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Thread: Some oil answers; financial perspective

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    Default Some oil answers; financial perspective

    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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    Default Re: Some oil answers; financial perspective

    PT 2


    It is easy to see now that traditional policy measures will not work to correct the problem
    created by Index Speculators, whose allocation decisions are made with little regard for
    the supply and demand fundamentals in the physical commodity markets. If OPEC
    supplies the markets with more oil, it will have little affect on Index Speculator demand
    for oil futures. If Americans reduce their demand through conservation measures like
    carpooling and using public transportation, it will have little affect on Institutional
    Investor demand for commodities futures.
    Index Speculators’ trading strategies amount to virtual hoarding via the commodities
    futures markets. Institutional Investors are buying up essential items that exist in limited
    quantities for the sole purpose of reaping speculative profits.
    Think about it this way: If Wall Street concocted a scheme whereby investors bought
    large amounts of pharmaceutical drugs and medical devices in order to profit from the
    resulting increase in prices, making these essential items unaffordable to sick and dying
    people, society would be justly outraged.
    Why is there not outrage over the fact that Americans must pay drastically more to feed
    their families, fuel their cars, and heat their homes?
    Index Speculators provide no benefit to the futures markets and they inflict a
    tremendous cost upon society. Individually, these participants are not acting with
    malicious intent; collectively, however, their impact reaches into the wallets of every
    American consumer.
    Is it necessary for the U.S. economy to suffer through yet another financial crisis
    created by new investment techniques, the consequences of which have once again
    been unforeseen by their Wall Street proponents?
    The CFTC Has Invited Increased Speculation
    When Congress passed the Commodity Exchange Act in 1936, they did so with the
    understanding that speculators should not be allowed to dominate the commodities
    futures markets. Unfortunately, the CFTC has taken deliberate steps to allow certain
    speculators virtually unlimited access to the commodities futures markets.
    The CFTC has granted Wall Street banks an exemption from speculative position limits
    when these banks hedge over-the-counter swaps transactions.21 This has effectively
    opened a loophole for unlimited speculation. When Index Speculators enter into
    commodity index swaps, which 85-90% of them do, they face no speculative position
    limits.22
    The really shocking thing about the Swaps Loophole is that Speculators of all stripes
    can use it to access the futures markets. So if a hedge fund wants a $500 million
    position in Wheat, which is way beyond position limits, they can enter into swap with a
    Wall Street bank and then the bank buys $500 million worth of Wheat futures.23
    In the CFTC’s classification scheme all Speculators accessing the futures markets
    through the Swaps Loophole are categorized as “Commercial” rather than “Non-
    Commercial.” The result is a gross distortion in data that effectively hides the full impact
    of Index Speculation.
    Additionally, the CFTC has recently proposed that Index Speculators be exempt from all
    position limits, thereby throwing the door open for unlimited Index Speculator
    “investment.”24 The CFTC has even gone so far as to issue press releases on their
    website touting studies they commissioned showing that commodities futures make
    good additions to Institutional Investors’ portfolios.25
    Is this what Congress expected when it created the CFTC?
    Congress Should Eliminate The Practice Of Index Speculation
    I would like to conclude my testimony today by outlining three steps that can be taken to
    immediately reduce Index Speculation.
    Number One:
    Congress has closely regulated pension funds, recognizing that they serve a public
    purpose. Congress should modify ERISA regulations to prohibit commodity index
    replication strategies as unsuitable pension investments because of the damage that
    they do to the commodities futures markets and to Americans as a whole.
    Number Two:
    Congress should act immediately to close the Swaps Loophole. Speculative position
    limits must “look-through” the swaps transaction to the ultimate counterparty and hold
    that counterparty to the speculative position limits. This would curtail Index Speculation
    and it would force ALL Speculators to face position limits.
    Number Three:
    Congress should further compel the CFTC to reclassify all the positions in the
    Commercial category of the Commitments of Traders Reports to distinguish those
    positions that are controlled by “Bona Fide” Physical Hedgers from those controlled by
    Wall Street banks. The positions of Wall Street banks should be further broken down
    based on their OTC swaps counter-party into “Bona Fide” Physical Hedgers and
    Speculators.
    There are hundreds of billions of investment dollars poised to enter the commodities
    futures markets at this very moment.26 If immediate action is not taken, food and
    energy prices will rise higher still. This could have catastrophic economic effects on
    millions of already stressed U.S. consumers. It literally could mean starvation for
    millions of the world’s poor.27
    If Congress takes these steps, the structural integrity of the futures markets will be
    restored. Index Speculator demand will be virtually eliminated and it is likely that food
    and energy prices will come down sharply



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    Default Re: Some oil answers; financial perspective

    too true ! However, the US Congress probably fails to realise that commodity futures contracts can be traded in europe or asia as well as on US commodity exchanges. As such, any attempt to regulate the potential profits of US commodity investors via the tightening of US exchange rules / margin requirments will probably only result in US commodities brokers losing business as the uber-rich move their commodity futures trades outside of US jurisdiction ! Ain't the global economy wonderful ?

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    Default Re: Some oil answers; financial perspective

    Quote Originally Posted by Melonie View Post
    too true ! However, the US Congress probably fails to realise that commodity futures contracts can be traded in europe or asia as well as on US commodity exchanges. As such, any attempt to regulate the potential profits of US commodity investors via the tightening of US exchange rules / margin requirments will probably only result in US commodities brokers losing business as the uber-rich move their commodity futures trades outside of US jurisdiction ! Ain't the global economy wonderful ?
    NYMEX is wanting to bring about an Exchange in Dubai. London's IIRC has or is changing itself to run parallel to ours, as will Dubai's.

    I'm not a globalist, but I do believe in global standards. Germany for transport (infrastructure, etc.), US for pollution standards, etc.. But, even though we 'have' that for certain things, there are what are termed No-Enforcement Zones, like in Europe. lol Defeats the purpose of it.

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