Bears, Bulls, Chickens and Pigs: wOw’s Wall Street Weekly With Liz Peek (Week of 5/26)

Editor’s Note: Liz Peek is a financial columnist.

Who would have ever thought $126 oil would look cheap? Only someone who watched prices soar towards $136 in the week leading up to Memorial Day, the symbolic start of the summer driving season in the United States.

A number of factors may (finally) be bringing world oil prices under pressure, including old-fashioned demand and supply. Signs of declining consumption are everywhere: the Energy Information Administration announced that U.S. demand has fallen to a five-year low, and gasoline demand in the United Kingdom dove 7% in April.

There is another, possibly darker, force at work here. The Commodity Futures Trading Commission revealed yesterday that it has been conducting an investigation over the past six months into oil trading in the United States. Many observers (including me) have cited unprecedented speculation as one reason for the surge in prices for a host of products ranging from sugar to gasoline.

I recently received an e-mail from a Wall Street friend on this very topic. He sent the powerful testimony of a money manager named Michael Masters, who appeared on May 20 before the Committee on Homeland Security. Describing himself as "a concerned citizen," he convincingly argues that a huge amount of new money from institutional investors, like pension funds and college endowments, has been flowing into commodities accounts, and has driven prices higher.

Very simply, the case he makes is this: First, he distinguishes the new institutional investors entering the commodities arena from the traditional speculators, in that these institutions only buy; they do not sell. That is, traditional traders in the commodities pits would buy oil, let’s say, and sell short gasoline, hoping to cash in on temporary dislocations in the relationships between the two markets. The new entrants have been buying (and holding) commodities that are included in various indices to diversify away from other investments that aren’t doing well. He calls this new group "index speculators."

Second, he shows there that this group has poured a giant amount of money into a fairly small (relative to equities) market. He demonstrates that assets allocated to this strategy have grown from $13 billion at the end of 2003 to $260 billion as of the end of March. Over that time, the prices of the 25 commodities in the index have grown 183%!

Third, he claims that commodities futures prices determine the prices actually paid for spot – or current – transactions in many markets. That is, what goes on in the pits determines real prices.
There’s much more to this, but here’s a figure that brings this document into focus: We’ve all heard that oil prices are sky-high because of rising demand from China, right? Mr. Masters points out that in the past five years annual demand from China has increased from 1.88 billion barrels to 2.8 billion, an increase of 920 million barrels. Over that same five years, the demand from index speculators has grown by 848 million barrels – nearly the same amount.

I think we’re going to be hearing a lot about this issue. It’s one thing to take a hands-off approach to traders who are buying and selling stocks and who only occasionally cause isolated market disruptions. It’s quite another to conclude that world inflation is being driven higher by institutional investors speculating on higher prices. Yesterday the NYMEX raised margin requirements in some commodities. I think this is long overdue.

Mercifully, oil prices have driven the financial sector off the front pages. Banks and investment banks are still struggling with investments that are overvalued on their books, but progress is being made. Write-offs and recapitalizations are still underway but the panic of last fall has receded.