Quantitative easing and the commodity markets
-The views expressed are the author’s own-
A warning by an International Energy Agency (IEA) analyst this week that quantitative easing (QE) risked inflating nominal commodity prices and derailing the recovery drew a withering response from Nobel Economics Laureate Paul Krugman, who labelled the unfortunate analyst the “worst economist in the world”.
According to New York Times columnist Krugman “Higher commodity prices will hurt the recovery only if they rise in real terms. And they’ll only rise in terms if QE succeeds in raising real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery”.
Krugman’s criticism is unfair. There are clear links between QE and investor appetite for commodity derivatives and physical stocks (via the Federal Reserve’s “portfolio balance” effect), and from investors’ holdings of derivatives and physical inventories to cash prices (given the relatively inelastic supply and demand for raw materials in the short term).
In other words, there are financial as well as real economy links between QE and commodity prices. Commodities have some of the characteristics of financial assets as well as physical consumption materials. Via portfolio effects, QE could boost the relative (real) price of commodities even if it did not boost employment and output in the United States by very much.
It is a more open question whether commodity-driven inflation would hinder or promote a recovery in output and employment in the advanced industrial economies. It would reduce the real burden of inherited debts from the boom years. But it would harm savers, and it might harm manufacturers and households, depending on whether increased commodity prices were matched by rising non-commodity consumer prices and wages.
Overall, an unbalanced, commodity-driven inflation would probably be more of a drag on recovery than a help. Reasonable observers have reached different conclusions. In any event, the analyst’s warning was certainly not a “classic freshman mistake” or evidence of a new “Dark Age of economics” that the erudite professor labelled it.
Wanted: more commodity hedgers
For the last decade, investors such as pension and hedge funds have been the fastest-growing segment of commodity derivatives markets. The most successful banks and dealers have been those which marketed themselves most effectively to this new group of customers.
In the next five years, however, expanding the use of derivatives as hedging instruments for producers and consumers will re-emerge as the priority area. Banks and dealers will be searching for natural counterparties for all the pension funds and hedge funds wanting to use futures and options as a source of returns, diversification and inflation protection.
Separating derivatives users into “hedgers” and “speculators” is notoriously hard. Problems with the U.S. Commodity Futures Trading Commission (CFTC)’s classification of commercial and non-commercial users are well-known. Even the more detailed categories contained in the new disaggregated commitments of traders reports are not completely satisfactory.
But one detailed study of the NYMEX oil market by the Commission’s own economists showed the share of futures and option contracts attributable to producers, consumers and merchants shrinking from 39 percent in 2000 to 15 percent by H1 2008.
Producers, consumers and merchants boosted open interest by 80 percent over the nine years covered by the study. Dealers, investors and others increased their positions a massive 550 percent over the same period.
NATURAL BALANCE
Unbalanced growth has damaged returns to investors. Unlike equities and bonds, derivatives are zero-sum instruments. Gains for some market participants are exactly offset by losses for others.
Roll losses swallow up commodity inflows
Total assets under management in commodity-tracking indices and exchange-traded products (ETPs) have stalled over the last nine months, as roll losses swallow up fresh money inflows.
There has been little change in total money committed to index-like investments or its distribution between long and short positions, according to the latest quarterly figures released by the U.S. Commodity Futures Trading Commission (CFTC) yesterday, which show positions as of 30 June 2010.
The data is based on a special call sent to all known index operators and firms offering futures and options-based exchange-traded products. It is the most comprehensive measure of total funds under management in the passive sector, but excludes physically backed ETPs such as the popular SPDR Gold Trust .
Investors had a total of almost $264 billion in commodity indices and ETPs at the end of Q2 2010, down from the $271 billion at the end of Q1, but little changed from the $263 billion reported at the end of 2009.
Investments were split in a ratio of 4.11:1 with $212 billion worth of long futures and options positions and $52 billion worth of shorts. The ratio was slightly more bullish than at end-March (3.95:1) but essentially identical to the ratio reported at the end of 2009 (4.12:1).
In energy, the long/short ratio climbed from 3.88 to 4.37, the most bullish since 2008. But the jump was due to profit-taking by shorts after a profitable period characterised by declining spot prices and a pronounced contango structure in futures markets. On a net basis, there were no new long positions. Investors’ long exposure fell reflecting roll losses. Commodity futures markets have reached equilibrium. Fresh money is still flowing in (evidenced by the fact assets under management have remained steady despite roll losses associated with the contango structure). But inflows have been offset by the contango structure, ensuring little upward pressure on prices.
Much greater switching in the proportion of funds allocated to individual commodities indicates that the investment focus is switching away from indices with fixed weightings towards dynamically re-weighted products or single-commodity indices and ETPs that enable a more active and tactical approach to take advantage of particular trends or futures market structures.
from The Great Debate (Commentary):
Commodities should be short-term investments
Commodity indices and exchange-traded products (ETPs) should be regarded as short- to medium-term investments rather than long-term strategies, as a quick glance at performance over the last 10 years shows.
Their value lies in providing simplicity and liquidity for retail investors and institutions such as pension funds, which do not want the complexity of managing futures positions with their daily margin adjustments and rollovers.
They also permit institutions and retail investors forbidden from investing in derivatives to gain exposure indirectly by repackaging derivatives as swap transactions or embedding them in structured notes, which resemble debt or equity securities.
But they are really only suitable for implementing tactical and value-based views about the short-term direction of commodity prices over horizons ranging from intraday trading of a few hours to as much as six to 36 months to exploit the economic and commodity price cycle.
Their usefulness deteriorates over longer horizons as the cost of carrying the position outweighs eventual cyclical or secular price gains. "Buy and hold" strategies tend to lose money over the long term.
EXPOSURE TO THE COST OF CARRY
Investors in equities and bonds usually receive dividends and coupons to compensate for the use of their capital (as well as upside participation in capital gains in the case of stock).
Goldman slashes risk-taking in commodities
John Kemp is a Reuters market analyst. The views expressed are his own
Goldman Sachs cut the amount of risk it staked on commodity trading during Q2 2010 by almost 35 percent, part of a broad-based reduction in risk across the bank’s trading book. Value-at-risk (VaR) linked to commodity prices fell to an average of just $32 million per day between April and June, down from $49 million in the prior quarter and $40 million in the same period a year earlier, according to the firm’s earnings release. Cuts in VaR allocated to commodities were in line with reductions elsewhere, including interest rate risk (down just over 20 percent) and equities (down just over 30 percent). Only currency trading saw a slight increase in risk taking (up 3 percent). Commodity VaR was reduced to its lowest level since the three months ended September 2009, and before that November 2007.
Goldman has been reducing firm-wide VaR (net of diversification) since the middle of 2009 — shortly after the firm converted to Bank Holding Company (BHC) status regulated by the Federal Reserve, subsequently changed to Financial Holding Company (FHC) status, rather than its previous incarnation as a securities firm. Gross VaR (excluding diversification) started dropping after Q3 2009 (when it peaked at a massive $416 million). Gross VaR now stands at a more modest $272 million (down 35 percent). The firm’s massive interest rate risk (which peaked at $218 million in Q1 2009) has been cut to less than half that ($87 million in Q2 2010). But the April-June quarter was the first time the de-risking process had extending to commodities.To some extent, VaR is endogenous. Unless position limits are changed to offset it, VaR naturally rises and falls with market volatility. But firms can always over-ride fixed limits to keep VaR “budgets” unchanged despite changes in volatility if managers decide it is worthwhile.
What is notable is that market volatility rose during Q2 2010 in most asset classes (including commodities) after a quiet Q1. Yet Goldman’s VaR measures declined almost across the board, suggesting a deliberate policy to cut risk. Opportunities to generate revenue by taking market risk appear to be declining across the company’s trading operations. One crude measure of the firm’s “trading efficiency” is the amount of dollars it generates in net revenue for every $1 put at risk (VaR). Trading efficiency peaked at $46 for every $1 risked at the start of 2007 and has never recovered to the same level. Efficiency in Q2 2010 was just 24:1, down from 32:1 in the prior quarter, and less than half the peak (Charts 4 and 5).
While efficiency has improved since the dark days of the crisis, it is nowhere near the levels achieved prior to 2007, even though management has started to dial back risk-taking. The company’s earnings releases indicate management has been gradually cutting VaR and tightening risk budgets as profitable opportunities have become scarce. The general retrenchment or consolidation finally reached commodity desks in Q2.
The darkest period before dawn?
Abandon hope all ye who enter here was the inscription written above the gates of Hell in Dante’s Divine Comedy.
Investors who decided to take a long position in commodity futures at the start of 2010 anticipating a global recovery, tightening supply-demand balances, and rising prices, could be forgiven a sense of despair.
Their risk-taking has been rewarded with range-bound prices and a contango eating deeply into returns. Most longs lost money in H1 2010.
Flagship U.S. oil prices have moved sideways for the last 12 months, while negative contango rolls ensured investors lost around 13 percent since the start of the year.
The problem is not confined to WTI, which has been likened by some analysts to a “chocolate teapot” because of its sensitivity to inventories around the delivery point at Cushing. An investment in Brent futures, which reflects the seaborne international oil market more faithfully, according to analysts, is down just over 9 percent on a total return basis.
Oil is not the only commodity which has underperformed in H1. The Standard and Poor’s Goldman Sachs Non-Energy Index has produced negative returns of 8.5 percent so far this year.
So many wasted words for such a simple investing issue: when volatility goes up, one should invest short; when the volatility drops off, then go long. If these ‘investors’ got burned by holding on to beliefs instead of re-examining their holdings as new data came in then they deserve to get burned. Caveat Emptor pal
from The Great Debate UK:
Facebook group defends “harassed” BP
BP’s chief executive Tony Hayward branded “the most hated man in America” may be surprised to find himself cast in the role of victim by a growing clan of web-based supporters on Facebook.
One such group ‘Support BP’ calls itself the defender of an “undeservedly harassed institution” and seeks to show that the public opprobrium BP faces over its now 60-day-old Gulf of Mexico oil spill is not universal.
Members have been increasingly vocal since a succession of strong rebukes of BP by U.S. President Obama and lawmakers at Thursday’s congressional hearing, which they are calling a “lynch mob”.
The outburst of sympathy follows an apology to Hayward from Texas Republican Representative Joe Barton on Thursday, later withdrawn, for having to agree to a deal with President Obama to set up a $20 billion fund for Gulf claim damages.
Some of the Facebook posts echoed this same spirit of regret: “My apologies as an American to Tony Hayward for the rude and insulting conduct as well as the rush to judgement by U.S. politicians on 16/7,” wrote George Gray, 50, from Pennsylvania, referring to Thursday’s hearing.
The bulk of the group’s posts are written by Americans.
Anti-Keynesians and falling commodity prices
Policymakers’ new enthusiasm for cutting budget deficits will slow growth across the advanced industrial economies, cutting the outlook for commodity consumption and prices over the next 2-3 years.
For the past year, investors and commentators have been trying to guess how quickly extraordinary stimulus provided during the 2008-2009 crisis would be withdrawn.
Most attention focused on the timing of interest rate increases and measures to mop up excess liquidity provided by central banks. Instead tightening is set to commence from the fiscal side.
Until recently, most commentators saw government spending as part of the solution, and worried about withdrawing fiscal stimulus too quickly, risking a double dip recession. Now deficit spending is seen as the problem, risking a financing crisis. Keynes is once again unfashionable and the bond market vigilantes are in the ascendant.
AUSTERITY IS FASHIONABLE
Governments in Germany, Portugal, Spain, Italy, Greece and Ireland have already outlined austerity measures, while the United Kingdom and France have also promised unspecified efforts to cut deficits and restore public finances.
OECD Secretary-General Angel Gurria has endorsed the approach, albeit with phased implementation. At a conference in Montreal this week, he urged policymakers “Make sure you give signals to the markets about fiscal consolidation.” But he suggested delaying implementation. “Do we have to start now? No. Do we have to announce now? Yes.”.
Real commodity prices and the U.S. rate cycle
– John Kemp is a Reuters columnist. The views expressed are his own. –
Commodity prices exhibit a strong cyclical component — though it can be masked when producers are carrying a lot of excess capacity.
The attached chart shows the real price of various commodity baskets (Jan 1980=100) overlaid by U.S. interest rates (discount rate, later funds target), and the business cycle (NBER Business Cycle Dating Committee).
Prices began rising well ahead of interest rates after three of the last four recessions. Commodity markets anticipated future increases in demand even as policymakers prefered to hold back while recovery became more firmly established.
The current price rebound is unusual only for its strength.
Part of the explanation is the increasing weight of China and other emerging markets in global commodity consumption. As a result, the U.S. business and rate cycles and those of the other advanced economies now affect less than half the consumption of many commodities worldwide.
Prices are geared to the global cycle, which is not captured by measures of industrial output and capacity in the United States and the rest of the OECD.
from Commentaries:
CFTC prepares to recant speculators’ influence
-- John Kemp is a Reuters columnist. The views expressed are his own --
Like Archbishop Thomas Cranmer before he was burned at the stake for heresy, the U.S. Commodity Futures Trading Commission (CFTC) seems about to make a dramatic recantation.
Later today, the Commission will hold the first of three public hearings to discuss whether to impose tougher position limits in energy markets and restrict the availability of hedging exemptions. But it is already preparing to release a report that will accuse speculators of playing a significant role in last year's oil price spike, according to a report in the Wall Street Journal.
While it might seem a minor shift in emphasis, it is a radical reversal of the Commission's previously stated view that there was "no evidence" that investment flows had a material impact on prices. Commission staff have doggedly maintained that physical supply and demand factors could explain all the observed volatility in oil and other commodity prices over the past two years.
The position was stated most forcefully by CFTC Chief Economist Jeffrey Harris in testimony to the House of Representatives' Agriculture Committee in May 2008 (http://www.cftc.gov/stellent/groups/public/@newsroom/documents/speechandtestimony/harris-fenton051508.pdf).
It was repeated in September 2008 in the CFTC's "Staff Report on Swap Dealers and Index Traders" and again this year in a joint report with the United Kingdom's Financial Services Authority (FSA) on commodity regulation for the International Organisation of Securities Organisations (IOSCO).
The Commission's view has come under pressure from sceptical legislators as the scale of speculative positions in commodity markets and the number of exemptions the Commission and exchanges have granted have been revealed. Congressional anger threatened to derail Gensler's confirmation. The price of allowing him to take office seems to have been a promise to take a tougher approach.
Could you please post your article “Peak Oil is right answer to wrong question” on this blog so that I may pull it to pieces. However, I suggest that you have a look at the energy costs in extracting non-conventional oil or CTL. The production costs (mostly natural gas) are absolutely linked to the oil price, so as oil prices rise, so do production costs, which in turn cause the price to rise some more. A sustainable level of production in the Canadan Tar Sands, even if nuclear is used, would be no more than a paltry 5 million barrels a day (in 20 years) this is because of the water (& other environmental) constraints. The IEA predict peak beyond 2020, but this is only because of a growth in production in “Fields yet to find”. These fields are however unlikely to be developed as the bulk of them are in OPEC and OPEC won’t want to develop them even if they are found.
Central banks tend to use quantitative easing when interest rates have already been lowered to near 0% levels and have failed to produce the desired effect. QE always favor all the commodity investments with low risk matter. Higher QE, higher commodities inventories.
http://www.mikeastrachan.com/