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NEW YORK - COMMODITIES are too small and specialised an asset class to receive the kind of money stocks are used to - that is the simple but compelling logic some analysts and politicians are using to push for new laws against speculators in oil and other raw materials.

As oil hit a record US$135 a barrel on Thursday, escalating the debate over the impact speculators are having on commodity prices, the argument for new limits on investor activity focused on the disproportionate amount of funds that could be flowing into relatively small markets.

‘Commodities futures markets are much smaller than the capital markets, so multibillion-dollar allocations to commodities markets will have a far greater impact on prices,’ Mr Michael Masters, an equities hedge fund manager, said on Tuesday in testimony that a United States Senate committee plans to use as a centrepiece in its efforts to curb speculation in commodities.

He added that pensions, sovereign wealth funds and university endowments investing in passive commodity indexes were one of the reasons, if not the primary one, for record energy and food prices.

Commodity indexes basically track contracts in commodity futures markets. Although such contracts run according to calendar months and expire at scheduled periods, an investor in a commodity index typically moves to another contract before one expires.

Critics of this investment model say it creates an unrealistic demand for commodities as investors are perpetually ‘long’ or bullish, and never ’short’ or bearish - the two elements required for any market to work in balance.

‘They never sell,’ Mr Masters said, referring to index investors.

‘When institutional investors decide to allocate 2 per cent to commodities futures, for example, they come to the market with a set amount of money.

‘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’.’

As a result, he said, index investors theoretically owned the equivalent of 1.1 billion barrels of petroleum - eight times the US Strategic Reserve. They own enough corn futures to fuel the US ethanol industry at full capacity for a year. The 1.3 billion bushels of wheat they own could make all the bread, pasta and baked goods Americans needed for two years.

The solution? Mr Masters suggests closing a loophole in the Commodity Exchange Act that allows Wall Street banks an exemption from speculative position limits when they hedge in over-the-counter (OTC) swaps for commodities.

OTC trade refers to commodity deals done outside exchanges such as the New York Mercantile Exchange, the Intercontinental Exchange or the Chicago Board of Trade, which account for a large portion of formally traded raw materials.

Putting limits on speculation through OTC swaps ‘would curtail index speculation and…force all speculators to face position limits,’ Mr Masters said.

A spokesman for the US Senate’s Homeland Security and Governmental Affairs Committee under Senator Joseph Lieberman said a panel was being convened to study the merits of closing the swaps loophole after Mr Masters’ testimony.

Some disagree with Mr Masters’ findings.

Barclays Capital estimated that the money in commodity futures and related instruments had reached US$225 billion (S$307.5 billion) by the end of the first quarter of this year, and only half of that belonged to institutional investors.

‘Beyond some wildly incorrect numbers being placed into the public domain, the actual inflow of net new investor money is very modest indeed,’ the bank said in a report on Thursday.

But legislation to control speculation more effectively in commodity markets over the longer term may be an option after the Bush administration’s tacit admission this week that it could not do much about oil prices in the near term.

‘We think Congress will take some steps that could indirectly dent the energy price spiral by hiking margins on energy investments and/or restricting fund flows into the sector,’ said Mr Edward Meir, an analyst for oil and metals at MF Global, the world’s largest commodity futures brokerage. - REUTERS

MAJOR CAUSE OF PRICE SURGE

Mr Michael Masters, an equities hedge fund manager, says pensions, sovereign wealth funds and university endowments investing in passive commodity indexes were one of the reasons, if not the primary one, for record energy and food prices…

An investor in a commodity index typically moves to another contract before one expires.

Critics say this model creates an unrealistic demand for commodities as index investors are perpetually ‘long’ or bullish, and never ’short’ or bearish - the two elements required for any market to work in balance.

Source : Straits Times - 24 May 2008