I finally got around to reading Michael Masters' testimony to Congress on rising prices in the commodities market.  It is worth the read.

Exerts

You have asked the question “Are Institutional Investors contributing to food and energy price inflation?” And my unequivocal answer is “YES.” In this testimony I will explain that Institutional Investors are one of, if not the primary, factors affecting commodities prices today. Clearly, there are many factors that contribute to price determination in the commodities markets; I am here to expose a fast-growing yet virtually unnoticed factor, and one that presents a problem that can be expediently corrected through legislative policy action.

Commodities prices have increased more in the aggregate over the last five years than at any other time in U.S. history. We have seen commodity price spikes occur in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today, unlike previous episodes, supply is ample: there are no lines at the gas pump and there is plenty of food on the shelves.

If supply is adequate - as has been shown by others who have testified before this committee - and prices are still rising, then demand must be increasing. But how do you explain a continuing increase in demand when commodity prices have doubled or tripled in the last 5 years?

What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

These parties, who I call Index Speculators, allocate a portion of their portfolios to “investments” in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as “Index” Speculators because of their investing strategy: they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices – the Standard & Poor's - Goldman Sachs Commodity Index and the Dow Jones - AIG Commodity Index. ...

In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculatorsʼ demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

In fact, Index Speculators have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over the last five years.

Let’s turn our attention to food prices, which have skyrocketed in the last six months. When asked to explain this dramatic increase, economists’ replies typically focus on the diversion of a significant portion of the U.S. corn crop to ethanol production. What they overlook is the fact that Institutional Investors have purchased over 2 billion bushels of corn futures in the last five years. Right now, Index Speculators have stockpiled enough corn futures to potentially fuel the entire United States ethanol industry at full capacity for a year. That’s equivalent to producing 5.3 billion gallons of ethanol, which would make America the world’s largest ethanol producer.

Turning to Wheat, in 2007 Americans consumed 2.22 bushels of Wheat per capita. At 1.3 billion bushels, the current Wheat futures stockpile of Index Speculators is enough to supply every American citizen with all the bread, pasta and baked goods they can eat for the next two years!

Demand for futures contracts can only come from two sources: Physical Commodity Consumers and Speculators. Speculators include the Traditional Speculators who have always existed in the market, as well as Index Speculators. Five years ago, Index Speculators were a tiny fraction of the commodities futures markets. Today, in many commodities futures markets, they are the single largest force. The huge growth in their demand has gone virtually undetected by classically-trained economists who almost never analyze demand in futures markets. ...

We calculate that Index Speculators flooded the markets with $55 billion in just the first 52 trading days of this year. That’s an increase in the dollar value of outstanding futures contracts of more than $1 billion per trading day. Doesn’t it seem likely that an increase in demand of this magnitude in the commodities futures markets could go a long way in explaining the extraordinary commodities price increases in the beginning of 2008?

There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.

Index Speculators’ trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.

Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged.

Why is there not outrage over the fact that Americans must pay drastically more to feed their families, fuel their cars, and heat their homes?

Index Speculators provide no benefit to the futures markets and they inflict a tremendous cost upon society. Individually, these participants are not acting with malicious intent; collectively, however, their impact reaches into the wallets of every American consumer.

Is it necessary for the U.S. economy to suffer through yet another financial crisis created by new investment techniques, the consequences of which have once again been unforeseen by their Wall Street proponents? ...

The CFTC has granted Wall Street banks an exemption from speculative position limits when these banks hedge over-the-counter swaps transactions. This has effectively opened a loophole for unlimited speculation. When Index Speculators enter into commodity index swaps, which 85-90% of them do, they face no speculative position limits.

The really shocking thing about the Swaps Loophole is that Speculators of all stripes can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with a Wall Street bank and then the bank buys $500 million worth of Wheat futures.

The primary criticism of Masters' testimony is that non-tradable commodities have outperformed commodities.  This is Gavekal's response, who argue that the the price increases of non-tradable commodities does not invalidate Masters' argument.

1. Industrial users of raw materials are driven by momentum just as much as purely financial players. When the price of coal, iron ore or potash goes up, commercial buyers increase their inventories and this can generate a very large incremental demand. I would suggest that such sudden panic buying by industrial users may partly explain the sudden rise in iron ore and fertilizer prices earlier this year. At the same time, some producers, who tend to sell their output forward to finance their investments and working capital, have suffered accounting losses and, in extreme cases, turned into forced buyers to meet margin calls and close their loss-making forward contracts. (This was a big factor in the recent agricultural price boom, which already seems to be turning to bust.)
2. Many non-traded commodities are directly or indirectly tied to heavily-traded commodities - eg coal to oil, fertilizers to corn and soya - and therefore tend to move in the same direction.
3. The most important of these non-traded commodities - eg coal, iron ore and increasingly even phosphates - are being bought by long-term financial players through index funds and relative value swaps. These instruments, in turn, lead to forward purchases and inventory-building by the investment banks who sponsor the index and swap investments. Because these commodities are thinly traded even a small amount of investment participation can have a very big price effect in the short-term. This is why I do NOT suggest that the main driving force for higher commodity prices has been short-term "speculation". If anything, traditional commodity speculators have tended to be on the short side of many of these trends, but they have been overwhelmed by long-term financial players, whose asset allocation strategies are relatively insensitive to price movements.
4. The very fact that almost all commodities have suddenly exploded on the upside is actually evidence AGAINST the theory of a fundamental imbalance between supply and demand. Why? Because final demand for many industrial commodities has actually been slowing since 2005 and especially since the middle of 2007, as global growth has slowed down. So if prices are being driven by supply-demand "fundamentals", this must mean that ALL commodities are suddenly suffering supply constraints. In other words, the world is not just facing a "peak oil" story, but also "peak iron", "peak coal", "peak potash", "peak soya" and so on. This is obviously nonsense. It's also very reminiscent of the situation in the 1970s , when the oil shortage was followed by shortages of coffee, sugar, cocoa and even toilet paper, as I wrote in 5 Corners last month. None of these panics were caused by traditional speculation. They were caused by sudden stockpiling by households and industrial users (similar to the recent rice crisis in the Philippines). None of these temporary commodity shortages and price booms had anything to do with fundamental imbalances between supply and demand.