Proposals coming out of US Congress for legislation to limit large institutional investors speculating in commodities markets has generated intense debate.
As Bloomberg reported last week, after a Congressional hearing into the matter, the legislation would be aimed at speculators and other investors who use commodities as a way to hedge against swings in other investment instruments such as stocks and the dollar, according to Joseph Lieberman, chairman of the Senate Homeland Security and Government Affairs Committee.
In testimony before the committee, hedge fund manager Michael Masters argued that institutional investors are “one of, if not the primary, factors affecting commodities prices today” and blamed the commodity bubble on an influx of speculation in the futures markets. Masters, notes the FT’s Short View columnist John Authers, told Congress that investment in indices based on commodity futures has risen from $13bn five years ago to $260bn now.
Delving into the debate, the Wall Street Journal noted that the traditional role of the commodity-futures markets was to allow players such as farmers and oil refiners to hedge against unexpected price swings. Now, more institutional investors are wading into commodity markets to invest, rather than hedge.
In a note to clients on Tuesday, Gavekal, the HK-based research and investment firm, points out that those who disagree with Masters highlight the strong outperformance of non-traded commodities. Surely this means that the surge in prices has been due to fundamental demand/supply imbalances and not financial factors? No, says Gavekal, for the following reasons:
1. Industrial users of raw materials are driven by momentum just as much as purely financial players. When the price of coal, iron ore or potash goes up, commercial buyers increase their inventories and this can generate a very large incremental demand. Such panic buying by industrial users may partly explain the sudden rise in iron ore and fertiliser prices earlier this year. At the same time, some producers, who tend to sell their output forward to finance their investments and working capital, have suffered accounting losses and, in extreme cases, turned into forced buyers to meet margin calls and close their loss-making forward contracts. (This was a big factor in the recent agricultural price boom, which already seems to be turning to bust.)
2. Many non-traded commodities price according to the nearest exchange-traded benchmarks – for example, coal to oil, fertilisers to corn and soya – and therefore tend to move in the same direction.
3. The most important of these non-traded commodities, such as coal, iron ore and increasingly, even phosphates, are being bought by long-term financial players through index funds and relative value swaps. These instruments, in turn, lead to forward purchases and inventory-building by the investment banks who sponsor the index and swap investments. Because these commodities are thinly traded even a small amount of investment participation can have a very big price effect in the short term, says Gavekal, adding:
This is why we do not suggest that the main driving force for higher commodity prices has been short-term ‘speculation’. If anything, traditional commodity speculators have tended to be on the short side of many of these trends, but they have been overwhelmed by financial players, whose allocation strategies are relatively insensitive to price movements.
4. The fact that almost all commodities have suddenly exploded on the upside is actually evidence against the theory of a fundamental imbalance. Why? Because final demand for many industrial commodities has actually been slowing since 2005 and especially since mid-2007, as global growth has slowed down. So if prices are being driven by supply-demand “fundamentals”, this must mean that all commodities are suddenly suffering supply constraints.
In other words, the world is not just facing a “peak oil” story, but also “peak iron”, “peak coal”, “peak potash”, “peak soya” and so on. This is obviously nonsense. It is also very reminiscent of the situation in the 1970s, when the oil shortage was followed by shortages of coffee, sugar, cocoa and even toilet paper, as Anatole Kaletsky recently observed. This final point, in Gavekal’s view, is the most convincing evidence that the commodity boom is just a financial bubble. That is not to say Gavekal supports the increase in regulation recommended by Masters. This bubble, ultimately, is likely to sort itself out – just like all the other financial bubbles of the past.