April 29, 2011
On Monday, April 11, Goldman Sachs told its clients to sell commodities, and the market reacted with a $4 tumble in the price of West Texas Intermediate (WTI) crude oil and sell offs in other commodities.
On Thursday, April 14, the leaders of the BRICS nations (Brazil, Russia, India, China and South Africa), meeting in Sanya, China, continued to press for a new world monetary system that has a much lower reliance on the Dollar, and called for stronger regulation of commodity derivatives to dampen excessive volatility in food and energy prices.
We are in another commodity price run up, like that experienced in the ’05-’08 period. Such commodity price frenzies have devastating consequences for the world’s poor who, in some instances, already spend half of their income on food. And, today, in the U.S. itself, the rise in the price of gasoline to more than $4/gallon threatens an economy still struggling to free itself from the still lingering effects of the last bursting bubble.
It appears that the Western economic systems have become ever more volatile over the past decade. That is, bubbles, followed by severe contractions, are appearing more often and with increased severity. This is in stark contrast to the dampening of the business cycle we observed, and celebrated, in the ‘80s and ‘90s. So, what changed?
In July, ‘10’s issue of Harper’s, Fredrick Kaufman wrote an article entitled The Food Bubble (scribd.com/doc/37709491/The-Food-Bubble-PDF) which explained the reasons for the run up in agricultural commodity prices just prior to the ’08 financial meltdown and worldwide recession. The popular business media gave the article short shrift. But, most of what Kaufman observed as the causes of the commodity price run up in the ’05-’08 period is now being repeated, a short three years later.
Supply and Demand?
We are told by “experts”, trotted out by the popular financial media, that it is supply and demand that is at work in the exploding commodity price arena. The tight supply of oil and the growing demand from emerging markets is pushing prices up. Yet, in mid-April, Saudi Arabia announced that they were considering reducing production by 500,000 bbl/day. And, the Cushing, OK, crude oil receiving facility in the U.S. has no more storage capacity. So, this certainly can’t be a supply issue!
Of course, Middle-East unrest is likely to warrant some oil price premium, as a significant proportion of oil production occurs in that region. But, use common sense. Do you really think that the run up in oil prices in ’08 to $147/bbl and a subsequent decline to $30/bbl six months later is due to supply and demand? During that six months, supply hardly changed, and while demand from industrial countries did shrink, weren’t the emerging nations demanding more (like we hear they are today)? So, today, we see WTI at $110/bbl and North Sea Brent at $123/bbl. This is occurring in the face of struggling industrial economies in Europe and the U.S.
From the above, it would appear that there is something more than simple supply and demand at work here.
According to Matt Taibbi, the Rolling Stone’s financial guru and author of Griftopia: Bubble Machines, Vampire Squids, and the Long Con that is Breaking America, on October 18, 1991, the Commodities Futures Trading Commission (CFTC) granted to commodity trader, J. Aron, a Goldman Sachs subsidiary, an exemption from long standing commodity position limits (5000 contracts) for speculators on the grounds that their speculative positions were really “hedges”. (The word “hedge” is a magic one in today’s financial world. It can mean anything from the complete protection of one’s financial position from market forces to the wildest speculation possible. Use the word “hedge” and your opposition, including your regulators, instantly melts.) Let’s not forget that we jailed the Hunt Brothers in the early ‘80s for violating those limits and cornering the silver market. According to Taibbi, at least 17 such exemption letters now exist, all of which have been granted to the nation’s largest (Too Big To Fail) financial institutions. And they now actively speculate in the commodities markets (food, energy, metals, etc.) both for their own and their clients’ accounts. So, for example, on February 22nd, it was reported (www.leveragedetf.org/commodity-etfs-2/copper-etf/) that JPMorganChase was attempting to corner the market in physical copper.
The purpose of Kaufman’s Harper’s piece was to explain the volatile run up in food prices, which played such havoc with the world’s poor between ’05 and ’08. He forecast that we’d likely see this again. I doubt he thought it would be so soon.
Only Traded Commodities
In March, I sat in a Board meeting of a small company in the Midwest whose business is the manufacture and sale of refractory products. These are linings that are used to protect the vessels that carry molten metal from the intense heat of the liquid. The company purchases huge volumes of earths (like brown and white fused alumina), which are their raw material manufacturing inputs. In the meeting, I asked what impact the rapidly rising prices of commodities was having on profit margins. “We see very little upward pricing pressures from our raw material suppliers,” I was told. Despite the fact that this was anecdotal, it was a revelation to me. The pricing pressures appear to be only in the commodities that are traded on the equity exchanges!
Like Taibbi, Kaufman traces the beginnings of the increased commodity price volatility to 1991, presumably when the CFTC granted Goldman the exemption from the 5000 contract speculative limit in the commodities futures markets. Goldman, then, began trading in commodities, set up a fund and an index (Goldman Sachs Commodity Index) consisting of cattle, coffee, corn, wheat, cocoa, etc. Others quickly followed suit, and, according to Kaufman, the Great Commodity Speculation had begun. In 2008, “the global speculative frenzy sparked riots in more than thirty countries and drove the number of the world’s ‘food insecure’ to more than a billion. In 2008, for the first time since such statistics have been kept, the proportion of the world’s population without enough to eat ratcheted upward. The ranks of the hungry had increased by 250 million in a single year, the most abysmal increase in all of human history.”
Backwardation and Contango
In the commodity markets, the prices of the futures are “normally” less than the prices of the spot. The wheat farmer, in April, expecting he will have a crop to take to market in September and knowing how many acres he planted and how much yield he usually has per acre, can “hedge” (there’s that word again) by selling the September contract and thereby guarantee himself a price for his crop. By doing so, he avoids the risk that the price of his crop in September will be lower (also sacrifices extra profits if the price in September is higher). The difference between the normally lower futures price and the spot price is an insurance premium the farmer is willing to pay to guarantee himself the September price, when he can deliver his crop. This normal market condition (futures prices lower than spot) is known as “backwardation”.
The opposite condition in the futures market, when the futures prices are higher than the spot prices, is known as “contango”. Prior to the speculative fervor of the last decade, contango was the exception, and would occur only in unusual circumstances. For example, if a drought occurred and the coming harvest was expected to be much lower, the futures prices may be in contango, i.e., higher than spot. So, contango was the exception, that is, until Wall Street got involved.
Unintended Investor Speculation
Today, as a result of those CFTC exemptions letters, regular investors are “speculating” in commodities, although almost no one recognizes this. As the commodity ETFs, mutual funds, and Indexes attract more and more investors, their cash positions increase. Per their prospectuses, they must purchase the commodities, and for these funds, this means buying the futures contracts. The more investors decide that they need some commodities exposure (as a portfolio diversifying tactic), the higher the number of futures contracts that must be purchased. These ETFs, mutual funds, and Indexes never take delivery of a commodity, so they must “roll” the futures contracts before they mature into a contract that expires further into the future. In other words, during the price run up in the commodities, these ETFs, mutual funds, and Indexes are all long and only long. The constant onslaught of cash into these markets causes a frenzy in the price of the futures contracts and drags the spot prices ever upward. Kaufman describes the ’08 debacle as follows: “Bankers had taken control of the world’s food, money chased money, and a billion people went hungry”.
Like all bubbles, the ‘08 one ended when the actual supplies of grain, especially wheat, proved to be greater than actual demand. “The wheat harvest of 2008 turned out to be the most bountiful the world had ever seen”, wrote Kaufman, “so plentiful that even as hundreds of million slowly starved, 200 million bushels were sold for animal feed. Livestock owners could afford the wheat; poor people could not.”
Today’s Commodity Bubble
We are, of course, seeing the same scenario play out again in food, energy and other basic and vital commodities. At this writing, retail gasoline prices have reached $4/gallon in many parts of the U.S., and it appears that they will go still higher in coming months. This, despite the fact that supplies appear more than adequate. So, in America, the taxpayers continue to pay excessive amounts out of their dwindling real incomes for energy, food, and other traded commodities (copper, cotton, coffee, livestock, cocoa, etc.) so that the Wall Street banks (yes, the very ones that the taxpayers saved only 2.5 years ago) can show record profits and pay record bonuses! The power of Wall Street, in effect, to corner markets worldwide in vital basic commodities, has played havoc with the business cycle and has fostered bubbles, allowing them to occur more often and with ever increasing amplitudes. As quoted at the top of this piece, when Goldman says “sell”, the price reaction is violent. (One must ask why they make such statements public rather than just to their paying clientele?) In the end, when Wall Street moguls tell their clients to buy or sell, the clients and hedge fund associates have enough market clout to move prices significantly. More or less, these pronouncements are self-fulfilling prophecies – the financial market equivalent of the infallibility of the Pope.
David Rosenberg, the former Merrill Lynch economist, now with the Canadian firm Gluskin Sheff, has argued that the run up in commodity prices is not a forerunner of a generalized inflation because incomes are not rising and there is huge excess capacity in the economic system, as indicated by high levels of unemployment. The above explanation of how the commodity inflation is occurring would confirm Rosenberg’s point of view. There are no basic, underlying inflationary pressures. These price run ups are due to speculation and to a broken system that has allowed greed and unethical behavior to thrive and prosper.
There clearly is a need to decouple speculative excesses from basic commodities. It would clearly help the market to control those excesses if it knew they existed in the first place. But, the popular business media continuously drags out “experts” who believe in the efficient market hypothesis, which ultimately leads to the view that since all information is known, the markets are efficient and bubbles cannot form. These folks miss the point that artificial demand for commodity contracts causes serious market distortions, and bubbles do form as a result.
Wall Street will certainly scream if we go back to the contract limits, but that may be what has to be done. That would keep most of Wall Street on the sidelines if the contract limits were too small for their huge investment portfolios. Or, perhaps, limits should be imposed on speculators (not those in the commodities businesses) when the futures are in contango. Finally, those institutions which now have FDIC insurance, can borrow from the Fed’s discount window at preferential rates, and pose systemic risks if they fail and therefore may call on taxpayers again sometime in the future, should not be allowed to speculate in the commodities futures markets. Yes, that is most of Wall Street! And, regulations in the rest of the world on similarly large institutions should also prevent such commodity speculation.
Just as the ’05-’08 commodity bubble burst when supplies turned out to be plentiful, so, too, will the current commodities price bubble burst. We just don’t know when. In the interim, the world will overpay for gasoline and other vital basic commodities, and many poor will continue to go hungry – all for the enhancement of a few Wall Street institutions! The “Unholy Washington-Wall Street Alliance” is alive and well.
Robert Barone, Ph.D.
April 18, 2011
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