Over the last several weeks, government agencies and securities regulators have been pouncing on speculators and index fund service providers as they seek to point the blame on booming commodity price inflation. Even legendary hedge fund investor, George Soros, has recently testified in Washington blaming the proliferation of index funds for the rapid increase in commodity prices.

Soaring food prices, rice shortages in dozens of countries and skyrocketing energy prices have put commodity inflation on center stage in 2008. Commodity index funds, red-hot over the last several years as a new secular bull market gains momentum, have played a role driving prices higher.

The Boom in Commodity Index Funds

To be sure, there’s been an incredible increase in the number of commodity based indexes since 2005. Every time a commodity index is launched, that respective strategy strips commodity supplies away from the market.

According to estimates calculated by Lehman Brothers, total commodity based assets have mushroomed from $70 billion dollars in January 2006 to $235 billion dollars through mid-April 2008. And in 2000, commodity indices barely managed $20 billion dollars – that’s a spectacular ten-fold rise in less than a decade!

Oil prices are especially causing all sorts of dislocations across world markets, including the food industry. Companies and farmers are forced to raise prices as input costs are soaring for fertilizer, feeder and energy, including diesel for tractors. And every time a broad commodity index is launched, energy is always the largest constituent of that index.

Energy futures contracts represent a hefty 78% of the widely followed S&P Goldman Sachs Commodity Index, 39% of the CRB Index and 32% of the Dow Jones-AIG Commodity Index. Those big percentages have an impact on energy prices as institutions raise their exposure to these contracts. But determining exactly how influential these products cause oil prices and other commodities to rise or fall is a hard science to decipher.

Bubble, or No Bubble?

Are commodities in a “bubble,” or financial market frenzy caused by excessive investor participation and irrational exuberance?

Though some commodities shouldn’t trade at current lofty levels based on supply and demand factors, the majority of the complex, determined vis-à-vis futures contracts are priced relatively accurately. In fact, many commodities, including soft agricultural commodities and the precious metals still trade miles below their inflation-adjusted peaks since 1974 or 1980.

It’s hard to accept an argument that corn, for example, is in a “bubble” when adjusted for inflation since 1974 prices are still 54% below their peak. The same goes for soybeans – still one-third below its highs and gold 60% below its inflation-adjusted high in 1980.

Tight Supplies, not Speculation, Mostly to Blame

It’s simply inaccurate to label most commodities in a “bubble” when other compelling supply-side factors are determining price trends, including declining supplies, volatile weather patterns, declining output, low U.S. interest rates and, of course, a plunging U.S. dollar since 2002. Also, commodity production and demand history is vital to understanding what has occurred within the complex.

Since the peak in commodities markets more than 28 years ago, global production of virtually every segment of the industry either declined or stagnated amid low prices and a glut for raw materials. This includes barely any new rig installations, no new mined supply and growing demand for foodstuffs in the prospering emerging markets. Making matters worse, devastating weather patterns continue to adversely affect crop yields in some markets, namely Australia and the Ukraine.

Also, Russia’s virtual collapse in the late 1990s resulted in a massive dumping of raw materials to desperately raise hard currency; coupled with the Asian economic crisis, which resulted in plunging demand for commodities, the asset class hit rock bottom by late 1998.

With super low interest rates in the United States by 2003 and easy monetary policy almost everywhere else this decade, investors and speculators have redirected assets to inflation hedges or tangible goods like commodities. China, of course, continues to devour almost every conceivable raw material to power its wonder economy. With supplies not growing by any significant measure over the last 20 years, it’s no surprise prices have skyrocketed.

It’s almost absurd to blame commodity price inflation only on speculators and index funds; futures investments of all public pension funds account for less than 5% of commodities indices – according to CALPERs, or the California Public Employees’ Retirement Plan, the largest U.S. pension fund. And significantly, many commodities have spiked over the last 12 months with no pension fund or commodity index fund participation. Many foodstuffs don’t trade on futures exchanges and gains in these commodities have nothing to do with speculators.

Regulators Attack Speculators and Index Funds

The Commodity Futures Trading Commission, or CTFC, has been grilling its members to increase trading transparency and appease regulators and government officials. Washington is attempting to decipher what role institutional investors – including corporate and government pension funds, sovereign wealth funds and endowments – are playing amid surging food and energy prices since last year.

Unfortunately, ongoing government and regulatory deliberations will probably result in higher exchange margin requirements and more transparency from commodity investors.

Commodity index funds and other speculators have played a role in driving prices higher – this is indisputably true. But this dynamic is far less powerful than basic supply and demand fundamentals that brought us to this historical bull market in the first place.

Thriving emerging markets, infrastructure constraints, stagnant commodity production and easy U.S. dollar monetary policies have all contributed far more to the current price trends in the commodities complex than just speculators and index funds.