Institutional Investors Behind Food and Energy Price Inflation

By Michael W. Masters

Testimony of  Michael W. Masters  
Managing Member / Portfolio Manager
Masters Capital Management, LLC

Before the  Committee on Homeland Security and Governmental Affairs
United States Senate,  May 20, 2008

Good morning and thank you, Mr. Chairman and Members of the Committee, for the invitation to speak to you today.  This is a topic that I care deeply about, and I appreciate the chance to share what I have discovered.

I have been successfully managing a long-short equity hedge fund for over 12 yearsand I have extensive contacts on Wall Street and within the hedge fund community.  Itʼs important that you know that I am not currently involved in trading the commodities futures markets. I am not representing any corporate, financial, or lobby organizations. I am speaking with you today as a concerned citizen whose professional background has given me insight into a situation that I believe is negatively affecting the U.S. economy.  While some in my profession might be disappointed that I am presenting this testimony to Congress, I feel that it is the right thing to do.

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 explainthat 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 thecommodities 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 legislativepolicy action.

Commodities prices have increased more in the aggregate over the last five years than at any other time in U.S. history.¹ We have seen commodity price spikes occur in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today, unlike previous episodes, supply is ample: there are no lines at the gas pump and there is plenty of food on the shelves.

If supply is adequate - as has been shown by others who have testified before thiscommittee² - and prices are still rising, then demand must be increasing. But how do you explain a continuing increase in demand when commodity prices have doubled ortripled in the last 5 years?

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.³

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.⁴

I’d like to provide a little background on how this new category of “investors” came to exist.

In the early part of this decade, some institutional investors who suffered as a result of the severe equity bear market of 2000-2002, began to look to the commodity futures market as a potential new “asset class” suitable for institutional investment. While the commodities markets have always had some speculators, never before had major investment institutions seriously considered the commodities futures markets as viable for larger scale investment programs. Commodities looked attractive because they have historically been “uncorrelated,” meaning they trade inversely to fixed income and equity portfolios. Mainline financial industry consultants, who advised large institutions on portfolio allocations, suggested for the first time that investors could “buy and hold” commodities futures, just like investors previously had done with stocks and bonds.

Index Speculator Demand Is Driving Prices Higher

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 2008,⁵ and the prices of the 25 commodities that compose these indices have risen by an average of 183% in those five years!⁶

COMMODITY INDEX INVESTMENT COMPARED
TO S&P GSCI SPOT PRICE COMMODITY INDEX

19701972197419761978198019821984198619881990199219941996199820002002200420062008

Source: Goldman Sachs, Bloomberg, CFTC Commitments of Traders CIT Supplement,

MAR

According to the CFTC and spot market participants, commodities futures prices are the benchmark for the prices of actual physical commodities, so when Index Speculators drive futures prices higher, the effects are felt immediately in spot prices and the real economy.⁷ So there is a direct link between commodities futures prices and the prices your constituents are paying for essential goods.

The next table looks at the commodity purchases that Index Speculators have made viathe futures markets. These are huge numbers and they need to be put in perspective tobe fully grasped.

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 demandfor petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billionbarrels, an increase of 920 million barrels.⁸ Over the same five-year period, IndexSpeculatorsʼ demand for petroleum futures has increased by 848 million barrels.⁹ The increase in demand from Index Speculators is almost equal to the increase in demandfrom China!

Commodity Purchases By Index Speculators The Last 5 Years

Sources: Goldman Sachs, Standard & Poors, Dow Jones,
CFTC Commitments of Traders CIT Supplement, calculations

In fact, Index Speculators have now stockpiled, via the futures market, the equivalent of

1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over thelast five years.¹⁰

Let’s turn our attention to food prices, which have skyrocketed in the last six months.  When asked to explain this dramatic increase, economists’ replies typically focus on the diversion of a significant portion of the U.S. corn crop to ethanol production.¹¹ What they overlook is the fact that Institutional Investors have purchased over 2 billion bushels of corn futures in the last five years. Right now, Index Speculators have stockpiled enough corn futures to potentially fuel the entire United States ethanol industry at full capacity for a year.¹² That’s equivalent to producing 5.3 billion gallons of ethanol, which would make America the world’s largest ethanol producer.¹³

Turning to Wheat, in 2007 Americans consumed 2.22 bushels of Wheat per capita.¹⁴ At

1.3 billion bushels, the current Wheat futures stockpile of Index Speculators is enoughto supply every American citizen with all the bread, pasta and baked goods they can eatfor the next two 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.¹⁵ 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.¹⁶ 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.¹⁸

Commodity Futures Market Size

Dollar Value of
Commercial Positions

Dollar Vale of Traditional
Speculators' Positions

Dollar Value of Index
Speculators' Positions

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 MAR

Source: Bloomberg, CFTC Commitments of Traders CIT Supplement, calculations

Chart Two shows this dynamic at work.  As money pours into the markets, two things happen concurrently: the markets expand and prices rise.

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.¹⁹ 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.²⁰

It is easy to see now that traditional policy measures will not work to correct the problem created by Index Speculators, whose allocation decisions are made with little regard for the supply and demand fundamentals in the physical commodity markets. If OPEC supplies the markets with more oil, it will have little affect on Index Speculator demand for oil futures. If Americans reduce their demand through conservation measures like carpooling and using public transportation, it will have little affect on Institutional Investor demand for commodities futures.

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.

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.

Why is there not outrage over the fact that Americans must pay drastically more to feed their families, fuel their cars, and heat their homes?

Index Speculators provide no benefit to the futures markets and they inflict atremendous cost upon society.  Individually, these participants are not acting with malicious intent; collectively, however, their impact reaches into the wallets of every American consumer. 

Is it necessary for the U.S. economy to suffer through yet another financial crisis created by new investment techniques, the consequences of which have once againbeen unforeseen by their Wall Street proponents?

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 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.²¹ 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.²²

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.²³

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.”²⁴ 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.²⁵

Is this what Congress expected when it created the CFTC?

Congress Should Eliminate The Practice Of Index Speculation

I would like to conclude my testimony today by outlining three steps that can be taken to immediately reduce Index Speculation.

Number One:

Congress has closely regulated pension funds, recognizing that they serve a public purpose. Congress should modify ERISA regulations to prohibit commodity index replication strategies as unsuitable pension investments because of the damage that they do to the commodities futures markets and to Americans as a whole.

Number Two:

Congress should act immediately to close the Swaps Loophole. Speculative position limits must “look-through” the swaps transaction to the ultimate counterparty and hold that counterparty to the speculative position limits. This would curtail Index Speculation and it would force ALL Speculators to face position limits.

Number Three:

Congress should further compel the CFTC to reclassify all the positions in the Commercial category of the Commitments of Traders Reports to distinguish those positions that are controlled by “Bona Fide” Physical Hedgers from those controlled by Wall Street banks.  The positions of Wall Street banks should be further broken down based on their OTC swaps counter-party into “Bona Fide” Physical Hedgers and Speculators.

There are hundreds of billions of investment dollars poised to enter the commodities futures markets at this very moment.²⁶ If immediate action is not taken, food and energy prices will rise higher still. This could have catastrophic economic effects on millions of already stressed U.S. consumers. It literally could mean starvation for millions of the world’s poor.²⁷

If Congress takes these steps, the structural integrity of the futures markets will berestored. Index Speculator demand will be virtually eliminated and it is likely that food and energy prices will come down sharply.

APPENDIX: HOW TO CALCULATE INDEX SPECULATORS’ POSITIONS

If someone knows how much money is invested in the total index then it is easy to calculate how much must be in each commodity in dollars and in futures contracts.

Total Dollars Invested _X Weight Of Individual ₌ Dollars In Individual
In Index Commodity Commodity

Total Dollars Invested _X Weight Of Individual _/ Dollar Value Of A ₌ # Of Contracts In An
In Index Commodity Commodity Contract Individual Commodity

And therefore if someone knows how many contracts are in an individual commodity along with the dollar value of a contract and the weight of that commodity in the index then you can calculate the total dollars invested in the index as follows:

# Of Contracts In An Dollar Value Of A Weight Of Individual Total Dollars Invested
Individual Commodity ^X Commodity Contract ^/ Commodity ⁼ In Index

The CFTC starting in January 2006 has been publishing the Commodity Index Trader Supplement to the Commitments Of Traders report.  This supplemental report shows the reported positions of Index Speculators in 12 different agricultural commodities.  Of the 12, two commodities:, KC Wheat and Feeder Cattle, are part of the S&P GSCI (and not the DJ-AIG) and one commodity: Soybean Oil, is part of the DJ-AIG (and not the S&P-GSCI). Note that 95% of dollars indexed to commodities are replicating either the S&P-GSCI or DJ-AIG.

Both the S&P-GSCI and DJ-AIG publish on a daily basis the individual weights of their constituent commodities. Also futures market data providers like Bloomberg publish daily closing prices for the commodities. Since the futures contract terms do not change that enables someone to calculate the daily dollar values of the individual commodity contracts.

So with these three data points it is simple to calculate the total dollars invested in the S&P-GSCI and the DJ-AIG on a weekly basis. And once the total dollars invested in these two indices is known then that results in the ability to calculate the number of contracts held by Index Speculators in the other 13 non-agricultural commodities.

A detailed example of this 3 step process follows. 

Step One - Estimate Total Amount Invested In S&P-GSCI and DJ-AIG

According to the CFTC’s January 17, 2006 CIT report, Index Specualtors had positiions in KC Wheat, Feeder Cattle and Soybean Oil of 21366 , 5613 and 59264 contracts respectively.  Plugging in the weights and contract values from the appropriate sources yields the following calculations:

21,366 X $18,762.50 / 0.82% = $48,887,753,049 5,613 X $56,137.50 / 0.68% = $46,338,204,044 59,264 X $12,732.00 / 2.77% = $27,240,045,054

So the S&P-GSCI had somewhere between $46 and $49 billion invested in it and the DJ-AIG had around $27 billion invested in it. This corresponds well to the figures published by Goldman Sachs and Dow Jones.

CALCULATIONS OF INDEX SPECULATORS’ POSITIONS (JANUARY 17, 2006)