. Example: oil refiners buy crude oil on the world market at $130 a barrel (thanks commodity market) and refine the oil into gasoline for sale in the U.S. The problem is commodity market trading has driven crude prices on the world market up 100+% in the past year (prices were around $60/barrel a year ago). But, gasoline prices have only risen 40% in the last year. Refiners costs went up and their product’s sale price can’t keep up. In the first quarter of this year, almost across the board, refiners lost money for the quarter. You think refineries will keep selling oil at a loss for long? Hello higher gas prices. Inflation. You think our bread company will be raising their prices on bread soon?

This article states that Speculators "consumed" as much additional oil as China in the past 5 years. Gee I wonder how supply and demand have gotten so far out-of-whack? Are these speculators you and me? Of course not, and if so we don’t make up very much of the total market. This money is pouring in from the institutions. Goldman Sachs recently forecast $180/ barrel oil. I guess they’d know that since they are bidding it all the way up to that price… and making money along the way. I’m all for lassez-faire and a free market economy but there has to be some regulation in banking. How about for starters a regulation that keeps financial institutions out of the commodity markets before something crazy happens like a bubble burst? One implosion of the banking system at a time please. The economy would benefit through a banking system that remains in existence (things get a little crazy when its not) and lower price levels. It all probably makes too much sense though.


Enjoy the Article:

Authored By: Philip Davis 05/21/08

That was a nice dip yesterday!

We were so well covered that we spent the day in member chat discussing World Hunger as we ho-hummed the sell-off, but we did get a little bullish towards the end of the day and started picking off some callers, looking for at least a bounce in the morning but willing to roll down or add to some of our stronger long positions.

The most exciting thing that happened Tuesday was the testimony of Michael Masters to the Senate Committee on Homeland Security (who have sweeping powers) as he spilled the beans and gave the Senate a very detailed inside view of exactly how speculators are the primary cause of high commodity prices.

Don't look for any commentary on this in the WSJ or most media outlets, you would think this entire investigation isn't going on as you watch CNBC wearing their Oil $130 party hats this evening!

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.

With very bold categories in his presentation like "Index Speculator Demand is Driving Prices Higher" Masters lays out a simple and compelling case that illustrates how over $250Bn of speculative money has poured into the commodities markets since 2003, driving the average cost of commodities indexed up 183% WITHOUT ANY SIGNIFICANT INCREASE IN ACTUAL DEMAND.

It's not just oil, there is a chart on page 4 of his presentation that shows how on Jan 1st 2003 sugar futures stockpiled totaled 2.3Bn pounds. On March 12th of this year, speculators had stockpiled 48Bn pounds of sugar. Soybean oil went from 163M pounds to 4.5Bn pounds, corn from 242M bushels to 2.4Bn bushels, coffee from 195M pounds to 2.4Bn pounds. wheat from 166M bushels to 1.1Bn bushels. Even cattle and hogs have had 10-fold increases in speculation. This is your "demand," 10 month supplies of commodities removed from the markets over 5 years and held by speculators who point to the "demand" as evidence of a tight supply - A TOTAL CROCK!

Speculators "consumed" as much additional oil as China in the past 5 years (848M barrels) while gasoline stockpiles have risen from 1.1Bn gallons to 3.5Bn gallons and natural gas stored by speculators has gone up from 331M BTUs to an insane 2.3 Billion BTUs. Aluminum - 10x, Nickel - 5x, Zinc - 10x, Copper - 7x, Gold - 10x, Silver - 15x — Madness!

In fact, Index Speculators have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over the last five years.

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.

I urge you to set aside the time to read this full report, it is an excellent presentation of pretty much everything I've been "ranting" about for 2 years put together by a guy who trades commodities for a living and is, as I am, totally fed up with the destruction of our economy and the suffering that is being caused by this rampant commodity speculation. In order for Goldman Sacks to make $1Bn, every driver on Earth needs to pay another $1 per gallon for gas this year - is that an efficient market? If all 2Bn of us just send GS a check for .50, THAT would be efficient. Unfortunately, as we discussed last week, Goldman's partners in crime who got together and formed the ICE back in 2003 (when all this started) also want their Billions - no matter what it costs you.

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.

When Congress passed the Commodity Exchange Act in 1936, they did so with the understanding that speculators should not be allowed to dominate the commodities futures markets. Unfortunately, the CFTC has taken deliberate steps to allow certain speculators virtually unlimited access to the commodities futures markets.

Masters closes with the key issue, that:

The CFTC has granted Wall Street banks an exemption from speculative position limits when these banks hedge over-the-counter swaps transactions. This has effectively opened a loophole for unlimited speculation. When Index Speculators enter into commodity index swaps, which 85-90% of them do, they face no speculative position limits.

The really shocking thing about the Swaps Loophole is that Speculators of all stripes can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with aWall Street bank and then the bank buys $500 million worth of Wheat futures. In the CFTC's classification scheme all Speculators accessing the futures markets through the Swaps Loophole are categorized as "Commercial" rather than "Non-Commercial." The result is a gross distortion in data that effectively hides the full impact of Index Speculation.

Additionally, the CFTC has recently proposed that Index Speculators be exempt from all position limits, thereby throwing the door open for unlimited Index Speculator "investment." The CFTC has even gone so far as to issue press releases on their website touting studies they commissioned showing that commodities futures make good additions to Institutional Investors' portfolios.

This is how the current administration, through the "Enron Loophole" and other directives to the CTFC, has perverted an organization that is supposed to be CONTROLLING speculation and turned them into more than an enabler, but an actual cheerleader for the commodity markets. You would think this would be news but the same people who are sucking over $2Tn a year out of our pockets (over and above what we paid for the same commodities 5 years ago) are also the people who control the mainstream media and the very government that is listening to this testimony.

In order to put a stop to this YOU have to act. YOU have to get mad, YOU have to tell people what is happening because no one else is doing it are they? Feel free to copy this, Email it, print flyers - whatever - this is something that needs to be talked about and what better time than the day oil hits $130 a barrel while you drive less than you did last year, when it was $51.03 in January!

4 Comments – Post Your Own

#1) On May 21, 2008 at 2:32 PM, MRTShorts (97.22) wrote:

what goes up, must come down. spinning wheel round and round.

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#2) On May 21, 2008 at 2:35 PM, FourthAxis (< 20) wrote:

wow, you used the words:

Oil 12 times
Speculator 20 times
Speculation 6 times

Thanks for the returns.

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#3) On May 21, 2008 at 4:14 PM, cubanstockpicker (21.20) wrote:

Speculation is becoming the maifa middlemen creating a global pressure on all commodities that shouldnt be traded with such robust angst.

I agree with you wholeheartedly. The world investment market has too much cash to invest in commodities like wheat, corn etc...

There needs to be a stronger CAP on total speculation, or there will be another crash, not like if its a bad thing being the excess cash floating around is whats creating this mess. 

There must be an abrupt halt to this madness because we are only self perpetuating our own problems and creating another disaster (see housing bubble and Unregulated housing lending practices) 5, 10 or even Twenty years ago, ags were not even traded at a fraction of todays volume.




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#4) On May 21, 2008 at 4:19 PM, ATWDLimited (< 20) wrote:

Well, its better than bad US debt filled assets, if the Us government was small, cut spending, lowered taxes, put up pro industry barriers, it would be a different story, like a century ago.

Investors don't want weak, high debt, low growth holdings, so they don't want the US. 

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