So, a hedge fund could buy $500 million worth of wheat, which would be way beyond the actual market position limit, through a swap with a Wall Street bank, without having to worry about position limits. And there is no doubt that large purchases of any commodity will drive up prices, at least in the short term.

What does Masters think Congress should do? Prohibit pension funds from commodity index buying, close the swaps loophole on speculative positions, and make the CFTC (Commodity Futures Trading Commission) provide more transparency as to who is buying commodities. That would stop those nasty index speculators from driving up food and energy prices. Prices would come back down and we could all go back to driving our SUVs without having to worry about the cost.

Well, then, maybe not. It's not that simple. While there is no doubt that excess demand in the form of index buying can have a very real effect -on prices, it's not the whole story.

What an index fund does is buy a futures contract for a given commodity when money is first invested. Say that contract is six months out. When the contract is one month from expiration or delivery, the index fund sells that contract and buys another contract six months out. They sell before the contract could have an effect on the cash price of the physical commodity. The cash price is determined by supply and demand.

Let's look at supply. Masters mentioned wheat. Yes, the index speculators have built up a large futures position. But that's not the same as a large physical position. With demand soaring abroad and droughts crimping supply, the world's wheat stockpiles have fallen to their lowest level in 30 years, and stocks in the United States have dropped to levels unseen since 1948. That could go a long way to explaining rising wheat prices.

Corn? The USDA is expected to report corn stocks for the year ending Aug. 31, 2009, to fall to 685 million bushels, according to analysts surveyed by Thomson Reuters, down 47% from 1.283 billion bushels in 2008. The corn crop season ends on Aug. 31. (They expect wheat and soybean stocks to rise, for which we can be thankful.)

Bob Greer, executive vice president at PIMCO, rebuts Masters arguments in a very cogent paper recently sent to me. He argues that index funds do not affect the price but may contribute to volatility.

"Some market observers have tried to tie the level of inventories to index investment, most notably in crude oil. Their arguments take one of two forms:

1) The indexer's act of selling the nearby and buying the distant contract forces the futures curve to be upward sloping (future price is higher than nearby price). This creates an incentive to own inventories and earn the "return to storage" represented by the slope of the futures curve. The act of increasing inventory keeps the commodity off the market, thus decreasing supply.

2) A variation of the above argument is that the short seller, who takes the other side of the indexer's purchase, needs to protect their position by buying and holding the physical commodity.

It would be nice if either of these arguments were true, in which case, the developed world would not be hostage to the Organization of the Petroleum Exporting Countries (OPEC). Any time we needed to increase crude inventories, we need merely to bring in more indexers, and the inventory would appear. In fact, the explanation for inventory levels of any commodity is much simpler. If, in the cash markets, production exceeds demand, inventories will rise. Otherwise they will fall. That is why, in six of the last eight years, global wheat inventories fell, regardless of index investment (USDA). That is why from 2006 to 2008, crude oil inventories declined and the crude oil curve went from upward sloping to downward sloping, in spite of increasing index investment (EIA). Furthermore, the second argument above breaks down when applied to non-storable commodities such as live cattle."

Further, Greer shows a chart from Deutsche Bank (DB) which highlights the fact that many commodities which are not in the index fund portfolios have risen higher than exchange-traded commodities (rice, for instance). Look at the chart below:


Click to enlarge

Greer concludes with these important paragraphs:

"Regarding intrinsic value, commodity futures prices converge to cash prices, and cash prices are set by the level of demand to consume physical goods such as steak, gasoline, and Wheaties. The price setting mechanism is not based on possibly erroneous assessment of a financial statement, nor on irrational exuberance. In commodities there is an outside measure of intrinsic value--the cash market--that is not dominant in equity, real estate, or tulip bulb markets. As actual commodity prices go higher or lower, they reflect consumption requirements for actual products, many of which are not very storable.

This is a sharp contrast from internet stocks or vacation condos, which are subject to speculative bubbles. Unfortunately, our conventional wisdom regarding factors that create bubbles is rooted in asset classes like stocks and real estate, asset classes that have fundamentally different characteristics than physical and futures markets.

Coincidence is not the same thing as causality. It is a coincidence that commodity index investment has increased in the last few years just as commodity prices have increased. If there is any causality, it is the other way around. Rising commodity prices have caused an increased interest in commodity investment. And it is certainly causality that fundamental supply, demand and inventory factors have driven commodity prices in many markets higher, whether or not those are markets in which index investors participate. This is the same causality that has driven commodity prices both higher and lower for many decades."

Where Will Oil Prices Go?

So, let's look at the fundamentals for oil. While a large part of last week's rise in oil was short covering (you can tell that from open positions), the supply of oil was down 7% from last year, even with demand beginning to fall. But there is an interesting footnote to that statistic, which we'll visit later. Look at the chart below from www.economy.com:



Notice that supplies turned down sharply this last month, while the momentum of falling supply had been dropping since January. That is to say, the change in crude oil stocks was a negative 10% in January and was a little over -4% a month ago, falling to -7% today. But this is in the face of demand slowing. Last week we learned that gasoline usage was down 4.2%, as prices are finally changing American driving behavior.

Jakab Spencer noted in his always interesting Dow Jones column that there is a disconnect between the New York Stock Exchange and the New York Mercantile Exchange, just one mile apart. The NYSE is pricing in $75 oil in oil stocks, while the futures market is surging over $135, and there are calls for near-term $150-a-barrel oil. The stock market is telling us that oil, at least in futures terms, is in a bubble.

And frankly, if you listened to their testimony, and more importantly pay attention to their actions, oil company executives simply do not believe that the price of oil is going to be $135 a barrel for the next few years. If they did, they would be punching more holes in the ground in places where it might be expensive to get the oil to market - but at $135 a barrel it would be profitable.

And then there is an odd circumstance in the oil picture that I think may suggest that we could see a break, and perhaps a violent one, in the near term for the price of oil.

Where Are All the Tankers?

For a few weeks now, observers have noticed that Iran is leasing tankers and storing oil in them.