Whenever things go bad, some folks look for the underlying causes of the problem, which are often complex, while others look for a scapegoat.
In the aftermath of the commodity boom and bust, “the funds” have often been blamed for the evils of volatility and making cereal more expensive for little children. They’ve been a handy scapegoat for folks not wanting to remember what caused the rally. Right now the American Commodity Futures Trading Commission, the Securities and Exchange Commission and the Obama administration are involved in intense discussions of how to more strongly regulate the derivatives market.
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Some of this makes sense. Some derivatives have the potential – proven in the equity meltdown last fall – of being what Warren Buffett had warned years before were “financial weapons of mass destruction.” This is true of the over-the-counter derivatives which are recorded nowhere except in the contracts of the counterparties and which can create giant expansions of risk for the parties involved. This matters if the parties involved are essential financial players in the economy, like AIG and the investment banks. If they go bust, the whole system can collapse. And no one knows that the risk is even there. That’s what happened with AIG and Lehman Brothers, as well as banks around the world. Making these players record – even confidentially – the positions they’re taking and placing some controls on the extent of risk they take on seems sensible to everyone, it seems.
But commodity index funds are a different beast. Hedge funds may leap in and out of the commodity markets, employing huge leverage, and can have a big short term impact on agricultural commodity markets. But the index funds are designed to be passive holders of long commodity futures and while holders of the funds can buy-in to them and sell-out as they speculate on the market, they mostly attract people who are making long term investments in the market, rather than quick trading positions.Â
No doubt they have noticeable short term effects. I’ve talked to lots of traders who say that most of the index funds roll forward their positions on the same day, causing a short term drop in the nearby contract and a short term boost in the next contract. And index funds never want to stand for delivery, so they can exacerbate covergence problems with the cash market. But they’ve never seemed to me to be too capable of fundamentally shifting the market in the long term. They add a lot of liquidity, and for every long contract that a fund makes someone goes short, so generally the market is simply expanded. If enticing enough people to go short to satisfy the index funds’ needs requires the long funds to push prices higher, that isn’t the sort of thing that most farmers would complain about.
Reuters had a story yesterday about the fact that long wheat index funds were almost completely passive during the 2008 rally. With wheat trading at five dollars per bushel in March 2007, the index funds had a net long position of about  200,000 contracts. As prices shot higher in 2008 that position didn’t increase – which could have been used to suggest index money pouring-in was having an effect – but actually decreased. Three months before the $13 peak in Chicago wheat, the funds were net long 194,000 contracts. The month before the peak they were down to 191,000 and the week before they had fallen to 189,000.Â
So how are the funds to blame?Â
For the past year people have latched onto the notion that “greed” was the cause of the equity meltdown. Apparently the folks on Wall Street were motivated by altruism and feelings of goodwill towards all men until about five years ago, when they suddenly got greedy and made the financial world blow up. What about hubris and the widespread feeling amongst economists, financial wizards, bankers and common folk that we were so darned good at operating our system that we could eternally rally our markets and double our house prices every three years, living off home equity loans we’d cover when we sold our homes for $1 million? Well, hubris is a complex phenomenon when it’s society-wide and infects smart, well-intended people, so it’s better just to find a few bad guys like Bernie Madoff, yell “Greed!” and forget about studying our own ability to hoodwink ourselves into false, glib and silly hubristic assumptions.Â
Same with the dreaded funds: when the rally was powering ahead in 2008, I didn’t hear economists, analysts and farmers raging that “These crop prices are getting too high!” and there must be a problem in the market because of index funds. I heard a lot of economists and the others offering all sorts of sober supply and demand reasons for believing that skyrocketing prices were entirely justified and should keep going higher. Some commodity funds are getting shut down now because of new rules on position limits, including a big oil fund. But I remember at the time of the $147 peak hearing people like CIBC’s Jeff Rubin talking about $200 oil based on “peak oil” and other fundamental factors. Most of the mainstream economists weren’t cautioning against believing in the commodity rally or saying it was just a financial phenomenon: almost everyone seemed to believe in the theory of the Long Term Commodity Bull Market and that everything that was happening had a solid fundamental basis.Â
I also know that some of the folks who bought into the hard red spring wheat rally right when it was at its peak at the Minneapolis Grain Exchange were commercial grain companies, so the idea that restricting the market to farmers and commercial buyers and sellers of crops doesn’t suggest that the market’s extremes won’t recur if people develop the honest notion that the market is making a strong and sustainable move in some direction.Â
And I remember how many farmers across North America refused to sell old or new crop during the heights of the rally, because prices had to get higher. Thirty dollar canola anyone? Had to be coming.
No doubt the commodity funds create all sorts of minor issues within the derivatives market. But damming off this sea of liquidity from contracts that are often volume-poor doesn’t seem like a good thing for farmers who rely on these futures contracts. (How are futures contracts like Chicago oats and Winnipeg canola going to do if commodity index funds disappear?) And blaming the funds for 2008’s rise and fall is just another way of letting us not face up to the fact that we can all get caught up in these moments of market hubris and all get burned by our inability to lift ourselves out of our euphoria and be hard-nosed about our situation.
