Commodity Exposure vs. Speculation

A new report from Rice University's Baker Institute by Kenneth Madlock and Amy Jaffe argues the Commodities Futures Modernization Act of 2000 is one of the main reason for high oil prices. A 2007 GAO study concluded the CFMA made it easier for financial players to obviate speculative limits and made it more difficult for the CFTC to regulate oil futures markets. The CFMA allowed oil to be used for risk management products that artificially drove demand. The report states that before the CFMA 20% of oil trading was from "noncommercial participants" (speculators) while today 50% of trading is from these participants. The graphs speak for themselves:

As you can see, the price of oil corresponds with the amount of speculators in the market. When oil peaked at $145, the percentage of non-commercial traders in the market was at its highest.

It is astounding how much opposition there has been to the idea that commodity prices are heavily influenced by speculators. It seems common sense that money flooding into a market will inflate prices, especially if the new entrants are net long. Commodity markets are simply fundamentally different than capital markets because they are intended to serve a completely different purpose. Commodity markets are meant to match supply with demand while capital markets are meant to efficiently allocate capital. When NYMEX oil futures trading is 10 times more than daily consumption, a market is no longer matching supply with demand (very few contracts actually end up in delivery). Peak oil, as it is commonly perceived, is a myth. Prince Turk Al-Faisal underscored this recently in an article in Foreign Policy. If peak oil is a reality and oil is a desparately scarce resource, why does Saudi Arabia have 4.5million bpd excess capacity?

I attribute much of the interest in commodities to trends in popular investment theory. The rising popularity of "absolute returns" and the success of funds who invested in alternative assets (great example is the Yale endowment managed by David Swenson) led to the conviction that all portfolios should have at least a 10% exposure to commodities, since this asset class is historically not coorrelated to traditional assets, thereby reducing risk. This wisdom was spread by consultants and has now become a firm staple of retail investing.

One place where this has been evident recently has been natural gas. After the turmoil of last fall, when commodity prices dropped across the board, investors piled back into commodities. Since retail investors can't buy futures, they bought many shares of commodity ETFs, especially USO and UNG, expecting prices to re-inflate. All commodities, that is, except natural gas. Natural gas actually fell and continued falling. Merril Lynch recently forecast it to go as low as $2/mmbtu. So while institutional investors shunned natural gas, retail investors literally could not get enough of UNG. UNG went from a $447m fund to a $4.5bn fund in three months. The fact that the fund is trading at a 19% premium to NAV underscores the retail demand.

There is nothing wrong with investors seeking exposure to un-correlated assets or hedging their risks with commodities, but these markets were clearly not designed for this level of activity. One good change would be position limits. A market that can be as easily manipulated as commodity markets needs many small players to be efficient, and not distorting elements like the UNG and USO.

(Interestingly, every recession since 1973 can be associated with some sort of oil shock: 1973 and the Yom Kippur War, early 80s and 1979 Iran Hostage Crisis, early 90s and Persian Gulf War, 9/11 and the early 2000s recession, and finally the 2008 oil shock and the "Great Recession." Obviously correlation does not imply causation...but why take the chance and leave these markets to undue influence?)