A Senate hearing weighs charges that speculation by big investors and sovereign wealth funds is behind the rise in commodities and energy prices
If you're wondering why driving to work has gotten so expensive, you might want to peruse your pension fund's investments. That's because speculation by institutional investors pouring money into the commodities market may be largely to blame for spiking oil prices, according to testimony on May 20 before the Senate Committee on Homeland Security & Governmental Affairs. Crude oil, a so-called hard asset, is viewed as a buffer against inflation—a foe of longer-term investment returns. At the hearing, "Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation?," senators heard from those defending the role of speculators in oil and commodities markets as well as those who argue that excessive speculation is the root of global price surges.
"[Commodities] are experiencing demand shock from a new category of speculators: institutional investors like corporate and government pension funds, university endowments, and sovereign wealth funds," said Michael Masters, managing member of Masters Capital Management, a Virgin Islands-based hedge fund. "Index speculators are the primary cause of the recent price spikes in commodities."
On May 20, crude oil prices settled at a record $129.07 on the New York Mercantile Exchange (NMX) after touching a new high of $129.60. The national average for a gallon of gasoline hit a record of $3.80 per gallon the same day.
Light CFTC Hand
The explosion in the number of financial players in the energy markets has occurred particularly in the past two years—also a period of soaring energy prices. That's why speculators are now under fire from Congress and the public as potential culprits (BusinessWeek.com, 5/15/08).
But in the hearing, Masters distinguished between traditional speculators and what he calls index speculators, or passive investors who enter the commodities markets as a long-term hedge against inflation. Commodities exchanges limit the number of positions an investor can take in the market, but Masters says the Commodity Futures Trading Commission has allowed unlimited speculation in these markets through a loophole. This so-called swaps loophole exempts investment banks like Goldman Sachs (GS) and Merrill Lynch (MER) from reporting requirements and limits on trading positions that are required of other investors. The loophole allows pension funds to enter into a swap agreement with an investment bank, which can then trade unlimited numbers of the contracts in futures markets.
Some experts fault the CFTC, charged with regulating commodities markets, for allowing such loopholes. "Congress has provided the CFTC the power to control this unlimited [speculation]; the law is very specific about establishing position limits," says Steve Briese, author of The Commitments of Traders Bible and CommitmentsOfTraders.org, a site that focuses on U.S. futures markets. "The problem is they have abdicated this role." The dramatic surge in energy prices has helped to spark inflation across the economy and, as others at the hearing testified, has cut into profits of most in the supply chain. Briese points to Treasury reports that the top five users of swap agreements are investment banks, four of which dominate swap dealing in commodities and commodities futures: Bank of America (BAC), Citigroup (C), JPMorgan Chase (JPM), HSBC North America Holdings (HBC), and Wachovia (WB).
Speculative activity in commodity markets has grown dramatically over the last several years. In the past decade, the share of long interests—positions that benefit when prices rise—held by financial speculators has grown from one-quarter to two-thirds of the commodity market. In only five years, from 2003 to 2008, investment in index funds tied to commodities has grown twentyfold, from $13 billion to $260 billion.
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.
Time to 'Muscle Up'?
Pressure on Congress is increasing not only from consumers but also from industry groups. The New England Fuel Institute (NEFI) and the Petroleum Marketers Association of America (PMAA), whose members are marketers and retailers of petroleum products, have called on Congress for more oversight of speculation in energy markets. A trucker-consumer coalition called Truckers & Citizens United has also called for greater market transparency amid "crippling" energy prices.
At the Tuesday hearing, Senator Claire McCaskill (D-Mo.) grilled CFTC chief economist Jeffrey Harris on why his agency is not more concerned with the impact of speculation on commodity prices. "The people of America are about to pick up pitchforks," she said. "If you were Popeye, I'd give you a can of spinach. It's time to muscle up here." Harris said the agency monitors markets daily, and has "an active engagement in the Agriculture and Energy Depts. The CFTC does not need further legislation to perform its duty of overseeing commodities markets, and that government intervention could distort the market, he added. "Markets are most healthy when there is no limit on who can participate in them," Harris said. "When investors are limited, they will transfer funds to other [less regulated] markets and diminish the effectiveness of hedging."
For their part, pension fund managers say they're not to blame for commodity price surges. The California Public Employees Retirement System (CalPERS), the largest U.S. pension fund, has invested about $1.1 billion in commodities swaps contracts through investment banks like Goldman Sachs. CalPERS spokesman Clark McKinley says the fund started considering commodities investing in 2006 as an inflation hedge and because many economists predict rising energy costs for several decades. However, that represents a fraction of the fund's $242 billion in assets, he says, and ultimately has only a minimal effect on commodity prices. "We understand that there is of course some effect of investors on [commodity] prices. But it's a relatively small impact," McKinley said in a telephone interview.
Senator Joe Lieberman (I-Conn.), the committee chairman, concluded the hearing by agreeing that institutional investors are having a disproportionate impact on commodity prices. He says he will convene another panel of witnesses to examine how to close the "swaps loophole," among other ideas for reform, some of which are included in the Consumer First Energy Act of 2008 proposed on May 7 by a group of Senate Democrats. "At times it is in the public interest to limit the opportunity people have to maximize profits," Lieberman said. "A lot of the rest of us are paying through the nose as a result, including a lot of us who can't afford to pay through the nose."