The recent spike in oil and gas prices has been attracting concern and accusations from all over the world. Yesterday Senator Clinton announced a crazy plan to sue OPEC producers for failing to produce more oil. This is a wild idea born of desperation in an election year. OPEC has repeatedly said that they do not need to produce more oil as no one is actually in need of more oil. Demand for consumption is not the issue here, other forces are at work.
Yesterday, the US Senate Committee on Homeland Security & Governmental Affairs held a hearing on “Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation?” The Senate committee heard from those defending the role of speculators in oil and commodities markets as well as those who argue that excessive speculation is the root of global price surges.
Today BusinessWeek reports on yesterday's senate hearing in “Are pension funds fuelling high oil demand?” Clearly recent price spikes are not just from demand and not just from speculators. Clearly both have played a key role in an uptrend which is becoming increasingly precarious for all of us. But recently “demand” in energy and commodity markets have come to include players who had for many years stayed almost completely out of the equation. This new type of demand is from a new category of speculators: institutional investors like corporate and government pension funds, university endowments, and sovereign wealth funds. Infact Index speculators are a primary cause of recent price spikes in commodities.
“Speculative activity in commodity markets has grown dramatically over the last several years. In the past decade, the share of long interests — positions that benefit when prices rise — held by financial speculators has grown from one-quarter to two-thirds of the commodity market. In only five years, from 2003 to 2008, investment in index funds tied to commodities has grown twentyfold, from $13 billion to $260 billion.”
Data shows that over the last five years, China's demand for oil has increased by 920 million barrels, while over the same period, index speculators' demand has increased by 848 million barrels. So China's growth in oil demand has only slightly outpaced the demand by this new group of investors and speculators.
“Some analysts say that as commodities markets have been deluged with investment bank money, supply and demand has been rendered less relevant, to the detriment of consumers and producers and marketers.”
Recognizing the need for basic items, governments and regulators have long had rules to limit speculative investment in key commodities. For this reason, commodities exchanges do limit the number of positions an investor can take in the market, but a loophole has appeared which has allowed virtually unlimited speculation in these markets. This so-called swaps loophole exempts investment banks like Goldman Sachs and Merrill Lynch from reporting requirements and limits on trading positions that are required of other investors. The loophole allows pension funds to enter into a swap agreement with an investment bank, which can then trade unlimited numbers of the contracts in futures markets.
“In a May 9 research note, Lehman Brothers economists argued that oil's recent rise has been fuelled by “non-supply-demand factors and by potential inventory misperceptions.” In other words, the dollar weakening and “investors' desire to be exposed to real assets” has spurred increased inflows from investors biased toward long positions.”
Why is this distinction between investment demand and consumption demand relevant? Because those who are creating this passive investment demand are different from those who need the commodities for consumption and use. Investors and speculators are a much more fickle, impatient group. They are looking to make a profit and hedge inflation they are not in need of the commodities for themselves. In this sense theirs is a false form of demand. Their capital can and does flow quickly from one asset class to another.
Meanwhile these passive investors are helping to spike price on many things which are essential to our daily existence like food, heat, and gas. And once investment interests shift away from these themes, producers are left pumping out much more product than consumption demands or warrants.
These are trends which have made the Canadian stock market outperform dramatically over the past 5 years and now year to date in 2008. They have also left the Canadian market and resource-based economy one of the most over-priced and risk exposed in the world right now.
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