What's With the Price of Oil?
Heavy trading in commodity indexes pushing crude higher.
Why has the price of oil risen so much in the past few months? Is it a supply and demand issue as some believe; or is it because of an out-of-control futures market driven by the proliferation of commodity index funds and rampant speculation, as everyone tries to get in on the rise in commodity prices? This is a very complex issue, with a lot of emotion attached to it.
This week I'll try to give you an understanding of why oil prices have risen and whether they're likely to stay at such lofty heights or maybe even fall! I look at a very odd statistic: where are all the tankers? There are some very unusual things happening in the oil patch. If you're currently exposed to the energy or commodity markets, or are thinking about it, I believe you'll find this article of interest. I'll also tell you how you can personally see that help gets to the victims of Cyclone Nargis in Myanmar. It's a desperately needy situation. There's a lot to cover, so we'll get to it right after this quick note.
I've talked for the past few months about why I feel we may be in for a tough investment environment and a Muddle Through Economy. I think in this type of market cycle it's important to increase your portfolio allocation weighting to noncorrelating investment strategies. I work with Steve Blumenthal and his team at CMG to help investors find managers who can take smaller minimums and who have such alternative strategies. My firm is creating a platform of managers that you can access for your personal portfolio. I recently completed a special write-up on Eric Leake of Anchor Capital, an investment advisor I am particularly impressed with. For the last 12-1/2 months, he's up 16.77%, in comparison to the S&P 500 index that is down -2.08% (net of fees from April 30, 2007 through May 15, 2008). Equally impressive is that he has generated this return while being uncorrelated to the S&P, and with lower volatility than the market.
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Those Nasty Index Speculators
Are institutional investors in the form of large commodity index funds the reason behind the current rise not just in oil prices but in the prices of seemingly all commodities? Michael Masters, a long-short hedge fund manager, in testimony before the Congressional Committee on Homeland Security and Governmental Affairs, said:
"You have asked the question 'Are Institutional Investors contributing to food and energy price inflation?' And my unequivocal answer is 'YES.' In this testimony I will explain that Institutional Investors are one of, if not the primary, factors affecting commodities prices today. Clearly, there are many factors that contribute to price determination in the commodities markets; I am here to expose a fast-growing yet virtually unnoticed factor, and one that presents a problem that can be expediently corrected through legislative policy action."
You can read the entire testimony here, but let's hear the basics of his argument:
"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.
These parties, who I call Index Speculators, allocate a portion of their portfolios to "investments" in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as "Index" Speculators because of their investing strategy: they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices - the Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG Commodity Index."
These index funds are composed of a number of commodities. While oil is the biggest component of the various funds, they also have exposure to grains, base metals, precious metals, and livestock. When you buy one of these funds you're buying a basket of commodities.
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Why would an investor want exposure to a long-only index of commodities? Perhaps for portfolio diversification, as commodities are uncorrelated with the rest of the portfolio, or as a way to play the growing demand for commodities of all sorts from emerging markets, as a hedge against inflation and so on. Mainline investment consultants began to suggest a few years ago to their clients that they get into the commodity market on a buy and hold basis, just like they do with stocks and bonds.
And they've done so in a very large way. As the chart below shows, at the end of 2003 there was $13 billion in commodity index funds. By March of this year, that amount had grown 20 times, to $260 billion. Masters also shows that this corresponds with the stratospheric rise in commodity prices. In many commodity futures markets, index speculators are now the single largest participant.
Click to enlarge
Is Correlation Causation?
There's no doubt that the rise in the investment in commodity indexes and the rise in prices correlate significantly. But does correlation necessarily mean that there's a direct cause and effect? Masters says it does. (Later I'll look at arguments against this view.)
As an illustration, Masters shows that the rise in demand for oil from China in the past five years has been 920 million barrels of oil per year. But index demand (the word Masters uses) for oil has risen by 848 million barrels, almost as much as another China.
And Masters gives us facts that are interesting. There's enough wheat in the index speculator "stockpiles" in the US to feed every man, woman and child all the bread, pasta, and baked goods they can eat for the next two years - about 1.3 billion bushels. Yet wheat has soared in price.
As the prices of the indexes have risen, the demand for the indexes has grown. And these indexes are not price sensitive. If a billion dollars is invested in a given week, the index funds simply buy whatever allocation of futures contracts is needed to make up their index, at whatever price is offered.
For the first 52 trading days of the year, demand for commodity index funds grew by more than $55 billion, or more than $1 billion a day. And as Masters points out:
"There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.
Index Speculators' trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits."
And now we get inflammatory:
"Think about it this way: 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."
What about position limits? Aren't there real limits to the amount of a physical commodity that a fund or speculator can accumulate? Masters points out that there is, but the CFTC has given investment banks a loophole, in that they can sell unlimited size positions in the OTC swap markets if they hedge the positions.
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