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Why Congress Blames Index Speculators

by: Hard Assets Investor July 23, 2008    
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By Brad Zigler

It's never been easy for index investors. For one thing, there are financial advisors decrying investors' settling for "average" returns. As if it's not bad enough having money managers nattering them, now Congress wants to take it out of investors' hides as well.

In hearing rooms on both sides of the Capitol rotunda, commodity index investors are being pilloried by witnesses and legislators alike for pushing commodity prices - most particularly oil prices - higher.

Or so the argument goes. Long-only index funds, say critics, are indiscriminate buyers of commodity futures, snapping up contracts at whatever prices are necessary to put all of their capital to work. This price insensitivity, it's said, excessively bids up the cost of commodities like corn and oil.

But is that really so? Do index investors deserve such blame?

It's easy to see why legislators might think so. After all, oil prices picked up the pace of their northward gallop at about the same time exchange-traded commodity index funds - the focal point of so much Congressional vituperation - hit the market.

Funds based upon the S&P Goldman Sachs Commodity Index [S&P GSCI] and the Deutsche Bank Liquid Commodity Index [DBLCI] were launched in 2006. Owing to their large weightings in crude oil - now 55% for the S&P GSCI fund and 35% for the one based upon DBLCI - critics said they were nothing more than oil index funds in disguise. To make matters worse, exchange-traded funds and notes based exclusively on oil futures were also floated in 2006.

For a time, the carpers' fears might have seemed justified. There was a direct link between oil prices and long speculation. Between January 2006 and January 2007, the price of NYMEX spot futures and the size of the net long interest held by large speculators - where index funds would be counted - rose and fell apace. (Open interest represents the number of contracts awaiting liquidation or delivery, a measure of supply analogous to shares outstanding in the stock market.) The correlation between price and net long interest, at 78%, was, in fact, quite strong.

In 2007, though, the connection between long speculative interest and price fell apart. NYMEX crude advanced to dizzying values, while the proportion of open interest controlled by long speculators actually declined. Between January 2007 and mid-July 2008, in fact, the correlation deteriorated to only 42%.

 

Crude Oil Futures Prices Vs. Speculative Long Interest

Chart: Crude Oil Futures Prices vs. Speculative Long Interest

 

Because of the lack of granularity in government-mandated reports, though, we can't tell how much of that net long interest in oil futures actually belongs to index funds. The Commodity Futures Trading Commission [CFTC], however, has operated a pilot program since 2006 that monitors commodity index fund trading in certain agricultural futures.

The price trajectory of corn fairly well traces the same arc as that of crude oil, as it more than doubled over the past year. Corn's the largest agricultural component of both the S&P GSCI and the DBLCI. If we compare the net long position of index funds in corn between January 2006 and now, we might gain some insight into their behavior with respect to oil.

Back in 2006, commodity index funds held about a quarter of the total open interest in corn futures: 

January 3, 2006

Index Fund Net Long Interest:                               264,624 contracts

Total Open Interest:                                              996,901 contracts

Percentage of Open Interest:                                 26%

 

July 15, 2008

Index Fund Net Long Interest:                               402,291 contracts

Total Open Interest:                                              2,026,276 contracts

Percentage of Open Interest:                                 20%

 

Change in Net Long Position                                 +137,667 contracts

Change in Percentage of Open Interest                  -6%

 

If you focus on the absolute size of long corn positions held by index traders, which grew 52% in two and a half years, you'd think you've found your inflationary culprit. But look how much of the total open interest was actually held by indexers. The influence of index funds as buyers, in reality, waned 6%. How can one attribute corn's near tripling, then, to index fund buying? The evidence simply doesn't support that point of view.

Ah, but witnesses tell Congress those crafty index fund managers can get their index exposure through over-the-counter swaps instead of futures. By doing so, they hide their tracks and circumvent position limits meant to keep speculators in check.

In a swap, an index fund obtains a commodity return from an investment bank in exchange for a stream of interest payments, tied typically to the London InterBank Offered Rate [LIBOR]. With a swap, the fund doesn't go to the futures market itself, but the dealer selling the swap might do so to hedge its resulting exposure. If a swap dealer can establish that a genuine risk is being hedged through futures, it's exempted from speculative position limits.

Even though swaps dealers' hedge transactions may be exempted from position limits, they'd still be reported. They'd just show up as commercial transactions in the long column. So what happened to long commercial positions in corn over the past couple of years?

January 3, 2006

Commercial Long Interest:                                    232,729 contracts

Total Open Interest:                                              996,901 contracts

Percentage of Open Interest:                                 23%

 

July 15, 2008

Commercial Long Interest:                              517,962 contracts

Total Open Interest:                                             2,026,276 contracts

Percentage of Open Interest:                                 25%

 

Change in Long Position                                +285,233 contracts

Change in Percentage of Open Interest                  +2%

 

Commercial long positions, indeed, increased over the past two and a half years, but in gross disproportion to the hike in corn prices. Is it likely that a 2% uptick in the weight of commercial interests could cause prices to nearly triple?

If there's a lesson to be learned here it's this: Something is causing commodity prices to rise. That something doesn't seem to be index fund buying. There are a myriad of other reasons for oil and other commodity prices to be at their present levels, not the least of which are supply scares and denigration in the value of the dollar. It's more politically expedient, however, to paint a bull's-eye on the backs of speculators and index investors. More expedient ... but more dangerous.

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This article has 14 comments:

  •  
    Jul 23 01:50 PM
    Over the past year, the price of oil has moved inversely to the U.S. dollar 90% of the time, so I would agree with you but I'm not sure why it is "dangerous" for Congress to target speculators and index funds? Do you mean, for example, that Nymex oil traders would switch to trading oil in Asia or London?
    Reply
  •  
    Jul 23 02:41 PM
    index investors may settle for average returns, but congress would not settle for average contributions and lobbying from them and will put them in the shotgun. that's life in the rabbit hole.
    Reply
  •  
    Jul 23 04:33 PM
    maybe some misdirection while the guilty(congress) point fingers and say look there(instead of here). the correction is happening giving investors a chance at entry prices. i think it is a good thing. i want to increase pbr if i can free up the cash in time. CHARLIE i would if that was what i did? or maybe the public will realize the political cause of u.s. shortages and billions of$ pouring out of the country. right now the show is a great comedy as pundits and politicos push there agendas. to bad it is a tragedy underneath.
    Reply
  •  
    Jul 23 09:04 PM
    Great analysis, Mr Zigler. That is one of the simplest and most compelling on the subject (out a huge pool of articles).

    Cheers,
    john
    Reply
  •  
    Jul 23 09:09 PM
    I am surprised I am the first to point out that the abbreviation ICE appears no where on this page. I posit that most of the index fund trading in oil is transacted there. Why would an fund want to trade on NYMEX where the government can watch when they can trade on ICE which is totally in the dark?
    Reply
  •  
    Jul 23 10:04 PM
    zhandax -

    Positing is not proof. It's supposition.

    ICE doesn't own the market for West Texas Intermediate (WTI) crude oil futures. Today's WTI volume on ICE was 165,641 contracts. At last count, the average daily volume (ADV) for WTI futures on NYMEX was 558,214 contracts. That doesn't count the 144,915 ADV for WTI regular futures options, the 3,873 ADV for average price options and an equal number of calendar spread options.

    Why would somebody trade on CFTC-regulated NYMEX versus FSA-regulated ICE?

    Well, in the first place, liquidity. Form the numbers you see above, futures liquidity alone at NYMEX is triple that of ICE.

    ICE contracts, too, are cash-settled ONLY; there's no physical delivery mechanism. That, believe it or not, is a important factor for many traders. NYMEX contracts can be physically or cash-settled.

    Third, there are no options traded on ICE futures. NYMEX futures can be spread, hedged and margined with options as integrated units, allowing a trader much greater flexibility in targeting exposures.

    Fourth, clearing fees. ICE charges members 73 cents per contract per side; NYMEX only 70 cents. Pennies add up.

    Need I say more?
    Reply
  •  
    Jul 23 10:13 PM
    Charlie -

    It's dangerous for Congress to go off half-cocked.

    Discouraging legitimate speculation makes a market inefficient. And there IS a legitimate side to speculation. Speculators shoulder risks commerical entities are unable or unwilling to carry.

    It's for this -- risk transference -- that the futures market as we know came into being in the first place.

    Look at recent legislative attempts to curtail speculation in India. Disastrous.
    Reply
  •  
    Jul 23 11:56 PM
    I have never understood the logic of any futures index or futures vehicle based on a long-only model. I have written on other posts regarding commodites and have referenced CTA's who have crafted index products that are both long and short. (I would be happy to provide specific examples, but do not want to run afoul of marketing rules for CTA's.) Of course, these indexers also have their own managed products. But how is this different from what Goldman does with a long only product? Or one hand clapping as I like to say.

    Here's an example. I know of one index and fund that has identified the 22 most liquid futures contracts, with the exception of the SPX. Eleven commodities, six currencies and five bonds, no equities. Each of the 22 gets a constant 4.5%. Through a defined model once a month the manager makes a single long/short call. Therefore the portfolio is only traded 12 times a year; consider it re-balancing monthly. The fund could be 20 long and 2 short, or eleven long and eleven short, or any permutation based on methodology. An investor captures returns from long term trends, not trades. Is this not a more logical approach to capturing returns from futures markets?

    Long only indexing is a problem under the observation rule. Observing an event alters the event. Long only commodities funds do impact futures markets. However they are not villans, just slow plodding investors likely to post gains then give them back.

    As for Congress, they gave away control of financial markets with the creation of the SEC, a Commission born out of panic. Sound familiar? With the exception of a few Members and Senators, no one on the Hill has any interest in financial markets because the system runs through the SEC. And what a great job they've done!

    Remarkably Congress knows more about commodities than it does securities. After all, every farmer knows how to compute ag futures. Dont kid yourself, plenty of these guys know exactly what's going on. Consider that corn is not grown in the Middle East, a point well made in this article. Where is the outrage over inflation caused by ethanol, and the subsidies locked into king corn? Did anyone on Alpa post an article on the Ag Department's inflation projections for next year? It was not a pretty picture. But don't worry, the federal system specifically de-links food and energy from its inflation calculation. And you guys think the feds don't know what they're doing...

    These are indeed strange days.

    Reply
  •  
    Jul 24 06:29 AM
    Too many people are fooling with options, short selling, naked short selling, hedge funds, funds of funds, speculation and other things that do not produce anything of value.

    It's all about having a "product" that you can entice someone to buy.

    Please stop the B/S.

    50 years ago, I was in high school where we were taught what Capitalism was all about. Many of you either did not learn what capitalism is or, maybe, you forgot.

    The attitudes, culture ( call it what you want ) that has produced the current financial mess has hit our economy very very hard. This has been done by some of the most "intelligent"... people in banks, I- banks, homebuilders, etc.

    A solution would be to get back to basics and stop screwing around by selling B/S.
    Reply
  •  
    Jul 24 06:33 AM
    As an aside here...I put the word intelligent into quotes.

    I got intelligent and quote.

    What is "intelligent&...

    Is this a new language?
    Reply
  •  
    Jul 24 07:33 AM
    Managing Editor, you should read this Bloomberg article to see why Congress wants to crack down on oil speculators:

    www.bloomberg.com/apps...

    For example, it is estimated that the price of oil would go down to about $80 a barrel if it were not for speculation.

    Disclosure: I don't personally care what Congress does as long as they don't try to do it to me, and I plan to go long stocks like PBR when I think the price of oil has bottomed.
    Reply
  •  
    Jul 24 08:31 AM
    Three points:

    1. Futures trading other than as a hedge is gambling. Federal law preempts state gambling laws so that these trades won't be illegal for those not hedging real obligations. This is not a moralizing quibble. The point is that the contracts are not tied to actual delivery and so are unlimited in quantity; they are not really part of the commodity market at all. Thus, any effect they have on price is too much.

    2. Index investing is bad market citizenship. Stock and commodity futures markets are auctions. Unless people bid, the auction doesn't work. Index investors merely bet on how other people wil bid. But if everyone bets on the bids, no one actually bids, and the market itself is corrupted. You can save energy by riding in the slipstream of a bus, so long as the bus driver doesn't decide to ride a bike, too. Then what?

    3. The logic of the corn surrogate seems off. Corn is up because oil is up, i.e., because corn's price is responding to its highest and best (economic) use as fuel. Even if there were no market in corn futures, what happens in the oil market would determine the price of corn. So there is no reason to believe that anything is learned about the effect of oil index futures on oil from the correlation or absence there of between the prices of corn index futures and corn.
    Reply
  •  
    Jul 24 09:38 AM
    jjason -

    Speculation in futures DOES produce value. Historically, the presence of speculators has reduced price volatility and that results in lower net prices for consumers. That's been the case for over 130 years, long before you entered high school.


    Charlie --

    Trying to pinpoint the "cost" of something like speculation embedded in the price of a barrel of oil is an interesting, but highly subjective enterprise.

    One well-known market observer (Phil Verleger) argued that a third of the run-up in the price of oil, from $70 to $100 a barrel, was due to buildups in the US Strategic Petroleum Reserve. Inventory reductions, he said, were responsible for another ten percent of the price hike and delta hedging -- a dynamic risk management technique used by commerical users such as airlines -- was responsible for the remaining 60 percent.

    You want numbers? Quantify the effect the erosion in the value of the dollar has had on oil's price. Compare the price of oil in euro to its greenback price over the Verlager price period. There's $47-$50 a barrel worth of price inflation right there.

    What empirical evidence does the PEMEX official making the $80 claim offer?

    remarkl -

    I'm sorry, but I can't fathom your arguments.

    1. If speculation is banned, how does hedging even happen? Hedgers rely on speculators. Take them out and there IS no hedging.

    2. Index investing is bad citizenship? There's ONLY room for active investing -- a form of speculation? Trades made by index investors are exposed to the auction market in the same manner as all other trades. In fact, the argument made by detractors is that the bids made by index funds and their agents are driving prices higher.

    3. To say that corn's price has risen solely because of the influence of oil means you're ignoring the demand and supply curves for the commodity. Are you really saying that there's no intrinsic worth to field corn? That planting intentions and weather are irrelevant?

    4. You say you plan on buying PBR shares. Isn't the purchase of the stock, itself, a speculation?
    Reply
  •  
    Jul 24 11:07 AM
    Congress to speculators: It's you fault!
    Speculators to Congress: Maybe, but you made it an easy bet for us!
    Reply
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