From: Commodities: Who's Behind the Boom? -- Wall Street Journal, March 31, 2008

Speculators also use the older commodity pools, whose position is likewise tracked on the charts. The pools, open to sophisticated investors, are flexible enough to sell short as well as buy long and are subject to position limits. But since they are generally trend-followers, they will almost always go long in bull markets. Through most of the recent period, then, the pools have been adding to the price distortions caused by the index funds. Add the pools' bets to those of the index funds, and speculative money forms 58% of all bullish positions.

Barron's economics editor Gene Esptein says a bubble is growing in the commodities market. He sees $250 billion of 'naive money' on the long side of the market (March 31). To get a further idea of the impact of these speculative bets, Barron's asked Briese to measure them against production in the underlying markets. He calculates that in soybeans, the index funds have effectively bought 36.6% of the domestic 2007 crop, and that if you add the commodity pools, the figure climbs to 59.1%. In wheat, the figures are even higher -- 62.3% for the index funds alone, and the figure jumps to a whopping 83.6% if you add the pools. Betting against them as never before are the commercials, who deal in the physical commodity.

From: Goldman:Oil May Hit $150-$200/Bbl In Next 6-24 Mos -- Dow Jones Newswires (3rd Update), May 6, 2008

Long And Gradual Or Short And Sharp

Murti sees two scenarios for rising crude prices: either a longer, gradual rally in prices or a sharp, sudden spike. Under the first scenario, the price of benchmark U.S. crude would rise from $108 a barrel in 2008 to $120 by 2010, before dropping to a "normalized oil price" of $75 a barrel in 2012.

Under the super-spike scenario, spot prices would hit $125 in 2008 and peak at $200 in 2009 before dropping sharply again in subsequent years to the normalized oil price as oil users rapidly change their habits in the face of extreme prices.

From: This commodities bubble may be just about to burst -- The Kansas City Star, May 10, 2008

Although commodity prices are notoriously volatile, the price increases in the past year are off the chart: rice up 122 percent; wheat, 95 percent; soybeans, 83 percent; crude oil, 82 percent; corn, 66 percent; gold, 37 percent.

[...]

Speculators have always played a prominent role in commodities markets, but in the past year, they have literally overwhelmed them.

To meet the needs of these investors, Wall Street and Chicago’s commodities houses came up with all sorts of new vehicles, including the commodities equivalent of mortgage pools and asset-backed securities.

There are various estimates of how much of this new investment money flowed into these vehicles in the past two years. Philip Verleger, who closely studies commodity markets, estimates that the inflow was running at an average of $100 million a day during most of 2006 and 2007, rising to as much as $1 billion a day during the frenzied trading of February and March.

It’s hard to imagine that it wasn’t a significant factor in skyrocketing prices that have created problems for many of the nonfinancial players who rely on the commodity futures markets for selling products, assuring supplies and hedging against price fluctuations.

[...]

Indeed, the only people who don’t believe speculation is driving a commodities bubble are the big commodity traders and the commodities exchanges, which are profiting handsomely from the soaring prices and trading volumes, and the regulators at the Commodities Futures Trading Commission, whose economists cannot seem to find statistical evidence that financial investors have had much of an impact on commodity prices.

From: Bogleheads Conversation 17664 -- May 11, 2008

Quote:

A separate but related issue is the unprecedented rate of U.S. money printing that devalues our currency. It takes more and more dollars to buy a barrel of oil when the value of those dollars are worth less and less.

I agree to a point. However, there must be more than currency changes affecting the price of oil. We see this when comparing the appreciation of oil and the Euro (FXE).

From: The Looming Commodity Crisis -- MarketWatch May 13, 2008

There is a crisis looming in the world's commodity markets, but it is has nothing to do with high prices, food shortages or the "peak oil hypothesis."

It has everything to do with the flood of capital into new financial instruments tied to commodity prices.

The ongoing debate as to whether this new "investment" demand has caused a price bubble is misdirected. We should be paying attention to the economic damage being done by these new instruments, which are creating a level and type of volume for which the futures exchanges are ill-suited.

[...]

In practice, the problem is that the investment capital is too large relative to the size of the underlying commodity markets. The traditional regulatory tools for preventing this sort of excess are "speculative position limits," which are designed to limit participation per control entity. However, swap dealers are exempt. Other types of vehicles also fall outside this regulation because their participation is diffused among many control entities, even though in aggregate they may behave identically.

The inordinate and one-sided volume is breaking down the traditional relationships between the futures markets and the cash markets. Without a close correlation between the two, commodity producers and users cannot rely on the futures exchanges for price discovery and risk management. Moreover, it can become downright dangerous for them to do so; when hedgers do not see corresponding moves in the cash markets and their futures positions, they are at substantial financial risk

There is already anecdotal evidence of grain elevators going out of business due to disruptions in the wheat futures, and legitimate hedgers of cotton were faced with a costly cash flow drain exceeding $1 billion when dislocations in that market in early March generated margin calls. Commercial players have been simultaneously trapped in a short-squeeze and a credit-squeeze.

All this is a tremendous new burden for the agricultural industry. The Commodity Futures Trading Commission, the futures regulatory authority, called a special roundtable on April 22 to review "whether the futures markets are properly performing their risk management and price discovery roles." The commission heard numerous reports that suggested that the markets' ability to fulfill these critical functions is eroding. Some participants went so far as to declare their markets "broken."

If the commodities-as-investments trend continues, the market disruptions will only worsen. Without regulatory intervention, we will do enormous damage to the U.S. commodity production and distribution chain. This, in turn, will impose inefficiencies and very real costs on the U.S. economy in a fragile period.

While there are no easy solutions, the path to fixing this problem starts with recognizing the destructive role played by the volume of commodity participation by the investment community.

From: Oil mkt balanced, no need for emergency OPEC meet: Qatar -- Reuters, May 17, 2008

Oil markets are balanced and there is no need for an emergency OPEC meeting before September despite record oil prices, Qatari Oil Minister Abdullah bin Hamad al-Attiyah said on Saturday.

"The oil market is balanced... There is no threat to or crisis in supply," he told Al Arabiya TV by telephone.

[...]

Under pressure from consumer nations hard hit by the rally, OPEC kingpin Saudi Arabia said on Friday it had boosted output by 3.3 percent, or 300,000 barrels per day, to loosen up the market and make up for declines from other producers.

But Saudi officials at the same time said that the increase would not reduce prices at the pump.

[...]

Like other OPEC members, Qatar has blamed factors other than supply for oil's rise and Attiyah said speculation on oil markets was now so strong that it was hard to make an impact.

"True it is a record figure but the question is is this because of a lack of supply?" he said.

"It is not now in our hands or that of any power to intervene in these markets. This market today is reacting to politics and speculation. The speculators have moved from the stock and bond markets to the commodities markets."

From: Opening Statement from Chairman Joseph Lieberman (pdf)
-- U.S. Senate Committee on Homeland Security and Governmental Affairs, May 20, 2008

In recent years, Commodity markets have attracted increasing amounts of money from large investors, such as pension funds. This influx of institutional investors and hedge funds into relatively small markets for goods such as rice and corn raises important questions about the ability of the markets to absorb these new investors without distorting or undermining fundamental supply and demand forces.

Speculative activity in commodity markets has grown by staggering leaps and bounds over the last several years. From 1998 to 2008, the share of long interests in commodities held by financial speculators - that is, market positions that benefit when prices rise - has grown from one-quarter to two-thirds of the commodity market. By comparison, during the same period, the share of the market held by actual physical traders has dropped from three-quarters to just one-third. In only five years, from 2003 to 2008, investment in index funds tied to commodities has grown twenty-fold, from $13 billion to $260 billion.

From: Testimony of Michael W. Masters, Managing Member / Portfolio Manager, Masters Capital Management, LLC (pdf) before the U.S. Senate Committee on Homeland Security and Governmental Affairs, May 20, 2008

The CFTC Has Invited Increased Speculation

When Congress passed the Commodity Exchange Act in 1936, they did so with the understanding that speculators should not be allowed to dominate the commodities futures markets. Unfortunately, the CFTC [Commodity Futures Trading Commission] has taken deliberate steps to allow certain speculators virtually unlimited access to the commodities futures markets.

The CFTC has granted Wall Street banks an exemption from speculative position limits when these banks hedge over-the-counter swaps transactions. This has effectively opened a loophole for unlimited speculation. When Index Speculators enter into commodity index swaps, which 85-90% of them do, they face no speculative position limits.

The really shocking thing about the Swaps Loophole is that Speculators of all stripes can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with a Wall Street bank and then the bank buys $500 million worth of Wheat futures. In the CFTC's classification scheme all Speculators accessing the futures markets through the Swaps Loophole are categorized as "Commercial" rather than "Non-Commercial." The result is a gross distortion in data that effectively hides the full impact of Index Speculation.

Additionally, the CFTC has recently proposed that Index Speculators be exempt from all position limits, thereby throwing the door open for unlimited Index Speculator "investment." The CFTC has even gone so far as to issue press releases on their website touting studies they commissioned showing that commodities futures make good additions to Institutional Investors' portfolios.

From: Are Pension Funds Fueling High Oil? -- BusinessWeek, May 21, 2008

Some analysts say that as commodities markets have been deluged with investment bank money, supply and demand has been rendered less relevant, to the detriment of consumers and producers and marketers. In a May 9 research note, Lehman Brothers (LEH) economists argued that oil's recent rise has been fueled by "non-supply-demand factors and by potential inventory misperceptions." In other words, the dollar weakening and "investors' desire to be exposed to real assets" has spurred increased inflows from investors biased toward long positions. Additionally, hedge fund director Masters points to data showing that over a five-year period, China's demand for oil has increased by 920 million barrels, while over the same period, index speculators' demand has increased by 848 million barrels.

From: Are Commodity Traders Bidding Up Food, Fuel Prices? -- LA Times, May 21, 2008

Rep. Joe L. Barton of Texas, the top Republican on the House Energy and Commerce Committee and influential among his fellow GOP lawmakers on energy issues, said in an interview that he supported efforts to rein in energy trading.

"I don't think there's any question that speculators in the oil markets have taken prices higher than they would be otherwise," Barton said. "I think there ought to be new rules."

Barton, Lieberman and others have said they would draft legislation that would restrict commodity investments by large investors and close a loophole that allows speculators to avoid investment limits. A separate provision embedded in the Senate Democrats' energy bill would ensure that foreign exchanges using trading terminals within the United States adopt the same limits and reporting requirements as energy commodities traded on U.S. exchanges.

"You've got futures exchanges that are rife with the ability to manipulate and excessively speculate," said Michael Greenberger, a University of Maryland law professor who spent two years in charge of the Commodity Futures Trading Commission's trading and markets division. "Congress firmly believes that they've got to bring this speculation under control. And it is my thesis that if these markets were policed, the prices would drop very rapidly."

From: Commodities Not Like Stocks for Speculative Plays -- Reuters, May 22, 2008

Commodity indexes basically track contracts in commodity futures markets. Although such contracts run according to calendar months and expire at scheduled periods, an investor in a commodity index typically moves to another contract before one expires.

Critics of this investment model say it creates an unrealistic demand for commodities as index investors are perpetually "long" or bullish, and never "short" or bearish -- the two elements required for any market to work in balance.

"They never sell," Masters said, referring to index investors. "When an institutional investor decides to allocate 2 percent to commodities futures, for example, they come to the market with a set amount of money. 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.'"

Speculators Own More Commodities Than They Need

As such, he said, index investors theoretically owned the equivalent of 1.1 billion barrels of petroleum -- eight times the U.S. Strategic Reserve. They own enough corn futures to fuel the U.S. ethanol industry at full capacity for a year. The 1.3 billion bushels of wheat they own could make all the bread, pasta and baked goods Americans needed for two years.

The solution? Masters suggests closing a loophole in the Commodity Exchange Act that allows Wall Street banks an exemption from speculative position limits when they hedge in over-the counter (OTC) swaps for commodities.

OTC trade refers to commodity deals done outside of exchanges such as the New York Mercantile Exchange , the InterContinental Exchange or the Chicago Board of Trade , which account for a large portion of formally traded raw materials.

Putting limits on speculation through OTC swaps "would curtail index speculation and ... force all speculators to face position limits," Masters said.

From: Futures watchdog investigates oil market -- Financial Times, May 29, 2008

The CFTC said its agreement with the FSA [the UK's Financial Services Authority] would expand information-sharing for surveillance of energy commodity contracts with US physical delivery points - such as the benchmark West Texas Intermediate crude oil futures contract. The agreement also involves the InterContinental Exchange (ICE), an operator of energy derivatives markets in the US and UK.

The CFTC's actions are unusual because the agency's chief economist this month told a Congressional hearing that "to date", the agency believed that "broad-based manipulative forces" were "not driving the recent higher futures prices in commodities across-the-board".

However the agency said on Thursday: "The measures will expand the amount and quality of information received from energy traders to further the integrity and oversight of our nation's futures markets. The recent dramatic increases in the price of crude oil traded on futures exchanges make these efforts paramount.

"The implementation of today's measures will improve oversight of the energy futures markets to ensure they reflect fundamental economic forces of supply and demand, free of manipulation and fraud," it said.

The FSA is involved because it oversees ICE's London-based energy derivatives market, ICE Futures Europe - formerly the International Petroleum Exchange.

[...]

It will also develop a proposal to "routinely require more detailed information" from index traders and swaps dealers in the futures markets, and to review whether classification of these types of traders can be improved for regulatory and reporting purposes.

[...]

The CFTC also announced closer scrutiny of index funds trading. Pension funds are pouring billions into commodities indices to gain exposure to the booming energy markets and some lawmakers are concerned those flows are boosting prices artificially.

[...]

Several hearings have been held in Congress surrounding the increasingly controversial issue of the role of speculation in petrol, crude oil and natural gas markets.

They come almost a year after similar hearings, held by Mr Levin, into the role of "excessive speculation" in natural gas derivatives on ICE and Nymex by collapsed hedge fund Amaranth in 2006.

[...]

Some lawmakers are now saying they may consider barring certain institutional investors, such as pension funds, from investing in commodities through index funds.

Bart Chilton, one of the CFTC's commissioners wrote a letter to senators recently saying he supported an investigation into potential "improper" speculation in the energy markets, particularly in institutional investor trading.

From: Speculation — but Not Manipulation -- BusinessWeek, May 29, 2008

What can be corroborated is vastly increased trading levels as hedge funds, investment banks, pension funds, and other professional investors have poured money into oil and other commodities, seeking a hedge against inflation and alternatives to a shaky stock market. In the past five years investment in index funds tied to commodities has grown from $13 billion to $260 billion. More than 630 energy hedge funds are placing bets, up from just 180 in 2004, according to Peter C. Fusaro, founder of the Energy Hedge Fund Center, a trading information Web site.

Futures contract traders on the IntercontinentalExchange (ICE) made bets on oil with a total paper value of $8 trillion in 2007, up from $1.7 trillion in 2005, according to U.S. Securities & Exchange Commission filings. Over the same period the volume of futures contracts traded on the New York Mercantile Exchange more than doubled, although dollar figures aren't available. The over-the-counter market is even larger but difficult to measure.

From: Feeding Frenzy -- The Globe and Mail, May 31, 2008

On a Tuesday morning in late April, a group of more than 100 people shoehorned themselves into a cramped conference room in the Washington headquarters of the CFTC [Commodities Futures Trading Commission]. There were farmers and bakers, brokers and stock exchange officials, pension fund executives, professors, and even cotton growers, all convening for what was, by any measure, an extraordinary meeting: In the midst of skyrocketing prices for food and unheard of gyrations in futures contracts, the chief commodities regulator was trying to figure out whether the markets it oversees still worked properly.

Almost immediately, fault lines emerged between the "commercial" players - farmers, grain elevators, processors, and anyone else directly involved in the food chain - and "speculators" - index funds, pension plans, hedge funds, and other investors who buy futures to bet on price movements, but who never intend to take physical possession of the commodity.

One by one, the commercials took their turn at the microphone, ticking off a laundry list of grievances: Prices were moving too quickly and unpredictably; grain elevators were at their credit limit, depriving farmers of a primary source of hedging risk.

And, for some mysterious reason, the price of the futures contract was not converging with the underlying price of the cash commodity it represented when that contract drew close to expiration.

Can a market be trusted if prices soar the same day reports come out showing that there is an oversupply of that product, they asked. Is the market sound when prices shoot up 85 per cent in a matter of days and then fall back down again for no apparent reason? Almost to a person, these commercials laid a large portion of the blame at the feet of investment funds, particularly the pensions and indexers who are able to skirt trading limits.

From: Greenberger's Testimony: I-Banks Control the Energy Market -- Seeking Alpha, June 04, 2008

Michael Greenberger, the former head of the CFTC's Division of Trading and Markets, testified yesterday before the Senate Commerce Committee on the topic of Energy Market Manipulation. He stated that the investment banks, namely Goldman Sachs (GS) and Morgan Stanley (MS), control the price of oil and natural gas through the ICE futures market. He cited that Morgan Stanley currently owns 27% of the natural gas futures.

[...]

Greenberger suggested that the current attempt of closing the Enron loophole by Senator Levin through the Farm Bill, would not work - as it would leave the government with the constant burden of proof to prove manipulation was occurring. Also it would only be enforcable on domestic market manipulators and not international ones.

Greenberger said that legislation immediately closing the Enron Loophole with a broader, international scope would stop market manipultion and would cause oil prices to plunge over 25% overnight.

From: Oil and the Euro -- Index Universe, June 11, 2008

Oil going to $200/barrel and the euro going to $2 are not separate phenomena, Jim. There's a fantastic column today in the Financial Times by Paul Betts about the link between the European Central Bank, the euro and oil prices. Betts' column picks up on a recent research note from Marco Annunziata of UniCredit, which argued that the key to controlling global inflation was the dollar.

Writing at the beginning of last week, Annunziata noted that the dollar was stabilizing. That stabilization was reflected in oil prices, which moderated from a high of $132/barrel down to $122/barrel. The dollar was helped by Fed chief Ben Bernanke's aggressive jawboning about a strong dollar policy.

But just when the air started coming out of the oil bubble, the ECB issued a statement expressing concern about inflation and said that it was considering raising interest rates. The result? The dollar stumbled and all hell broke loose in the energy markets, with oil posting back-to-back record gains and settling near $140/barrel.

You can see the disastrous cycle here. The ECB has a mandate to keep inflation within a certain range. If inflation rises above that range, the ECB responds by raising interest rates. But higher interest rates in Europe pressure the U.S. dollar, which boosts oil prices. Rising oil prices, in turn, contribute to higher inflation, which encourages the ECB to raise rates again...

It reminds me of George Soros' theory of reflexivity, which states that people's misconceptions about the market - and the actions they take based on these misconceptions - have important impacts on the market itself. In this case, the ECB may be viewing inflation through the wrong lens, setting up this self-reinforcing spiral.

From: Are European Bankers Pushing Up Oil Prices? -- Financial Times, June 10, 2008

By continuing to remind us all of its inflation-busting credentials, the ECB may in fact be doing quite the opposite and stoking inflationary pressures. Indeed, its hawkish declarations last week about a possible rise in eurozone interest rates seem to have contributed to the unprecedented spike in oil prices last Friday.

To ward off the risk that higher commodity prices could eventually trigger more inflationary pressures in the form of rising wages and higher consumer prices, the ECB indicated it was prepared to increase interest rates next month. In so doing, it simply encouraged a further significant rise in oil prices and energy costs.