Juggling Dynamite

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.

I have long said that I am not impressed with efficient market theories about the genius and rationality of capital markets in asset pricing. Markets can often be just plain dumb, driven by irrational and erroneous assumptions of emotional participants.
Here is the latest example. Today the Financial Times reports Moody’s awarded incorrect triple-A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models!! See Moody’s error gave top ratings to debt products and watch this short news clip for Monty-Python-esque impact.
Although the error was apparently discovered by some Moody's insiders in 2007, the products in question remained triple A until January this year when, amid general market declines, they were downgraded several notches. The products were designed for institutional investors. In the recent credit market turmoil, those who still hold the products will have suffered some paper losses while others who have bailed out have lost up to 60 per cent of their investment.
This is a common skit that we have seen many times in the financial world. The asset holders lose big chunks of their capital. They turn to the asset advisors and say you gave us bad advice. The asset advisors turn to the product creators and raters and say you designed bad products. The product creators and rating agencies say it’s not our fault the computer screwed up. Conveniently, no one is there to accept the blame when the music stops, though many made enormous fees passing the potato ‘round and ‘round while the music played.
Oh yes, and there is nothing risky about the current price of oil either…the computer models all agree that demand is accurately setting the price.

Brian Milner had an interesting article on the front of the ROB Saturday, “Warning to equity investors: 'Watch your tail.”
Noting the stock market's recent shift back to bullish sentiment over the past couple of months, Milner interviewed famed value investor Jeremy Grantham of GMO of Boston. Grantham has made a name for himself over the years by correctly calling over-zealous markets and taking a defensive stance to protect assets under management from bear market declines. Grantham has explained that he learned the need for a defensive, tactical approach early in his career when full of confidence and efficient market theory, and fresh out of Harvard Business School in 1968, Grantham played the Go-Go market at its peak and lost all his money by 1970.
Harsh lessons in investing are very valuable when they are taken to heart and they are particularly valuable when learned early on in one's career while there is still time to change one's ways. Grantham did. By the late 90's GMO had some 40 billion in assets under management, when they noted that equity valuations were beyond all reasonable prospects for lasting reward. Grantham and company moved a large weight of their equities to cash. Within months they were seeing large numbers of redemptions as impatient investors fled their fund in pursuit of the hottest high tech flyers. Grantham stood his ground even as risk-obsessed clients fled and assets under management shrank by half. And in the end of course, Grantham and company were right. In the end the crash of 2000-2002 proved Grantham was right, and he and the clients who had stuck with him were protected and ideally positioned then to step in and buy after others had been devastated. Investors ultimately recognized GMO for its strength and wisdom. Today the firm manages assets of more than $145 billion.
I noted over the past couple of years that Grantham had been writing and speaking again about building asset bubbles all around the world. I had not heard him interviewed in the past many months now until Milner's article Saturday. His comments on recent market strength are candid as always:
“I think the equity investors are likely to be very wrong. We've had the initial shock to animal spirits and the initial shock to the housing market. But most of these things take a long time to work through the system. The contraction of liquidity might take years, in fact. It might very well be the end of an era. I suspect it is.”
Stock chasers argue that this is the ideal time to hunt for bargains among the battered blue chips. Mr. Grantham, whose investing technique involves asset allocation rather than individual stock selection in any case, couldn't disagree more.
“Stock pickers always say that,” he says. “If the market's dangerous and overpriced and vulnerable, and in denial like this, it isn't about stock picking. In an ordinary year – and there are many of them; they just haven't been around recently – it's all about industry- and stock picking. But not now. Now it's about the big picture, which is: Watch your tail.”
For the many investors enamoured of commodities, Mr. Grantham also suggests caution. Although he agrees that the long-term trend is up, “they've gone too far too fast, and you can get hurt pretty badly” by a sharp correction stemming from temporary excesses in a slowing global economy.
The toughest thing to do is to stay out of the market, load up on cash “and fret about all the money you're not making. But that's probably the best advice. Let the other suckers take all the risk.”