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Supply and demand pressures came before institutional investors, economists say

Date: Wednesday, June 4, 2008
Author: Claudia-Teresa Pou, Medill Reports, Chicago

When the dust settles in Washington, the lawmakers and regulators may just rule out placing restrictions on futures trading by hedge funds and other large institutional investors, as economists are quick to explain that the spike in commodity prices is driven by fundamental supply and demand issues and not speculative investments. 

Of course, speculators follow the markets, reinforcing buying by hedgers, explained Eric Nijensohn, a partner at Marquette Partners LLC.  “As prices go up, people will invest more money, supplies will be scarce and then prices will continue to go up.  But it’s also self-reinforcing on the downside,” he said.

The participation by both institutional and retail investors has picked up over the last year, particularly after the sub-prime mortgage crisis hit the U.S.  In only five years, from 2003 to 2008, investments in commodities index funds have grown 20-fold, from $13 billion to $260 billion, according to a statement prepared by Sen. Joseph Lieberman (D-Conn) for a hearing on speculative investing. 

Yes, investors have contributed to the volatility of the markets, but they have entered in response to the inflationary environment that has taken hold of commodities, stated Jason Britt, president of Central State Commodities Inc. in Kansas City.  Chicago Board of Trade prices are continuing to set new highs; corn closed Tuesday at $6.07 a bushel, soybeans at $13.56 a bushel, and, wheat, $7.46.

So before big investors jumped into one of the fastest growing financial markets, notes President Lannie Cohen of Capitol Commodities Services Inc. in Indianapolis, futures had already shot up due to mounting supply and demand pressures.

As countries get richer, people tend to change their eating habits and increase their caloric intake, Nijensohn said.  In developing countries such as Brazil, India and China where billions of people reside, demand has significantly increased.  Supply is just not keeping up."

Because these countries are industrializing, they are demanding more crude oil and other raw materials, straining the world supply.  Crude oil prices seem to set a new record every day, and have already reached $135 a barrel.

“The world is competing now.  Billions of other people are getting involved,” Cohen stated.  “Among Brazil, Russia and India there are about 5 billion people.”

Other drivers behind the record corn prices, economists point out, are the U.S. government's biofuel production mandate and the use of corn for ethanol.  The law mandates 9 billion gallons of ethanol this year and 15 billion gallons by 2015.

“Corn is a political hot potato.  Ethanol and the biofuel mandate have put a political strain on corn,” Cohen said.

However, as economists and lawmakers try to unscramble the which-came-first  debate, one thing that is undeniable is that more institutional investors have seeped into once-small markets such as rice and corn, raising the question of whether the markets can smoothly absorb these new investors.

“A few years ago people were in the pits, and now you have professional investors and retail investors investing in ETFs, like gold, silver and grains,” Nijensohn said.  Exchange-traded funds (ETFs) are similar to mutual funds but they trade like stocks.

Commodity ETFs cover a wide spectrum, including heating oil, lean hogs, corn, cotton and coffee.  Indices such as Goldman Sachs Commodity Index (GSCI) and Dow Jones-AIG Commodity Index (DJ-AIGCI) are traded on U.S. exchanges and are just two other ways investors can get some exposure to commodities traded on the derivatives markets.

“According to the CFTC [Commodity Futures Trading Commission] and spot market participants," Michael Masters of Masters Capital Management LLC told a May 20 Senate hearing on market speculation, "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 in the real economy.”   The spot price or cash price is the price quoted for immediate settlement and delivery of the commodity.

The Senate’s Committee on Homeland Security and Governmental Affairs met on May 20 to look into speculation and possible manipulation of the commodity markets.  The hearing, spearheaded by Senator Lieberman, the chairman, began an investigation to determine whether speculation in commodity markets, unrelated to supply, demand or weather, is one of the reasons why food and energy prices have skyrocketed. 

Shortly after the launch of this investigation, the CFTC announced it's also looking into possible manipulation in the energy markets, and then on Monday added cotton to its inquiry. 

The price of cotton futures, traded at the IntercontinentalExchange Inc., hit a 12-year high of approximately 93 cents a pound on March 5, but then dropped to 69 cents, a 26 percent decline.

Both the Senate and CFTC investigations come in response to soaring gasoline prices.  The national average for the price consumers pay at the pump is nearing $4 a gallon.

But what should be done to limit the growing number of heavyweight investors jumping into the market via ETFs or indices?

The CFTC is under pressure from lawmakers in Congress to make sure that the commodity markets are not being manipulated.  Lawmakers say the CFTC may be failing to adequately police speculative investing in commodity markets as energy and food prices surge.

The CFTC currently prepares a weekly Commitment of Traders (COT) report that is published every Friday afternoon for markets in which 20 or more traders hold positions above CFTC-established reporting levels, according to Jeffrey Harris, chief economist at the CFTC.  For reportable positions, the report shows commercial and non-commercial holdings and several other details, Harris explained in a report prepared for the Senate hearing.

The CFTC is now requiring even more information from investors in commodity-linked index funds as a way to boost surveillance.

Increasing margin or cash requirement for crude oil futures with the hope of lowering prices is one possible way to crack down, and is set forth in the proposed Consumer-First Energy Act of 2008.   However, some believe that “increased margin requirements would force many market participants off-exchange and into less transparent markets,” noted Thomas Erickson, chairman of the Commodity Markets Council, in the hearing.  The current margin requirement for crude oil trading at the New York Mercantile Exchange is 7.5 percent.

Margin requirements at the Chicago Board of Trade vary from commodity to commodity, but are primarily pegged to volatility, explained Jack Scoville, vice president at Price Futures Group Inc. in Chicago.  Of course, the price of the contracts also affects the margin requirement for each commodity, he added. The margin requirement for corn at the Chicago Board of Trade is approximately 4.5 percent; soybeans, 7 percent; and, wheat, 16 percent.