Testimony of
Michael W. Masters
Managing Member / Portfolio Manager
Masters Capital Management, LLC
before the
Permanent Subcommittee on Investigations
Committee on Homeland Security and Governmental Affairs
United States Senate
May 20, 2008
Good morning and thank you, Mr. Chairman and Members of the Committee, for the
invitation to speak to you today. This is a topic that I care deeply about, and I
appreciate the chance to share what I have discovered.
I have been successfully managing a long-short equity hedge fund for over 12 years
and I have extensive contacts on Wall Street and within the hedge fund community. Itʼs
important that you know that I am not currently involved in trading the commodities
futures markets. I am not representing any corporate, financial, or lobby organizations. I
am speaking with you today as a concerned citizen whose professional background has
given me insight into a situation that I believe is negatively affecting the U.S. economy.
While some in my profession might be disappointed that I am presenting this testimony
to Congress, I feel that it is the right thing to do.
You have asked the question “Are Institutional Investors contributing to food and energy
price inflation?” And my unequivocal answer is “YES.” In this testimony I will explain
that Institutional Investors are one of, if not the primary, factors affecting commodities
prices today. Clearly, there are many factors that contribute to price determination in the
commodities markets; I am here to expose a fast-growing yet virtually unnoticed factor,
and one that presents a problem that can be expediently corrected through legislative
policy action.
Commodities prices have increased more in the aggregate over the last five years than
at any other time in U.S. history.1 We have seen commodity price spikes occur in the
past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today,
unlike previous episodes, supply is ample: there are no lines at the gas pump and there
is plenty of food on the shelves.
If supply is adequate - as has been shown by others who have testified before this
committee2 - and prices are still rising, then demand must be increasing. But how do
you explain a continuing increase in demand when commodity prices have doubled or
tripled in the last 5 years?
What we are experiencing is a demand shock coming from a new category of
participant in the commodities futures markets: Institutional Investors. Specifically,
these are Corporate and Government Pension Funds, Sovereign Wealth Funds,
University Endowments and other Institutional Investors. Collectively, these investors
now account on average for a larger share of outstanding commodities futures contracts
than any other market participant.3
These parties, who I call Index Speculators, allocate a portion of their portfolios to
“investments” in the commodities futures market, and behave very differently from the
traditional speculators that have always existed in this marketplace. I refer to them as
“Index” Speculators because of their investing strategy: they distribute their allocation of
dollars across the 25 key commodities futures according to the popular indices – the
Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG
Commodity Index.4
I’d like to provide a little background on how this new category of “investors” came to
exist.
In the early part of this decade, some institutional investors who suffered as a result of
the severe equity bear market of 2000-2002, began to look to the commodity futures
market as a potential new “asset class” suitable for institutional investment. While the
commodities markets have always had some speculators, never before had major
investment institutions seriously considered the commodities futures markets as viable
for larger scale investment programs. Commodities looked attractive because they have
historically been “uncorrelated,” meaning they trade inversely to fixed income and equity
portfolios. Mainline financial industry consultants, who advised large institutions on
portfolio allocations, suggested for the first time that investors could “buy and hold”
commodities futures, just like investors previously had done with stocks and bonds.
Index Speculator Demand Is Driving Prices Higher
Today, Index Speculators are pouring billions of dollars into the commodities futures
markets, speculating that commodity prices will increase. Chart One shows Assets
allocated to commodity index trading strategies have risen from $13 billion at the end of
2003 to $260 billion as of March 2008,5 and the prices of the 25 commodities that
compose these indices have risen by an average of 183% in those five years!6
According to the CFTC and spot market participants, 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 the real
economy.7 So there is a direct link between commodities futures prices and the prices
your constituents are paying for essential goods.
The next table looks at the commodity purchases that Index Speculators have made via
the futures markets. These are huge numbers and they need to be put in perspective to
be fully grasped.
In the popular press the explanation given most often for rising oil prices is the
increased demand for oil from China. According to the DOE, annual Chinese demand
for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion
barrels, an increase of 920 million barrels.8 Over the same five-year period, Index
Speculatorsʼ demand for petroleum futures has increased by 848 million barrels.9 The
increase in demand from Index Speculators is almost equal to the increase in demand
from China!
Commodity Purchases By Index Speculators The Last 5 Years
Sector Commodity Units
Previous Futures
Market Stockpile
January 1, 2003
Net Purchases
Last 5¼ Years
Current Futures
Market Stockpile
March 12, 2008
Agricultural Cocoa Metric Tons 18,828 303,352 322,180
Coffee Pounds 195,716,944 2,238,858,056 2,434,575,000
Corn Bushels 242,561,708 2,138,383,292 2,380,945,000
Cotton Pounds 544,934,999 5,548,915,001 6,093,850,000
Soybean Oil Pounds 163,135,678 4,312,624,322 4,475,760,000
Soybeans Bushels 81,028,272 890,616,728 971,645,000
Sugar Pounds 2,291,358,746 46,094,097,254 48,385,456,000
Wheat Bushels 166,738,225 967,351,775 1,134,090,000
Wheat KC Bushels 54,746,014 102,618,986 157,365,000
Livestock Feed Cattle Pounds 104,446,612 365,453,388 469,900,000
Lean Hogs Pounds 517,414,747 3,827,425,253 4,344,840,000
Live Cattle Pounds 669,766,732 5,099,033,268 5,768,800,000
Energy Brent Crude Oil Barrels 47,075,357 144,524,265 191,599,621
WTI Crude Oil Barrels 99,880,741 538,499,579 638,380,320
Gasoil Metric Tons 1,682,662 6,027,680 7,710,342
Heating Oil Gallons 1,067,859,608 2,568,925,661 3,636,785,269
Gasoline Gallons 1,102,184,401 2,488,458,616 3,590,643,018
Natural Gas Million BTUs 330,652,415 1,932,356,225 2,263,008,640
Base Metals Aluminum Metric Tons 344,246 3,232,406 3,576,652
Lead Metric Tons 82,019 158,726 240,745
Nickel Metric Tons 20,147 101,988 122,135
Zinc Metric Tons 133,381 1,182,091 1,315,472
Copper Metric Tons 220,096 1,144,538 1,364,634
Precious Metals Gold Troy Ounces 979,863 8,742,401 9,722,264
Silver Troy Ounces 11,126,862 152,866,187 163,993,049
Sources: Goldman Sachs, Standard & Poors, Dow Jones,
CFTC Commitments of Traders CIT Supplement, calculations
In fact, Index Speculators have now stockpiled, via the futures market, the equivalent of
1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own
stockpile as the United States has added to the Strategic Petroleum Reserve over the
last five years.10
Let’s turn our attention to food prices, which have skyrocketed in the last six months.
When asked to explain this dramatic increase, economists’ replies typically focus on the
diversion of a significant portion of the U.S. corn crop to ethanol production.11 What
they overlook is the fact that Institutional Investors have purchased over 2 billion
bushels of corn futures in the last five years. Right now, Index Speculators have
stockpiled enough corn futures to potentially fuel the entire United States ethanol
industry at full capacity for a year.12 That’s equivalent to producing 5.3 billion gallons of
ethanol, which would make America the world’s largest ethanol producer.13
Turning to Wheat, in 2007 Americans consumed 2.22 bushels of Wheat per capita.14 At
1.3 billion bushels, the current Wheat futures stockpile of Index Speculators is enough
to supply every American citizen with all the bread, pasta and baked goods they can eat
for the next two years!
Index Speculator Demand Characteristics
Demand for futures contracts can only come from two sources: Physical Commodity
Consumers and Speculators. Speculators include the Traditional Speculators who have
always existed in the market, as well as Index Speculators. Five years ago, Index
Speculators were a tiny fraction of the commodities futures markets. Today, in many
commodities futures markets, they are the single largest force.15 The huge growth in
their demand has gone virtually undetected by classically-trained economists who
almost never analyze demand in futures markets.
Index Speculator demand is distinctly different from Traditional Speculator demand; it
arises purely from portfolio allocation decisions. When an Institutional Investor decides
to allocate 2% to commodities futures, for example, they come to the market with a set
amount of money. They are not concerned with the price per unit; they will buy as many
futures contracts as they need, at whatever price is necessary, until all of their money
has been “put to work.” Their insensitivity to price multiplies their impact on commodity
markets.
Furthermore, commodities futures markets are much smaller than the capital markets,
so multi-billion-dollar allocations to commodities markets will have a far greater impact
on prices. In 2004, the total value of futures contracts outstanding for all 25 index
commodities amounted to only about $180 billion.16 Compare that with worldwide
equity markets which totaled $44 trillion17, or over 240 times bigger. That year, Index
Speculators poured $25 billion into these markets, an amount equivalent to 14% of the
total market.18
Chart Two shows this dynamic at work. As money pours into the markets, two things
happen concurrently: the markets expand and prices rise.
One particularly troubling aspect of Index Speculator demand is that it actually
increases the more prices increase. This explains the accelerating rate at which
commodity futures prices (and actual commodity prices) are increasing. Rising prices
attract more Index Speculators, whose tendency is to increase their allocation as prices
rise. So their profit-motivated demand for futures is the inverse of what you would
expect from price-sensitive consumer behavior.
You can see from Chart Two that prices have increased the most dramatically in the first
quarter of 2008. We calculate that Index Speculators flooded the markets with $55
billion in just the first 52 trading days of this year.19 That’s an increase in the dollar
value of outstanding futures contracts of more than $1 billion per trading day. Doesn’t it
seem likely that an increase in demand of this magnitude in the commodities futures
markets could go a long way in explaining the extraordinary commodities price
increases in the beginning of 2008?
There is a crucial distinction between Traditional Speculators and Index Speculators:
Traditional Speculators provide liquidity by both buying and selling futures. Index
Speculators buy futures and then roll their positions by buying calendar spreads. They
never sell. Therefore, they consume liquidity and provide zero benefit to the futures
markets.20





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