Scott Irwin takes down Michael Masters
Econbrowser is pleased to host another contribution from Scott Irwin, who holds the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois. Today Scott offers a critique of a recent report by Michael Masters on the role of commodity speculation.
The Misadventures of Mr. Masters: Act II
by Scott Irwin
The impact of speculation, principally by long-only index funds, on commodity prices has been much debated in recent months. The main provocateur in this very public debate is Mr. Michael Masters, a hedge fund operator from the Virgin Islands. He has led the charge that speculative buying by index funds in commodity futures and over-the- counter (OTC) derivatives markets has created a "bubble," with the result that commodity prices, and crude oil prices, in particular, far exceed fundamental values. Act I of the Masters farce was his testimony to the Homeland Security Committee of the U.S. Senate in May of this year. Act II is now upon us in the form of a lengthy research report co-authored by his research assistant, Mr. Adam White, and his testimony this week to a subcommittee of the Energy and Resources Committee of the U.S. Senate. by Scott Irwin
My purpose in writing this post is to show that Mr. Masters' bubble argument does not withstand close scrutiny. He first makes the non-controversial observation that a very large pool of speculative money has been invested in different types of commodity derivatives over the last several years. The controversial part is that Mr. Masters concludes that money flows of this size must have resulted in significant upward pressure on commodity prices, which in turn drove up energy and food prices to consumers throughout the world. This argument is conceptually flawed and reflects a fundamental and basic misunderstanding of how commodity futures and related derivatives markets actually work. It is important to refute Mr. Masters' argument since a number of bills have been introduced in the U.S. Congress with the purpose of prohibiting or limiting index fund speculation in commodity futures and OTC derivative markets.
The first and most fundamental error Mr. Masters makes is to equate money inflows into futures and derivatives markets with demand, at least as economists define the term. Investment dollars flowing into either the long or short side of futures or derivative markets is not the same thing as demand for physical commodities. My esteemed predecessor at the University of Illinois, Tom Hieronymus , put it this way, "for every long there is a short, for everyone who thinks the price is going up there is someone who thinks it is going down, and for everyone who trades with the flow of the market, there is someone trading against it." These are zero-sum markets where all money flows must by definition net to zero. It makes as much logical sense to call the long positions of index funds new "demand" as it does to call the positions of the short side of the same contracts new "supply."
An important and related point is that a very large number of futures and derivative contracts can be created at a given price level. In theory, there is no limit. This is another way of saying that flows of money, no matter how large, do not necessarily affect the futures price of a commodity at a given point in time. Prices will change if new information emerges that causes market participants to revise their estimates of supply and/or demand. Note that a contemporaneous correlation can exist between money flows (position changes) and price changes if information on fundamentals is changing at the same time. Contrary to what Mr. Masters asserts, simply observing that large investment has flowed into the long side of commodity futures markets at the same time that prices have risen substantially does not necessarily prove anything. Mr. Masters is likely making the classical statistical mistake of confusing correlation with causation. One needs a test that accounts for changes in money flow and fundamentals before a conclusion can be reached (more on this later).
Mr. Masters' second error is to argue that index fund investors artificially raise both futures and cash commodity prices when they only participate in futures and related derivatives markets. In the very short-run, from minutes to a few days at most, commodity prices typically are discovered in futures markets and price changes are passed from futures to cash markets. This is sensible because trading can be conducted more quickly and cheaply in futures compared to cash markets. However, equilibrium prices are ultimately determined in cash markets where buying and selling of physical commodities must reflect fundamental supply and demand forces. This is precisely why all commodity futures contracts have some type of delivery or cash settlement system to tie futures and cash market prices together. (This is not to say that delivery systems always work as well as one would hope. See my earlier post here.)
It is crucial to understand that there is no change of ownership (title) of physical quantities until delivery occurs at or just before expiration of a commodity futures contract. These contracts are financial transactions that only rarely involve the actual delivery of physical commodities. In order to impact the equilibrium price of commodities in the cash market, index investors would have to take delivery and/or buy quantities in the cash market and hold these inventories off the market. There is absolutely no evidence that index fund investors are taking delivery and owning stocks of commodities. Furthermore, the scale of this effort would have to be immense to manipulate a world-wide cash market as large as the crude oil market, and there simply is no evidence that index funds are engaged in the necessary cash market activities.
This discussion should make it crystal clear that Mr. Masters is wrong to draw a parallel between current index fund positions and past efforts to "corner" commodity markets, such as the Hunt brother's effort to manipulate the silver market in 1979-80 . The Hunt brothers spent tens of millions of dollars buying silver in the cash market, as well as accumulating and financing huge positions in the silver futures market. All attempts at such corners eventually have to buy large, and usually increasing, quantities in the cash market. As Tom Hieronymus noted so colorfully, there is always a corpse (inventory) that has to be disposed of eventually. Since there is no evidence that index funds have any participation in the delivery process of commodity futures markets or the cash market in general, there is no logical reason to expect their trading to impact equilibrium cash prices.
A third error made by Mr. Masters, and unfortunately, many other observers of futures and derivatives markets, is an unrealistic understanding of the trading activities of hedgers and speculators. In the standard story, hedgers are benign risk-avoiders and speculators are potentially harmful risk-seekers. This ignores nearly a century of research by Holbrook Working, Roger Gray, Tom Hieronymus, Anne Peck, and others, showing that the behavior of hedgers and speculators is actually better described as a continuum between pure risk avoidance and pure speculation. Nearly all commercial firms labeled as "hedgers" speculate on price direction and/or relative price movements, some frequently, others not as frequently. In the parlance of modern financial economics, this is described as hedgers "taking a view on the market." Just last week, when commenting on new survey results of swap dealers and index traders , the CFTC stated that, "The current data received by the CFTC classifies positions by entity (commercial versus noncommercial) and not by trading activity (speculation versus hedging). These trader classifications have grown less precise over time, as both groups may be engaging in hedging and speculative activity." (p. 2)
What all this means is that the entry of index funds into commodity futures markets did not disturb a textbook equilibrium of pure risk-avoiding hedgers and pure risk-seeking speculators, but instead the funds entered a dynamic and ever changing "game" between commercial firms and speculators with various motivations and strategies. Since commercial firms have the considerable advantage of information gleaned from their far-flung cash market operations, they have traditionally dominated commodity futures markets and speculators have tended to be at a disadvantage. (If you are skeptical, I recommend reading the classic study by Michael Hartzmark about who wins and loses in futures markets.) In this light, entry of large index fund speculators has the potential to improve competition in commodity futures and derivatives markets, particularly as index funds become smarter about moving in and out of their positions.
I believe the points made here already build a persuasive case against Mr. Masters and his bubble theory. But there is more. It is possible to conduct a formal test of the hypothesis that money flows from index funds aided and abetted the recent boom in commodity prices. This can be done by running what are known as "Granger causality" tests between futures price changes and index fund position changes in commodity futures markets. To begin, the evidence available before the current commodity price boom ( summarized here ) would lead one to be highly skeptical of the hypothesis that positions for any group in commodity futures markets consistently lead futures price changes (this will not be true for individual traders with real skill). The CFTC has conducted thorough Granger causality tests in the crude oil futures markets, and guess what? They found absolutely nothing using non-public data on the daily positions of commercial and non-commercial traders. I am working with a Ph.D. student here at the University of Illinois to extend this testing to other commodities using the same daily database of trader positions, including those for index fund traders. As you might guess, I do not expect to find much evidence of a connection between index fund trading and futures price movements in other commodity markets. If we find anything, I expect the relationship to be small and fleeting.
While it is always possible to dither over the power of Granger causality tests or whether the specifications adequately control for changing fundamentals, I think most unbiased observers will reach the same conclusion: there is virtually no hard evidence to date of a link between index fund investment and commodity price changes. Isn't it about time for Mr. Masters to exit stage left?
