In 2008, before the financial system almost melted down and threatened an economic collapse of biblical proportions, some very odd events occurred in the market for commodities derivatives. It is now clear that financial institutions and investors already understood that the mortgage market was teetering and that severe problems for the financial firms were on the horizon. Stress was building, but how did this relate to the commodities markets? We still do not know for certain, but we do know that it coincided with peak investment levels of $317 billion in several investment vehicles known as commodity index funds.
In 1991, Goldman Sachs invented the commodity index fund. While several other firms have replicated the fund, Goldman has maintained a 60-75% market share.
A key factor in the success of commodity index funds was an exemption granted by the CFTC from limits on speculative positions. It allowed the fund holdings to grow enormously. Whatever the rationale was at that time, the conditions have changed and history suggests that the decision was unwise.
Goldman would take in funds from clients and invest the proceeds in futures contracts, a portfolio of energy, agricultural, minerals and financial contracts. It would be a sponsor and manager of the structure, not a principal. Futures contracts fluctuate based on the price of a commodity at a specified date in the future. For example, a barrel of oil to be delivered in August might be worth $70 to both a buyer and a seller as of today. The futures contract between a notional buyer and seller is essentially a financial instrument which continuously tracks that price each day until August arrives and the final price is known. It is not about actual oil, but rather the price of actual oil on a future date. A futures contract is the functional equivalent of a swap and is a derivative of the cash market for the given commodity.
The idea of the fund was not to trade short and long positions or hedge physical prices on delivery of the commodity. The fund ignored market views and only bought one side - the side on which value of the futures contract increased as the expected delivery price increased. The fund sponsor rolled over each contract into a new contract before the notional delivery date occurred. By rolling over the contracts, the fund became infinite, a rolling investment in an index of prices for commodities that never had an end date.
Goldman and other banks made plenty of money from fees and float (the cash paid by investors was mostly held by the banks as long as everything worked well). A side benefit was the huge increase in the volatility of commodities markets. By flooding the markets with one sided contracts (especially on roll over dates), price movements became more severe. Absolute commodities prices trended relentlessly higher and higher.
Volatility is essential to profits for the trading operations of the banks. Traders make money from price movements; stable prices mean low potential for trading profit. The logic is that commodities index funds lead to volatility which leads to trading profits for the fund sponsors. Goldman and other banks discovered that the commodities index fund operation, originally designed as a product for clients interested in investing in commodities markets, changed the marketplace and allowed them to trade for their own accounts far more profitably.
In recent years, most fund clients were not directly interested in the underlying commodities. In a 2005 paper by Gary Gorton and Geert Rouwenhorst, it was demonstrated that returns on commodities are inversely related to stock market returns. This relationship is especially strong in early stages of a recession and when share prices are lowest. If you believed that equity prices were going to go down (or if you wanted to hedge exposure to the stock market), you could make money by buying the index. By 2007/2008, as investors became concerned about returns on their equities investments, the commodities index funds grew rapidly as a hedge against a falling stock market and futures prices rose.
Over time, futures prices should converge to the actual delivery price for the commodity at the delivery date. The futures price is no more than the expected price of the commodity on delivery. On that date, the value of the futures contract and the value of the actual commodity are the same.
In 2008, this relationship became unhinged, particularly in agricultural markets. This coincided with a shift of fund assets from energy to agricultural futures. Remember that the funds were designed to be perpetual and the roll over of contracts made delivery dates irrelevant. Because the holders of so many futures contracts did not care about actual delivery prices, the futures markets lost their relationships with the physical markets which are centered on delivery dates. Physical delivery (or "spot") prices increased as if futures were driving spot prices rather than the other way around. But they could not keep pace with the perpetual index prices.
To many observers, the practical significance was a massive increase in the price of bread and fuel oil and many other products for reasons that defied the simple logic of supply and demand. (See Fredrick Kaufman's "The Food Bubble" in Harper's.) Consumers worldwide paid a heavy price. Some believe that the price spikes led directly to food shortages in the developing world.
For corporate producers and consumers (farmers, airlines etc.), the usefulness of futures contracts was lost because these contracts were so volatile and no longer usefully hedged real prices. Hedging only works if the futures converge to spot prices.
A byproduct of the financial crash was more normal price relationships. But there is no doubt that the banks prospered from owning a market structures that indirectly served their trading activities. The underlying structure survives and CFTC regulation of position sizes is under discussion.
The CFTC believes the funds at a minimum contributed to price increases and volatility. It is considering regulation of position sizes of funds. The CFTC conclusion has been disputed, however. One academic paper by Scott Irwin and Dwight Sanders, professors at the University of Illinois at Urbana-Champaign, suggests that the evidence for pricing pressure is unproved.
Nonetheless, the coincidence of events is troubling; so troubling that the Irwin/Sanders paper seems inadequate. From the time of the discovery of the relationship between the commodity index funds and the stock market
- Investment in the funds more than doubled;
- Commodities prices spiked, most significantly agricultural products and oil (wheat prices, for instance, tripled);
- Volatility in commodities markets increased;
- For a period, futures price convergence with spot markets ceased working in some markets; and
- Importation of food by developing countries declined markedly and hunger increased.
The problem is that the markets are not simply abstract environments for esoteric investments. They are the price and supply mechanisms for food, energy, money and many other real world items. They affect real people when they put food on the table, fill there cars with gasoline, turn on the lights and pay their mortgage and credit card bills each month. To the extent the large financial institutions continue to influence and control these markets, the promise of financial reform is diminished. Limitations on speculative positions facilitated by vehicles such as commodities index funds is a matter of moral as well as financial necessity.
Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.