The debate over the cause of record high commodity prices rages through Congress and the media, not to mention high-fuel-price demonstrations and food riots reported in dozens of countries. Unfortunately, this debate has generated more heat than light. Fundamental “supply imbalances,” “Chinese and Indian demand,” and “the plummeting dollar” are the rallying cries of the bulls. Those hurt by high prices point fingers at commodity speculators. Both cases have merit. Who is right? What, if anything, should Congress do?
There are definitive, obvious answers to both questions. First, the blame must be laid at the feet of speculators who have been allowed to run amuck by the Commodity Futures Trading Commission (CFTC), the very agency charged by Congress with preventing excess speculation. Why am I convinced that speculators are to blame? The answer will be obvious to fans of tv’s Dr. House. We can eliminate causes for which there is no ready cure; including supply shortages, Chinese and Indian demand, and the weak dollar. Ignoring the distraction of causes with no quick fix, we can focus on the one factor that has a prescription: excess speculation.
The source of commodity speculation is two-fold: traditional commodity pools and hedge funds who provide necessary liquidity to the futures markets, and the commodity indexers who buy and hold long futures contracts for appreciation (as they would stocks or bonds). Those who down-play speculative excesses point out that the “Commitments of Traders” report shows that the percentage of long contracts held by speculators has been declining. What they miss is that the CFTC commingles speculative long positions held by commodity index traders with those of traditional commodity hedgers—the actual end-users of commodities. This subterfuge effectively hid the accumulation of upwards of 40% of outstanding commodity contracts, making commodity index “investors,” the largest long players in US commodity markets.
How do we ascertain the commodity indexer numbers? Under pressure for more transparency, in 2007 the CFTC began publishing the positions of commodity index traders separately in the “COT-Supplemental” report. This development uncovered the fact that the four largest US investment banks dominate this business, issuing swaps to institutional funds wishing to invest in commodities, then locking in a profit by buying long futures contracts. At the behest of these swap dealers, who pleaded for continuing anonymity, the commission included only twelve agricultural markets in this weekly report. But since these swap dealers invest according to known commodity index benchmarks, we can deduce their gross positions fairly closely: currently about $230 billion in US markets alone.
The CFTC has, in direct violation of its mandate, orchestrated a free-for-all speculative environment, giving funds of all types virtual free reign to run-up prices. This has been accomplished through a covert two-front assault on federal laws: (1) Systematically raising or eliminating speculative trading limits, and (2) granting wholesale speculative exemptions to swap dealers.
The CFTC operates under the authority of the Commodity Exchange Act (CEA) of 1922. Section 6a of the CEA requires that the Commission “shall” set position limits to prevent excess speculation. In direct contravention of Congress, the CFTC has interpreted “shall” to mean “may, if I please” and instead of establishing speculative caps, has eliminated federal trading limits in all but a handful of agricultural markets.
This is why you did not hear a squeal from swap dealers and other large speculators when the CFTC announced plans to close the “London loophole,” and hold oil traders there to the same limits imposed on the New York Mercantile Exchange (NYMEX). News flash: The CFTC imposes no trading limits whatever on NYMEX oil futures trading (or gasoline, natural gas, and heating oil). The exchange itself limits trading, but only in the last three days before contract expiration, when indexers have long since rolled their massive positions forward to deferred contracts.
The lack of speculative limits would make exemptions to the limits moot, except that indexers wish to gain equivalent weightings in relatively small grain and livestock markets where limits still exist. Section 6c of the CEA states that the only exemptions permitted are for “bona fide hedging.” Here the CFTC’s own rules are in agreement with the CEA; they have simply chosen to ignore them. US Code Title 17 defines who is a bona fide hedger in such intricate detail that no one of reasonable intelligence could mistake swap dealers JP Morgan Chase, Citigroup, Bank of America, Wachovia, or HSBC North America as legitimate “bona fide hedgers” such as farmers, grain merchants, and other cash market participants.
What should Congress do? The question of whether commodity investment is good public policy should be debated in Congress, and not decided by a handful of political appointees drawn from the very industry they oversee. But please, first investigate current law enforcement before adding unneeded regulation. Congress anticipated the current mess, which might have been largely averted but for regulator subversion.
Before rubber-stamping current CFTC requests for more funding, ask the right questions of the acting Chairman Lukken. The big one: “Under what authority are you granting swap dealers exemptions to, or just plain eliminating, mandated speculative trading limits?” Number 2 might be to provide a rational explanation of how a small group of traders could accumulate 30% to 60% of a commodity’s long contracts and—as the agency claims—not inflate prices.
US futures markets are easily the most transparent markets in the world. But they and the public would benefit by requiring the CFTC to make permanent the 2-year pilot program under which it publishes the weekly “Commodity Index Trader” report and expanding it to include all futures markets. The CFTC should also require and publish the same trader report for foreign boards of trade and regulated swap platforms as a requisite for US distribution.
In your deliberations, be mindful that commodity bull markets are cyclical and responsive to laws of supply and demand. High prices discourage buying and stimulate new production, eventually retracing. Though the current run-up is arguably more speculative than usual, there is no reason to believe this time is different. This bubble will likely take care of itself long before Congressional action (or a Presidential magic wand) could be effective.
The direct and most efficient course would be to compel the CFTC to implement real speculative trading limits in accordance with current law, and to comply with their own regulations, which clearly disqualify swap dealers and other index traders for exemption from speculative trading limits. A logical first step might be to cap swap dealers positions at current levels.
A caveat: There is no evidence that the CFTC is capable of correcting the speculative excesses that they continue to deny. Even the most deft and delicate attempt to deflate the current bubble is likely to cause reverse market distortions even more painful than the bubble itself.