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Will the US government curb commodities speculation? Can they?

June 2, 2008

 

It’s not just prices at the pump which have been steadily moving higher over the past few years. Prices for everything from white bread (+20%), to eggs (+50%) to Apples (+21%) have seen significant increases well above the US government’s official readings of inflation.

But with food riots in the Americas, Africa, and Asia recently, and prices for nearly everything looking to once again post significant gains in 2008, many people are starting to look at this as a serious crisis, where at best higher prices will cause a slowdown in world economies, and at worst we’re looking at worldwide famine and political unrest.

Commodity prices being artificially inflated?

Who or what is really to blame for the higher prices? We’ve all heard the reports that higher commodity prices are the result of there being only a finite amount of the stuff around, and exploding demand by China and India as their populations become wealthier and modernize.

But recent congressional testimony by hedge fund manager Michael Masters would have you (and Congress) believe otherwise. Masters blames the run up in commodity prices in part on institutional investors such as corporate and government pension funds, sovereign wealth funds, and university endowments.

He makes some very good points, such as outlining the sharp jump in assets allocated to commodity index trading strategies, jumping from $13 Billion at the end of 2003 to $260 Billion as of March 2008. Over that time span, the prices of the 25 commodities that make up these indices surged by an average of 183%, Masters says.

The underlying issue is that these commodity index trading strategies are meant to replicate commodity indices which go up when commodity prices go up. So the managers need to buy futures in the underlying commodities to match the commodity index. This fact, that the index strategies are always buying, and never selling, is the problem, according to Masters – in that the futures markets participants agreeing to sell the futures contracts to them will keep demanding a higher and higher price for the contracts they sell.

This will cause a self-propelling affect, in which the index strategies’ buying interest causes prices to go higher, which causes the index to go higher, which in turn causes more money to flow into the index tracking funds, which causes those strategies to buy more commodity futures and start the cycle all over again.

As an example, Masters compares the “demand” for petroleum from these index speculators (as represented by the futures contracts they hold) with the actual increase in demand from China. He shows that the speculator’s demand increased by 848m barrels from ’03 to ’08, while Chinese demand increased 920m barrels, or a nearly equal amount.

In effect, Masters is saying that the large, long-only commodity index funds invested in by pension funds and other big institutional money – are unknowingly cornering the market on commodities and driving up prices, while current laws prohibit the transparency for the government to see that this is what’s happening.

You can read Masters full testimony here: http://hsgac.senate.gov/public/_files/052008Masters.pdf

Regulate the speculators?

Masters’ solution to this “crisis” is to pass legislation which prohibits pension funds from investing in long only commodity index strategies, and to re-work the existing legislation in order to provide better transparency.

With the general public quite unhappy with the rise in commodity prices (especially food and energy, you don’t see anyone complaining about the price of Gold), US lawmakers are lining up to “do something about it”.

They have already closed the so-called “Enron loophole”, which basically means there is now more oversight on over the counter commodity trading, and just closed the “London loophole’ as well, which was the name for US traders being able to trade futures on foreign exchanges and not have to adhere to US position limits, etc. Now British regulators have agreed to hand over daily trading data for all United States oil contracts traded in London via the ICE to the US government’s agency – the Commodity Futures Trading Commission (CFTC).

There is also a move by US lawmakers to “substantially” increase the margin requirements on energy futures (and I would assume other markets in turn), to make it “harder” to speculate on their prices. And the CFTC is also investigating market manipulation in the oil, Cotton, and now Corn and Wheat markets.

Maybe it isn’t Index Speculators:

There are a few holes in Master’s theory which we want to point out, however; and many more littered across the internet in response to his testimony.

First, there was a tripling of commodity prices in the 70’s, as represented by the CRB “spot index”, when by Masters own admission there was no money in commodity index strategies at that time. At the very least, this shows that prices can increase dramatically (and in fact even more so than they have recently) without the help of any outside forces.

Second, there have been substantial increases in commodities not represented in the indices the index speculators are replicating. If the artificial demand of index speculators is a result of the index funds buying futures contracts in those markets which comprise the index, then it would seem to follow that there would not be such a phenomenon in those markets with very small weights in the index or not in the index at all. We would expect those markets to not rise by as much without the “artificial demand” Masters outlines.

We can point out a few examples of where this simply isn’t the case. Eggs are not in any of the major commodity indices, and they have risen 50% in the last two years. Same with Apples, up 20% over the past two years (well above the 6% or so inflation gauge of the US government over that same period).

Further, the chart below shows that commodity prices on commodities not traded on regulated exchanges have increased much more than their brethren on regulated exchanges, with an average gain of roughly 500% since 2001 as compared to gains of 300% for the exchange traded futures. The exchange traded futures are the ones in the commodity indices, and the ones which should be most affected by the index strategies perpetual buying of their futures contracts, but they are not increasing as much (on average) as those markets not tied to an index. Curious indeed?

What could happen with CTA investments?

Unfortunately, whether the index speculators really are causing higher prices or not, the US government is likely to act on the assumption that they are, if only to appease the public and make it look like they are “doing something” about higher prices.

Which leads us to the point of this newsletter (at long last, you’re probably saying) – what could happen to your futures account if the witch hunt begins and new laws are passed to reign in the speculators.

The thing worrying most market participants is the fear that a law passed prohibiting pension funds from investing in long-only commodity index tracking funds would cause massive selling of positions in the futures markets. This would no doubt cause very large short term losses for all of the commodities represented in the major indices these funds are set up to mimic.

To this point, let us first say that any crisis you see coming is probably not a true crisis. If it is already being talked about, if we’re writing about it in our newsletter - it is out there in the public domain and is not likely to shock the markets.

So it is extremely doubtful that we’ll wake up one morning and find that $300 Billion worth of longs were forced out of their positions in the middle of the night – and all futures markets are limit down.

The lawmakers also have the pension funds to consider, which are made up of the retirement funds of everyday US citizens – teachers, local & state government employees, police, and so on. It wouldn’t play so well in the press for the government to cause losses in these folks retirement accounts by causing forced liquidations.

The likely scenario, in my mind, would be either a law saying no more index fund investing – which would protect the investors already in the space, while curing the supposed problem of new money driving up prices higher; and/or a law saying pension funds have to be out of the funds over the next 10 years or so.

Whatever the case, the result will likely be increased volatility (in the form of some sharp corrections) in commodity markets as participants try and decipher what the long term implications of less institutional demand for futures contracts is (if any). While this may scare your everyday investor, increased volatility is usually a good thing for CTA investments.

Most CTA programs have a long volatility profile (except option sellers, but those are mainly on stock index futures, however), meaning they are built to profit from sharp moves in one direction or the other. While many have done well during the run up in commodity prices, that does not mean they will not do well if prices sell off heavily. So a possible increase in volatility in commodity markets should not spook you as a CTA investor – and it may just be a welcome thing.

The bigger problem for CTA investors, in my opinion – would be the proposal to increase margins closer to the SEC level for stocks of 50%. Currently, a futures investor only has to put up about 5% to 8% of the value of the futures contract in order to trade that contract. An increase to 50% would mean investors would have to put up 10 times as much money to trade.

Now, CTA investors don’t trade on the bare bones margin requirement, and usually require about 5 to 10 times the required margin level as their minimum investment amount. But take an investment in CTA program Dighton Capital as an example. Their average margin to equity level is listed as 20%, meaning they ask for a minimum investment of $100,000 when the technical amount you need to put on their positions is only $20,000.

You can see in this example that an increase of the margin level to 10 times what it is now would require $200,000 (10 times $20,000) in the account just for margin, which would mean Dighton’s minimum investment would have to go up to at least that level, and more likely a healthy amount above that level, say $250,000 to account for any losses, drawdowns, etc. A Dighton investor who makes $30,000, for example, would now only see a percentage gain of 12%, versus what would have been a 30% gain on the old minimum of $100,000. Past performance is not necessarily indicative of future results.

Such an increase in margin would have a severe negative impact on the futures industry in my opinion. Online brokerage firms would likely go out of business rather quickly (their clients usually trade at close to 80% to 90% margin to equity). US futures exchanges would likely see volumes plummet, as small and large speculators alike would not be crazy about putting up 10 times the amount of capital to trade, and look to trade at exchanges in Dubai, Malaysia, and others, or go off exchange to engage in over the counter swaps and exchange for physicals.

And the CTA world would be changed dramatically, as minimum investment amounts would increase five to ten fold (just to cover margin) with no ability to notionally fund an account. With all of the investment being put towards margin, there’s nothing to notionalize.

From a CTA’s perspective, they would have a tough time raising capital and competing for investor funds in such a world, as their percentage returns would be slashed to just 10% to 20% of their current levels. A manager making 15% per year would suddenly be making just 1.5% to 3% per year – hardly an attractive return or efficient use of capital.

The good news:

Where do we go from here? The good news for the here and now is that the CFTC does not have the legal authority to increase margins on futures exchanges. Without sweeping powers being granted the CFTC - the margins are controlled by the exchanges themselves, and for many of the reasons outlined above, they have very little motivation for increasing them substantially.

It is also worth noting that so far, CFTC officials have not exactly been behind this view that undue speculation has fueled price increases. According to Christopher Doerning of Reuters, “The CFTC has cautioned against new regulations and shifting the blame entirely on so-called speculators. The regulatory agency's top economist told lawmakers in May the market seems to be acting appropriately, with global demand and tight supplies responsible for sending prices to record highs.”

The other good news is that there are trillions of dollars (and Euros, Yen, and Yuan) who like the system just the way it is, thank you very much. The biggest of these are the exchanges themselves, who have been among the fastest growing and most profitable US businesses over the past few years. Making their product essentially “more expensive” could only hurt that profitability.

Add to that the 300 billion in commodity index funds, and close to 200 billion in CTA programs, and you have a very interested (and well funded) group who does not want to see any of these measures go through.

Finally, even if a margin increase made it past the trillions of dollars against it – it could turn out to be essentially a non-event, and become just another way for large Wall Street firms and prime brokers to earn some fees. That is, if the increase in margin is just a regulatory hurdle, with no basis in the volatility of the market (meaning no way Crude Oil is going to move $45,000 worth in a day, but that’s what the margin is), the clearing firms would likely step up and allow investors to borrow funds in order to post the inflated margins (for a fee of course).

In the end, it is doubtful anything rash will be done with so much money and special interests lined up against it, and all but impossible for anything to happen “overnight”. . The more likely scenario are some more hearings, some investigations into market manipulation, and a long and dragged out debate on what and who is responsible for higher prices in order to satisfy the lawmakers – so they can appear to be “doing something” about higher commodity prices.

- Jeff Malec

Let us know what you think... Should speculators be curtailed? Could they be? Are they to blame? Email us at invest@attaincapital.com and let us know your thoughts.