When I first entered the floor and learned about oil pricing, it was clear that the cash market, where real barrels of oil were bought and sold, was where pricing was decided. Later, it became increasingly clear that the source of prices was coming from the futures markets that I engaged in, with the cash market following along—a true case of the tail wagging the dog. Even more recently, it has become increasingly clear that the massive growth in standardized and custom oil swaps (in indexes, for example) have been the primary movers of the futures markets and then of cash prices. This is the hair on the tail of the dog wagging the dog, I guess…
oil trader Dan Dicker
As any attentive shopper or driver almost anywhere in the world could tell you, the prices of basic things like food and gasoline have risen faster than inflation in the last five or ten years. In US Dollar terms, prices for all 24 commodities in the most widely traded commodity index fund rose by an average of about 100 percent from 2003 to 2008, for instance. And the pace is not letting up now. Gold rose by 30 percent in 2010, copper by 33%, wheat by 47, corn by 52, cotton by 92, and so on…Analysts, journalists, government agencies, and market players wedded to a traditional supply and demand calculus have struggled to explain the price explosion. Again and again they have reached for the same straws: positing resource scarcity, weather shocks, ravenous demand in Asia, the decline of the dollar relative to other currencies. These explanations do carry some weight, but they are woefully inadequate to account for the staggering ascent of commodity prices. Very slowly, the world is beginning to understand that supply and deman no longer governs the markets in basic commodites. It would be wise to come to grips with the forces that have taken the reins of commodity pricing as soon as possible, to weigh the consequences of the shift, and to take appropriate action to limit the damage.
The Financialization of Commodities
As we detailed in a previous piece for this forum, the transformation of the world's primary commodity markets into playthings for speculators and vehicles for price inflation began in the 1990s, when the Commodities Futures Trading Commission (CFTC) secretly caved in to pressure from the biggest Wall Street banks and exempted them from restrictions that had successfully minimized the role of speculation in the movement of commodity prices. The big banks were now free to trade on commoodity markets in scale, generating heavy profits for themselves and amplifying the volatility of these markets.
More important for our purposes here, the relaxation of restrictions on speculators opened the door for two forms of financial innovation that would bastardize commoodity markets. First, the big banks created commodity index funds, that keep investors money in contracts for the delivery of comodities in the near future. All of the money in this fast-growing investment category serves to inflate futures prices above the level they would attain in a market where producers and end-users dominated, as opposed to investors (who are simply speculators, where commodities are concerned). And, inexorably, prices on the cash (or “spot”) market for end users inflate in harmony with the futures prices (anyone selling to an end user is aware of the price of contracts for delivery one or two months out, and can look to store his product for delivery at a later point in time if the cash market price falls too far below the futures).
Second, the banks engineered myriad derivative products to facilitate betting on commodity prices, especially oil. While the influx of money into these products has not been quantifiable with any precision, it has clearly sufficed to shoot commodity prices in one or another direction (generally upward) on innumerable occasions. As the quote above attests, experienced market watchers no longer have any doubts about financial flows replacing supply-demand fundamentals as the primary determinant of price.
Tethering Commodities to the Stock Market
Because the separation of commodity prices from supply and demand fundamentals is still little appreciated, the freshly developed correlation between prices and stock markets is almost unknown outside narrow specialist circles devoted to studying these markets. Traditionally, higher commodity prices have not shown any consistent correlation to stock market performance, which makes perfect sense. Thus, on the one hand companies have to pay more for inputs when commodity prices are high, and are unable to pass all of these costs on to their customers. Historically, on the other hand, commodity prices have risen when economies are accelerating, which tends to be good for corporate profits (and stock prices). But the gradual financialization of commodities over the last two decades has generated a very different relationship between commodities and stocks, and for a simple reason: when financial markets are rising, asset managers have more money to invest, and now they can (and do) direct a portion of it into commodities (alternatively, of course, when stock markets are falling, asset managers are liable to withdraw some of their allocations to commodities).
Measurement of the correlation between oil prices and the S&P 500 illustrates the transformation as clearly as can be. The basic Pearson correlation coefficient (perfect correlation registering as 1, perfect negative correlation as -1) between the two tended to range from -0.2 to +0.2 at almost all times throughout the 1990s. The coefficient trended above 0 from the turn of the century, and has moved up steadily ever since, reaching an astonishing 0.6 in 2010.
Winners and Losers?
Keeping track of the winners and losers in the financialization of commodity markets is not quite as elementary as one would think. Oil refiners tend to be losers, for instance, because the market for their raw material, oil, has metamorphosized (and, hence, inflated) more thoroughly than have markets in refined oil products. Oil production companies proper have tended to prosper, naturally, but quite a few have run up enormous losses while setting up side operations in oil trading. The surest winners have been the biggest Wall Street banks (the asset management and trading arms of that are devoted to the commodity sector), and a whole fleet of winners are to be found among specialized commodity trading funds, which now number in the hundreds. Taken together, these players now bring enormous resources to bear on the traditionally sleep commodity markets. One running—but invariably incomplete–estimate, from Barclay's Capital, pegged the capital lodged in commodity-based investment vehicles at $451 billion as of April, an all-time high.
The surest losers, on the other hand, are consumers the world over. The poor around the world are under severe stress from escalatin food prices. The United Nations Food and Agriculture Organization (FAO) Food Price Index has been at record levels all year, and at last check stood at 37 percent above already-inflated year-ago levels. Just yesterday, newly appointed FAO chief Jose Graziano da Silva confirmed at his inaugural press conference that he is well aware of the source of the crisis: "High prices will remain not only a few years. This is not only a temporary imbalance. This is related to financial markets and until we reach a more stable financial situation worldwide, commodities prices will reflect that."
In the developed world, meanwhile, higher prices are sapping consumer purchasing power, slowing the economy, and constraining government tax receipts. As disturbing as the wealth transfer within the country may be, the wealth transfer from the US to oil exporters is also alarming. The country has imported an average of about 4.5 billion barrels of crude oil and oil products per year in the last five years. Taking a very modest estimate of a $20 per barrel inflation from financialization of oil (Goldman Sachs recently admitted the real figure was anywhere from $21-27 per barrel), that is an export of $90 billion per year. A good portion of the huge petrodollar stashes of oil exporting countries returns to the US via purchases of Treasury bills, it is true. But, inevitably, the fast-swelling soveriegn wealth funds of commodity-rich nations are beginning to prey on prostrate local governments in the US that are privatizing infrastructure and other assets.
What is To Be Done?
The last decade has provided ever sharper reminders of the dangers inherent in deregulated commodity markets, dangers the Commodities Exchange Act of 1936 kept under control quite well until Wall Street and the CFTC undermined it in the 1990s. There is no good reason to allow a free market in commodities. The free market fundamentalist orthodoxy that invokes the holiness of liquidity in maximizing market efficiency is plainly irrational as regards commodities, where liquidity has only served to undermine the functioning of supply and demand. The solution is to return to the regime begun in 1936, and to bolster it to account for new features of the financial landscape. The government and the CFTC should simply forbid all but a very select, licensed cohort of traders from participating in commoodity markets for trading purposes. This would banish index funds and exchange traded funds from commodity markets, and restore the primacy of supply and demand fundamentals.
Who is holding up reform?
Alas, the special interest that has driven the financialization of commodities in the US is Wall Street, which happens to be the most politically powerful special interest of all (together with the defense sector, one could argue). It is no accident that during the three months that the Senate and the CFTC began earnest deliberation on financial reform (including commodity markets) the number of lobbyists registering to approach the CFTC jumpred by 22 percent. Nor is it an accident that the CFTC's reform efforts to date have been halting and tightly circumscribed. In place of the fundamental reforms outlined above (banishing speculators from commodity markets), measures now under discussion are much less aggressive. They would merely lower the number of futures contracts a market participant could buy (“position limits”), or raise the amount of capital required to purchase a contract for future delivery (“margin requirements”). For a variety of reasons, such steps would not suffice to keep the speculators at bay. And the CFTC will not attempt to impose changes of any kind before 2012 at the earliest.
Contrast te CFTC's supine regulatory “effort” with the decisive intervention of the federal government and the relevant commodity exchange (the COMEX) against speculators in silver in 1980. At theat time, before monied interests had captured and tamed nearly all federal agencies, the regulators forced speculators out of that market, and silver prices promptly shrank by 77 percent. Times have certainly changed in Washington, and not for the better.
Might the Republican or Democratic Party step in and pressure the CFTC to act forcefuly in the interest of the great majority of the people? It would be naive to expect so. On the whole, the Republican-controlled House of Representatives has taken the phenomenon of rising prices as an opportunity to demand more deregulation of the oil industry (to open up lands for drilling, and to relax offshore drilling regulations). Most Democrats, for their part, have taken it as an opportunity to score political points by demanding repeal of about $4 billion per year in various tax subsidies the government has been giving oil companies.Moreover, and predictably, the Republicans are going so far as to block the funding the CFTC will need to enforce whatever new rules and regulations do emerge.
Will the World Wait?
International pressure could certainly influence the trajectory of commodity market reform, especially in Europe, home to influential exchanges of its own as regards many commodities (the London Metals Exchange, to name just the most famous). France has pushed for genuine measures to minimize speculation, and for international coordination to ensure success. But other European powers, especially Britain (home to an outsized financial sector) have not been cooperating with enthusiasm. Inevitably, therefore, recent meetings of the G20 did not provide cause for optimism regarding the problem of speculation in commodity markets.
While the prospects for radical reform of commodity markets may not look bright, large economic players will not necessarily accept the status quo. Thus Saudia Arabia, which has profited enormously from higher oil prices, has expressed its distrust and disturbance regarding manipulation in US oil markets by renouncing its traditional alliegiance to the US benchmark oil price (the WTI) as regards the pricing of its voluminous exports to America. Other oil-exporting countries have seriously considered taking the same step. They recognize that the speculator-driven pricing mechanism of US markets leaves them vulnerable to rapid price crashes, as happened with US-exchange traded oil in late 2008 and early 2009 (it fell far more sharply than did other oil price benchmarks, because speculators unwound their positions). Shifting to non-US price indexes is one step on the way to the international oil trade moving much of its business to non-US exchanges, at which point the US dollar would not likely retain its monopoly on the denomination of this business. Talk naturally continues regarding the establishment of an Asian oil benchmark (presumably Russian Eastern Siberian Pipeline Oil or ESPO) and the formation of an accepted exchange there. The consequences for the US dollar could be palpable (the denomination of trade in US dollars provides a continuous “transactional demand” for US dollars). At the very least, the world should welcome the prospect of US exchanges facing competition for their business.
Meanwhile, in the absence of real repair of commodity markets, the tightening correlation between US equity markets and commodity prices raises a provocative question for all international organizations exerting influence on economic and financial policy coordination.Given the agony that escalating food and oil prices have been visiting on poorer populations around the world in the last few years, might orchestration of a controlled collapse of US stock markets be a great blessing for humanity?