Seeker Blog

Most economists I read, and some I don’t normally read, like Paul Krugman, have been saying “no, it’s not speculation — it’s the increasing demand from China, India, Brazil, etc.” Harvard’s Jeffrey Frankel has argued the other side, specifically that negative real interest rates drive up demand from both investors and firms.

I thought both factors contributed to demand, but that consumption growth was the dominant factor — until I read the Senate testimony that follows. Fasten your seatbelt, then click on the graphic at left for the full-size chart of Commodity Futures Market Size, then fasten your eyeballs on the increasing area of the red circles = “Dollar value of Index Speculators’ positions”. Note the almost unchanged green and blue areas. Then check out the PDF of the testimony of hedge fund manager Michael Masters [Masters Capital Management, LLC] before the Committee on Homeland Security and Governmental Affairs.

Michael has convinced me that the institutions have poured into the futures market — he has the data, which I’ve not seen elsewhere. Michael is talking about institutional investors who have for the first time made significant asset allocation decisions in favor of commodities futures. He calls them Index Speculators because they are buying baskets of futures contracts corresponding to the leading indexes: the Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG Commodity Index. The numbers are staggering.

Today, Index Speculators are pouring billions of dollars into the commodities futures markets, speculating that commodity prices will increase. Chart One shows Assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March 2008, and the prices of the 25 commodities that compose these indices have risen by an average of 183% in those five years!

Index Speculator Demand Characteristics

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. Index Speculator demand is distinctly different from Traditional Speculator demand; it arises purely from portfolio allocation decisions. When an Institutional Investor decides to allocate 2% to commodities futures, for example, they come to the market with a set amount of money. They are not concerned with the price per unit; they will buy as many futures contracts as they need, at whatever price is necessary, until all of their money has been “put to work.” Their insensitivity to price multiplies their impact on commodity markets.

Furthermore, commodities futures markets are much smaller than the capital markets, so multi-billion-dollar allocations to commodities markets will have a far greater impact on prices. In 2004, the total value of futures contracts outstanding for all 25 index commodities amounted to only about $180 billion. Compare that with worldwide equity markets which totaled $44 trillion17, or over 240 times bigger. That year, Index Speculators poured $25 billion into these markets, an amount equivalent to 14% of the total market.

As to the oil markets:

In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculatorsʼ demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

Possibly scary w/r/t market volatility is Michael’s claim that the steep rise in commodities prices is sucking even more institutional money into the market. Positive feedback like this is guaranteed to cause a bubble.

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.

You can see from Chart Two that prices have increased the most dramatically in the first quarter of 2008. We calculate that Index Speculators flooded the markets with $55 billion in just the first 52 trading days of this year. That’s an increase in the dollar value of outstanding futures contracts of more than $1 billion per trading day. Doesn’t it seem likely that an increase in demand of this magnitude in the commodities futures markets could go a long way in explaining the extraordinary commodities price increases in the beginning of 2008?

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.

Best to read the Masters testimony in full, including the references. See what you think…