Should there be limits on commodity investment?

March 9, 2009

John Kemp Great Debate— John Kemp is a Reuters columnist. The views expressed are his own —

The commodity boom and bust in the last 5 years suggests there is a natural limit on how much investment money these markets can absorb before price-setting mechanisms become distorted and prices unmoored from supply and demand fundamentals.

Exchange operators and dealers have a strong interest in increasing turnover and volume, since it boosts income from fees and commissions. But most also argue that increased turnover makes markets more efficient because it sharpens price discovery and makes them more liquid.

In this “more is better” view, increased participation by investors works in the interests of producers and consumers.

By bringing more participants to the market, prices incorporate a wider range of views, and the market is more likely to find the “correct” equilibrium price quickly, improving the price discovery function.

It’s also more likely that producers and consumers wanting to execute hedging transactions will find a willing counterparty to take the other side of the trade, making it easier and cheaper to transfer unwanted price risks from industry to investors, boosting liquidity.

Economists and regulators have largely endorsed this view. Policymakers have been reluctant to take any steps that would restrict the number of participants in commodity futures markets or the size of the positions they may run.

But there are signs that a rethink is underway. In particular, regulators are beginning to ask whether the massive influx of investment money into commodity futures over the last five years actually distorted prices and reduced liquidity for other market users rather than increasing it as was expected.

In a letter to Senator Carl Levin ahead of his confirmation hearing, President Barack Obama’s nominee to head the Commodity Futures Trading Commission (CFTC) Gary Gensler acknowledged that “rapid growth in commodity index funds was a contributing factor to a bubble in commodities prices that peaked in mid-2008″.


Classic theory assumes futures markets are competitive. Prices are determined by interactions among a multitude of buyers and sellers running relatively small positions and unable individually to have a material impact on the outcome.

Protecting the market’s competitive nature has always been the justification for imposing position limits and banning participants from attempting to establish squeezes or corners.

Under CFTC oversight, the New York Mercantile Exchange (NYMEX) has established position accountability levels restricting market participants to no more than 10,000 light sweet crude oil contracts for any one delivery month, and no more than 20,000 for all months.

The limit becomes tighter and more binding in the last three days prior to contract expiry, when it becomes a firm limit and drops to 3,000 contracts. Similar limits exist in other contracts and exchanges.

But accountability levels have always been “soft” limits. NYMEX can grant exemptions for producers and consumers who need to run larger positions than this to hedge their physical exposures. In recent years, NYMEX has also granted exemptions to banks and swap dealers who run commodity indices and exchange-traded commodity funds so they can hedge their obligations to their clients out onto the public markets.

Position limits have become more theoretical than real:

(1) Congressional enquiries into the failure of U.S. hedge fund Amaranth Advisors in 2006 revealed it had amassed positions in U.S. natural gas contracts amounting to more than half the outstanding open interest for certain delivery months.

(2) When the CFTC was forced to correct its commitment of traders’ data last summer, after misclassifying some positions, it revealed one trader held more than 320,000 contracts for light sweet crude oil. Not only was that far above the 20,000-contract accountability level, it amounted to more than 10 percent of the entire open interest in one of the world’s most important commodity markets.

(3) In a letter to the CFTC last summer, investigators from the House of Representatives’ Energy and Commerce Committee demanded to know why NYMEX had granted 117 exemptions to the normal position limits in the light sweet crude oil contract alone since 2006.

The committee noted: “Of the 117 exemptions granted, 48 were given to 18 companies based exclusively on swaps exposure, another 44 were issued to 24 companies for combined hedge/swap positions, but only 25 were granted to 11 companies based on a bona fide hedge exposure” (Read pdf here.)

NYMEX has granted so many exemptions some commentators wonder whether the accountability levels have any meaning at all. In his pre-confirmation letter, Gensler promised to review them all to ensure they were appropriate.

(4) One existing beneficiary is the United States Oil Fund, which sells units linked to the price of NYMEX light sweet oil. The fund’s website discloses that it currently owns almost 50,000 contracts for NYMEX light sweet crude oil in the April 2009 delivery month, far in excess of the normal accountability level and amounting to 18 percent of all contracts outstanding for that date.

The fund’s holdings are so large it cannot hold them all on NYMEX. So it holds another 30,000 lookalike contracts for light sweet oil on the IntercontinentalExchange (ICE).


The problem is not the overall amount of money that investors have poured into commodity markets, but its concentration at certain points along the futures curve, and the fact investors have tended to behave as a herd, all trying to go long at the same time. As a result, the influx of investment money has tended to absorb rather than provide liquidity to the rest of the market.

In theory, rising commodity prices should have encouraged commodity producers to sell production forward, ensuring the market remained balanced. In practice, it simply encouraged producers to discontinue hedging programs and accept spot prices, in expectation prices would rise even further.

So as oil prices climbed relentlessly, buying interest from investors was met by less selling interest from producers, and less willingness from dealers to take a short position against the trend. Liquidity declined, prices became discontinuous and the market began to “gap” higher.

Even after prices have fallen, the concentration of investor positions in certain parts of the curve is still causing distortions. The need to roll the Oil Fund’s contracts and those of commodity indices forward each month (selling existing holdings in the nearby month and buying contracts for the next one) is keeping the market locked in a deep contango.

Contracts which the Oil Fund and the indices need to sell are locked at a permanent discount to the ones they need to buy, as the rest of the market preys on forced sellers. In the process it is inflicting substantial roll losses on index and fund investors even though oil prices have been steady over the last three months.

The solution is to enforce position limits more vigorously and restrict exemptions to genuine hedgers rather than dealers running commodity indices and exchange-traded funds.

Dealers would still be free to run indices and exchange-traded funds, drumming up business from pension funds and other investors wanting exposure to commodity prices. But only a relatively small part of this extra investment business could be “dumped” onto the public exchanges, creating an upward price spiral.

The rest would have to be warehoused in the dealers’ own books. Unless dealers wanted to be net short, it would give them a sharp incentive to go out and find willing sellers to match the number of new buyers they are bringing to the market.

Tougher position limits would force them to become two-way dealers again, rather than simply commodity-investment promoters. It would also help ensure the influx of investment money does not overwhelm the regular price-setting and hedging needs of physical users.


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The same mechanism that pumped the air into the system, is sucking it out now!
Do regulators ever learn anything? … or do they just have no balls?
You can only catch a thug with other thug – is an old wisdom —and bureaucrats just do not have what it takes to deal with wolfes.
Why is Madoff accused for his Ponzi scheme? What is different to these ones?
No good prospects to get out of this mess without a very serious fleecing.

Posted by Hans Schneider | Report as abusive

I don’t think there’s any doubt about the need to “reform” the commodities markets. The 2008 oil spike to $147 a barrel with many officials blaming “supply and demand” was a perfect example of why more regulation is required.
Said a January article here: 8/60minutes/printable4707770.shtml
“Approximately 60 to 70 percent of the oil contracts in the futures markets are now held by speculative entities. Not by companies that need oil, not by the airlines, not by the oil companies. But by investors that are looking to make money from their speculative positions,” Gilligan explained.
– and –
In a five year period, Masters said the amount of money institutional investors, hedge funds, and the big Wall Street banks had placed in the commodities markets went from $13 billion to $300 billion. Last year, 27 barrels of crude were being traded every day on the New York Mercantile Exchange for every one barrel of oil that was actually being consumed in the United States.

“Yes,” Gilligan said. “I tease people sometimes that, you know, people say, ‘Well, who’s the largest oil company in America?’ And they’ll always say, ‘Well, Exxon Mobil or Chevron, or BP.’ But I’ll say, ‘No. Morgan Stanley.’

These traders were like juveniles with their hands in the cookie jar and daddy needs to put the lid back on.

Posted by Ray | Report as abusive

When I hear ‘commodities’ I still think in terms of corn and hogs (ha, ha-but it’s true!) I’ll bet a lot of the ‘massive influx’ of investment money into these markets came from people not more sophisticated than me, but rather, as you say, from ‘pension funds’ which represent the retirement funds that have been (were?) placed into 401K’s.
Thanks to all who stood in the path of the plan to ‘privatize’ the US Social Security system. Oh, how those investors wanted that money! Remember the promises of fortunes waiting to be made? (I guess they got the money anyway when they got ‘rescued’).
Anyway, I wonder is who would enforce the tougher positions limits suggested as a correction to the out of control commodities market? It almost seems like real enforcement would necessitate the creation of something like the Justice Departments ATF (alcohol, tobacco, firearms-& explosives). A department with uniformed officers authorized to walk into these offices anytime and control the books; how much money would be ‘enough’ to buy one of these officers off? I can just hear the screams about the affront to ‘free’ markets.
Good discussion of a subject hard for ‘lay persons’ like myself to understand. Thanks Mr. Kemp. Economists rule!

Posted by QueZen | Report as abusive

This article is right on target. As a small industry player, we desperately need help from Congress to bring this situation under control and end the rule of the financial houses over this key commodity.

Posted by Ben | Report as abusive

Obviously this article has mostly to do with ONE commodity, namely oil. What if the price of oil were to go to $500 a barrel? Certainly consumption would fall dramatically, but would it really make much difference to producers? Producers would have to cut production by a large amount, but the amount of money they would make would probably not fall; in fact it might turn out to be even MORE profitable. This of course is due to the inelastic nature of the price/consumption of oil. With all of the asset speculation that was going on (due in my view to an excess money/capitol supply), it was probably only natural that the game moved on to oil. And why not force the price of oil way up? With such an inelastic AND essential commodity, the price does not make a whole lot of difference anyway when it comes to profitability. But asset speculation is over, at least for now, so regulation may not be entirely necessary. One of the biggest price stabilization factors of world oil prices has always been Saudi Arabia in my view. Thankfully they have usually acted rationally, increasing and decreasing oil supply as needed to help stabilize prices. Of course oil consumption by China and other emerging economies was also a big price factor.

Posted by Juan W | Report as abusive

All the deregulation across the markets in America that really started in the heady days of ‘Reaganomics’ have been nothing but a series of disasters. For those of us who’ve been around for 30 or 40 years, and survived the massacres and fallout of the oil embargo in 72 and the 87 crash, the writing was on the wall for this situation since 2004. But, despite our wink/nod acceptance that the end was nigh we didn’t speak out or even really care because we were makin so much money on this big run-up. And I think there-in lies the biggest problem – one that fills me with guilt now seeing that we may have finally brought down America – is that the people in the best position to recognize what was happening turned a blind eye to it out of greed, a greed that was buoyed on by investor greed. Whether it was policy X or investment bank Y or fund Z that finally pushed the issue into the public light, the fact is that anyone who had a single dollar invested in the markets, anyone who believes in deregulation of industry/markets, anyone that believes the Gordon Gekko mantra that ‘Greed is Good!’, they are all equally culpable for this disaster. So sleep tight America, and stop pointing fingers and saying you’re mad as heck – you’re probably just as much the cause as any Wall Street bank by continuing to feed the greed of the system with your own greed.

Posted by Richard | Report as abusive

It’s funny when people spend a great deal of time fighting about something that everyone can see is true. It should be no surprise that industry is going to argue it’s a supply demand issue and it’s likely the regulatory bodies are going to agree unless the evidence is overwhelming and the public is aware of what is going on. I have yet to see an industry that desires regulation, and lets face it those industries spend great amounts of money to ensure they have a veto over who gets appointed to the agency. Has anyone noticed who the people are who are choosing the next chairman to the NY Fed? Try partners at all the big firms. The great joke played on the american public continues.

Posted by db | Report as abusive

It is amazing to me how this “crisis” has led people from all across the spectrum, from all ideologies, to begin questioning free markets. A couple of points not to forget here… The notion that we can evaluate how much investment is too much in commodities, presupposes that the underlying currency retains its value. Price spikes in commodities reflect a belief that the “real goods” are worth more in terms of the underlying currency. Let’s also not forget that we weren’t seeing spot month price collapses at delivery… i.e. clients were taking delivery at prices well north of $100 a barrel. All of which points to a genuine belief that prices were justified at those levels. And let’s also not forget that most of us continued to fill up our tanks at those prices, while grumbling to our selves. The point being, what we witnessed was an upside probe in an an extremely inelastic commodity. Let’s not throw out the market’s ability to discover prices, in the misguided spirit of “regulating” our way out of this “crisis”.

Posted by sm | Report as abusive

That’s just what we need, more government meddling in what might otherwise be a “free market”. So much for capitalism.

Posted by jqp | Report as abusive

It seems to me the solution is enforced transparency. So much of what is wrong with our capitalistic system comes from the fact that powerful entities keep things secret.

To me, the fact the the Federal Reserve Chairman, while giving over a trillion dollars of taxpayer money in bailouts and guarantees to private enterprise, still refuses to divulge the names of companies to whom the money was given, is a sign that our government is really part of a corrupt, criminal financial aristocracy.

Transparency is a necessity in a free, efficient society. Without transparency, things always devolve to an alliance between bureaucrats and a criminal aristocracy.

Why not avoid limits on commodities positions, but instead require that all positions are available online for all to see?

Posted by AdamSmith | Report as abusive

Say I am on oil producer. If oil prices rise and I had a certain quantity of oil to sell and I intended to make a certain some of money, I can make that same money by selling less oil and keep the remaining oil to sell later when I need more money. So there is no way the price of oil can fall down. It will take a large fall in demand to make the oil price go down as only then there will be competition to sell oil so that I make the sum I wanted to make.

So make all oil futures delivery based and ditto for all commodity futures

Posted by TS | Report as abusive

Obviously, it is vesting of currencies in to the oil and encourage the enemies of the peace of the world. Why we don,t accept a clean and peaceful machine, like cycle. Take the latest example like China and Japan, they encourages their people by making the cycle lane. Everyone knows the benefits of it to individuals and the Nation. so please rethink about human capitalism, not mere capitalism.

Posted by Ashish Vora | Report as abusive

at last a voice of limits are essential for an orderly market. i have been trading oil for 27 years
what has gone on in the last 3 years is corrupt.large positions have destorted prices way beyond the norm -its theft and the consumer pays .wake up regulators!

Posted by bernard a | Report as abusive

It is not a question of whether oor not limits are useful or needed but a simple quesiton of enforcement. USO while a great product is the embodiment of what a “spec” is and should be held to the “spec” limits.

Posted by Steve Williams | Report as abusive

Commodities futures fall under 2 categories. 1) Hedgeing, a producer or shipper sets a price forward at the time of delivery. 2) Sepculator. Someone that is betting on or trying to control market pricing, and particularily for a certain forward month.Usually a true hedger, does not pay the smae margin call requirements that a speculator does. eg. A farmer shorts, or future sell 5 thousand bushells of wheat, while a speculator has NO wheat to sell, therefore cannot take delivery of the contract, so can only liquidate his position, and take the lose or profit. If you want to eliminate speculative swing in the market ( recent oil to $160/ barrel) then just elimante the specaultive positions..

Posted by allan bateman | Report as abusive

Again the one-sided accounting perspective is a little confusing to me. If investors are pouring in money (buyers), then the exact same amount of money was taken out (sellers). Increasing expectations does not affect liquidity per se but only the price of exchange. If I buy a future ounce for $1 billion, I take $1 billion out of cash to pay. The seller gets $1 billion. So I am not sure about liquidity unless we focus soley on the current owners. Huge buying interest is equivalent to huge selling interest.

Posted by Don | Report as abusive

If exchanges are really meant to be for hedging and price discovery, let only the commercial users participate in it also make it compulsory delivery contracts…this way we sure will not ahve any further recession ever not only in US but in world markets

Posted by Bhavneet | Report as abusive

It is interesting that most people believe that markets free from regulation result in greater competition and efficiency.We can see from this example, and many others of recent experiance , that when regulation is relaxed the result is quite the opposite. At leat the solution here seems straight forward, enforce the laws that do exist and limit any exemptions. Breaking up the giant financial supermarkets and restoring the seperation of the banking and investment communities may prove a far more intrangible problem.

Posted by Lloyd Quist | Report as abusive

Absolutely spot on and timing is excellent. It was just crazy how the commodities market was played by puppeters who were greedy. In addition to oil, I was more worried about groceries , pulses and veg that were just moving around so much with no logical reason. Not sure how we common people can influence the regulators to have tough regulations on commodities trading.

Posted by Shiva | Report as abusive

Some good but unfortunately spurious comments from the author and commentators.

All of you have ignored the role of politics, tax distortion and demand/supply manipulation that has occured which is outside the realm of speculators e.g.

1) China,Malaysia India et al have deliberately subsidised oil to the consumer so that it was at an artificially low level to market levels and therfore pushed up domestic demand during the economic boom.China and India have since decided to reduce subsidies – funilly enough this coincided with falling oil prices!

2) Globally inept farming policies the aim of which has been politically agreed protectionism have deliberately kept production and supply below what could be achieved through open markets.

2. From a point of pure political manipulation individuals such as Hugo Chavez of Venezuela (@6-7% of worlds oil) saught to drive prices up through rhetoric from out and out refusal to supply America to repeadedly saying that oil was headed up to $300 per barrel. Similarly other nations have banned the export of various commodities e.g. Thai fragrant rice to stockpile their own produce. Add to this the mania biofuels and the distorting tax and subsidies in this new area.

2. A number of mineral and other companies have manipulted supply i.e. deliberately extracted minerals at a slow pace to limit supply, in order to bolster revenue through higher price. In the instance of copper there was at one point during the boom only 3 days of available mined supply.

2. Speculators also add liqudity to markets. Where hedgers (both producer and consumer) may refuse to provide a price for a good, speculators have stepped in to fill the void. Where prices rose, speculators were on the sell side, ensuring that consumer hedgers could lock in a maximum purchase price, on the buy side they have stepped in whilst prices have fallen through the floor in order to lock in a sale price for the supplier. Without this prices would have peaked at a MUCH higher level and bottomed at a MUCH lower level.

Much of the Speculative world has been vilified as prices went through the roof but they are not being thanked as prices have tanked. But then, whats politics if it isnt to put the blame on others when things go wrong. Governments have seen the population explosion comming and have done nothing about it.

Posted by nick | Report as abusive

Wow – what an incredible collection of pinheads. The volume of US currency has increased 300% in the past 5 months, so for every dollar that existed last September there now are 4. The half-life of the US dollar is 14 years at 5% inflation, meaning in real terms it currently is less that 10 years. The US dollar is going into the toilet, and skyrocketing commodity prices won’t be because of speculators. They are attributable to the criminal ineptitude of the Treasury and Fed. Direct your anger to the appropriate places and you may get some relief. Commodities traders ain’t the place, brother.

Posted by KP Jensen | Report as abusive

There is always more than way to skin a cat. Different circumstances will require different tools to correct similar problems. We have the ability to reason and should rely upon it rather than philosophical dogmas.

Clearly when greed is prevailing and integrity is viewed as weak, stringent regulation will ultimately prevail. Future catastrophes will be averted but at some cost to efficiency and productivity. For a less regulated system to succeed all the players must act with integrity and due diligence so a to avoid a mess like the one we’re in.

I think such qualities of character are a product of upbringing and not the business school one attends. This generation of parents must recognizes this fact and raise their children wisely. If they succeed, I hope there is time enough left for their children to lead.

Posted by Anubis | Report as abusive

Someone may also want to ask why JP Morgan (which is currently on the TARP dole) is speculating in the silver market with a huge short position that amounts to almost one quarter of all of the silver produced in the world in a whole year.

Why is the US government giving money to banks just so they can use it to manipulate the small silver market?

The current market manipulation makes the Hunt brothers look like a couple of pikers.

“The vast majority of the additional short selling over the past two months was concentrated new short selling by those already holding a large concentrated short position. The most plausible explanation for this new selling was to cap the price and limit damage caused by rising prices to an already existing large short position. This is manipulation, pure and simple. If the price of silver were at a fair and free level, there would be many different participants competing to sell contracts, not just one to four. As it stands, there are very many traders buying and looking to buy, while the sell side is populated primarily by one big U.S. bank.”

TED BUTLER 09.html

Posted by EY Davis | Report as abusive