This is an excellent perspective on the influence of investors in the commodity markets and the problems this is creating for the agricultural industry.
This article and an extensive "Comments" section can be viewed at
http://www.marketwatch.com/news/story/looming-commodity-markets-crisis/
story.aspx?guid=%7b9DD4369A-14EC-4FC6-A991-9B3AECD74D4A%7d
The looming commodity crisis
Commentary: The issue is volume, not price
By Jeffrey D. Korzenik
BOSTON (MarketWatch) -- There is a crisis looming in the world's commodity markets, but it is has nothing to do with high prices, food shortages or the "peak oil hypothesis."
It has everything to do with the flood of capital into new financial instruments tied to commodity prices.
The ongoing debate as to whether this new "investment" demand has caused a price bubble is misdirected. We should be paying attention to the economic damage being done by these new instruments, which are creating a level and type of volume for which the futures exchanges are ill-suited. In our search for strong and uncorrelated returns, the investment industry is undermining a commodity production and distribution system that has served well for over 100 years.
Historically, rising commodity prices have always attracted investor attention. This is the first commodity bull market, however, where individuals and institutions have participated, not as "speculators" but as "investors," treating commodities as an asset class.
The explosion of commodity swaps, structured products, exchange traded funds, and mutual funds has opened the door for a broad spectrum of investors into the sector.
Unlike traditional speculators, this new participation is marked by little or no leverage, a distinctly "long-only" bias, and long holding periods. Barron's recently cited estimates of $200 billion in participation through the swap markets, and there is probably at least another $50 billion in ETFs, mutual funds and other securities.
A recent move by pension giant Calpers to commit to raise their commodity exposure to $7 billion (from less than $400 million) underscores this growing trend. All this money is directed into roughly two dozen futures contracts.
These new vehicles have made it easy for traditional stock-and-bond investors to participate in the strongest commodity market in decades. Sophisticated institutional investors have discovered a new way to move along the efficient frontier, with a non- or negatively-correlated asset that has added to portfolio returns. There's one problem with all this -- the commodity markets and the futures exchanges have never been intended to serve investors.
Instead, these markets have been created and are regulated to serve the needs of commodity producers and users. Speculators have been tolerated to the degree that they add economic value through liquidity, but not to the point that they can manipulate prices. Nowhere is there room for the type of long-term investment capital that marks today's environment. In practice, the problem is that the investment capital is too large relative to the size of the underlying commodity markets. The traditional regulatory tools for preventing this sort of excess are "speculative position limits," which are designed to limit participation per control entity. However, swap dealers are exempt. Other types of vehicles also fall outside this regulation because their participation is diffused among many control entities, even though in aggregate they may behave identically.
The inordinate and one-sided volume is breaking down the traditional relationships between the futures markets and the cash markets. Without a close correlation between the two, commodity producers and users cannot rely on the futures exchanges for price discovery and risk management. Moreover, it can become downright dangerous for them to do so; when hedgers do not see corresponding moves in the cash markets and their futures positions, they are at substantial financial risk
There is already anecdotal evidence of grain elevators going out of business due to disruptions in the wheat futures, and legitimate hedgers of cotton were faced with a costly cash flow drain exceeding $1 billion when dislocations in that market in early March generated margin calls. Commercial players have been simultaneously trapped in a short-squeeze and a credit-squeeze.
All this is a tremendous new burden for the agricultural industry. The Commodity Futures Trading Commission, the futures regulatory authority, called a special roundtable on April 22 to review "whether the futures markets are properly performing their risk management and price discovery roles." The commission heard numerous reports that suggested that the markets' ability to fulfill these critical functions is eroding. Some participants went so far as to declare their markets "broken."
If the commodities-as-investments trend continues, the market disruptions will only worsen. Without regulatory intervention, we will do enormous damage to the U.S. commodity production and distribution chain. This, in turn, will impose inefficiencies and very real costs on the U.S. economy in a fragile period.
While there are no easy solutions, the path to fixing this problem starts with recognizing the destructive role played by the volume of commodity participation by the investment community.
Jeff Korzenik is chief investment officer at vitale, Caturano & Company in Boston, a wealth management, accounting, and business services firm.
This article and an extensive "Comments" section can be viewed at
http://www.marketwatch.com/news/story/looming-commodity-markets-crisis/
story.aspx?guid=%7b9DD4369A-14EC-4FC6-A991-9B3AECD74D4A%7d
The looming commodity crisis
Commentary: The issue is volume, not price
By Jeffrey D. Korzenik
BOSTON (MarketWatch) -- There is a crisis looming in the world's commodity markets, but it is has nothing to do with high prices, food shortages or the "peak oil hypothesis."
It has everything to do with the flood of capital into new financial instruments tied to commodity prices.
The ongoing debate as to whether this new "investment" demand has caused a price bubble is misdirected. We should be paying attention to the economic damage being done by these new instruments, which are creating a level and type of volume for which the futures exchanges are ill-suited. In our search for strong and uncorrelated returns, the investment industry is undermining a commodity production and distribution system that has served well for over 100 years.
Historically, rising commodity prices have always attracted investor attention. This is the first commodity bull market, however, where individuals and institutions have participated, not as "speculators" but as "investors," treating commodities as an asset class.
The explosion of commodity swaps, structured products, exchange traded funds, and mutual funds has opened the door for a broad spectrum of investors into the sector.
Unlike traditional speculators, this new participation is marked by little or no leverage, a distinctly "long-only" bias, and long holding periods. Barron's recently cited estimates of $200 billion in participation through the swap markets, and there is probably at least another $50 billion in ETFs, mutual funds and other securities.
A recent move by pension giant Calpers to commit to raise their commodity exposure to $7 billion (from less than $400 million) underscores this growing trend. All this money is directed into roughly two dozen futures contracts.
These new vehicles have made it easy for traditional stock-and-bond investors to participate in the strongest commodity market in decades. Sophisticated institutional investors have discovered a new way to move along the efficient frontier, with a non- or negatively-correlated asset that has added to portfolio returns. There's one problem with all this -- the commodity markets and the futures exchanges have never been intended to serve investors.
Instead, these markets have been created and are regulated to serve the needs of commodity producers and users. Speculators have been tolerated to the degree that they add economic value through liquidity, but not to the point that they can manipulate prices. Nowhere is there room for the type of long-term investment capital that marks today's environment. In practice, the problem is that the investment capital is too large relative to the size of the underlying commodity markets. The traditional regulatory tools for preventing this sort of excess are "speculative position limits," which are designed to limit participation per control entity. However, swap dealers are exempt. Other types of vehicles also fall outside this regulation because their participation is diffused among many control entities, even though in aggregate they may behave identically.
The inordinate and one-sided volume is breaking down the traditional relationships between the futures markets and the cash markets. Without a close correlation between the two, commodity producers and users cannot rely on the futures exchanges for price discovery and risk management. Moreover, it can become downright dangerous for them to do so; when hedgers do not see corresponding moves in the cash markets and their futures positions, they are at substantial financial risk
There is already anecdotal evidence of grain elevators going out of business due to disruptions in the wheat futures, and legitimate hedgers of cotton were faced with a costly cash flow drain exceeding $1 billion when dislocations in that market in early March generated margin calls. Commercial players have been simultaneously trapped in a short-squeeze and a credit-squeeze.
All this is a tremendous new burden for the agricultural industry. The Commodity Futures Trading Commission, the futures regulatory authority, called a special roundtable on April 22 to review "whether the futures markets are properly performing their risk management and price discovery roles." The commission heard numerous reports that suggested that the markets' ability to fulfill these critical functions is eroding. Some participants went so far as to declare their markets "broken."
If the commodities-as-investments trend continues, the market disruptions will only worsen. Without regulatory intervention, we will do enormous damage to the U.S. commodity production and distribution chain. This, in turn, will impose inefficiencies and very real costs on the U.S. economy in a fragile period.
While there are no easy solutions, the path to fixing this problem starts with recognizing the destructive role played by the volume of commodity participation by the investment community.
Jeff Korzenik is chief investment officer at vitale, Caturano & Company in Boston, a wealth management, accounting, and business services firm.
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