Should There be Limits on Commodity Investment?

By John Kemp, Reuters
Thursday, March 05, 2009 2:47:18 PM ET

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

LONDON (Reuters)—The commodity boom and bust in the last five 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 Sen. Carl Levin (D-Mich.) ahead of his confirmation hearing, President Barack Obama's nominee to head the Commodity Futures Trading Commission, 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."

Position Limits Ineffective

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 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. The NYMEX can grant exemptions for producers and consumers who need to run larger positions than this to hedge their physical exposures. In recent years, the 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% 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 the 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." (Click here to read the letter.)

NYMEX has granted so many exemptions some commentators wonder whether the accountability levels have any meaning at all. In his pre-confirmation letter, Mr. 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 web site 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% of all contracts outstanding for that date.

The fund's holdings are so large it cannot hold them all on the NYMEX. So it holds another 30,000 lookalike contracts for light sweet oil on the IntercontinentalExchange, which has no position limits because the contract is based in London.

Absorbing, not Adding Liquidity

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.