November 2007:- You have it on good authority; the US and UK regulators are extremely concerned about the extent of speculation in the commodity markets. They have been investigating alleged collusion and manipulation on the part of a group of hedge funds.
This is hardly surprising. Raw material prices have skyrocketed in the past six years. Growing demand from China, India and other developing economies is the mantra of the army of resource analysts and fund managers.
But that demand and periodic supply disruptions alone, cannot be responsible for extent of price increases in the past five years. From their price lows in the months after 9/11 to recent peaks, oil has more than quintupled; nickel has shot up by over 12-fold; lead, eightfold; copper, over sixfold; zinc, nearly sixfold; and tin, over fourfold. Only aluminium experienced a more reasonable adjustment of 138 per cent. Numerous other key industrial commodities have also surged.
Freedom of Information disclosure
The US Commodity Futures Trading Commission (CFTC) and UK Financial Services Authority (FSA) aren't discussing their investigation. But they are monitoring a group of hedge funds that have purchased a sizeable proportion of commodity derivatives.
Markets need speculation as it improves liquidity. Prices are below their recent peaks and speculators can be bulls and bears. Speculative purchases, are thus, of course, not illegal. But there are concerns about alleged collusion and manipulation; about parties acting in concert.
Worries of regulators are revealed in a CFTC response to a Freedom of Information Act request from Metal Bulletin, a trade magazine. The request relates to copper, but market and regulator sources say that investigations have taken place into excessive speculative activities in commodities such as aluminium, nickel, lead, oil and natural gas.
Extent of CFTC Investigation Astounding
The extent of the investigation into alleged copper irregularities is astounding. The CFTC disclosed that it had collated almost 20,000 pages, including 15,989 pages of trading records, 2,592 pages of financial records and 71 pages of inter-agency memoranda.
The CFTC isn't disclosing the content as any revelation could 'interfere with pending enforcement proceedings'. The CFTC has been corresponding with the FSA and London Metal Exchange.
Serious CFTC investigations began in 2004 and accelerated after the hedge fund Amaranth lost US$6.5 billion on natural gas trading last year.
The volume of CFTC work on the copper allegations illustrates how difficult it is to prove collusion and manipulation.
Credit Squeeze Already Placing Pressure On Big Time Speculators
But whether there is an eventual prosecution or not, the sub-prime and junk credit crisis is already placing enormous pressure on hedge funds and other big time commodity speculators.
Losses on junk credit have forced banks to rein in credit lines. More and more money is required to boost commodity prices but time and cash are running out.
The commodity speculation has been financed with borrowings from banks to buy commodity derivatives on margin. In other words, it is leverage upon leverage where small moves can double or wipe out the margin deposit.
If the hedge fund incurs losses, investors withdraw their money and the banks call in their loans, forcing it to sell more assets, causing further price drops and so on.
Central bankers are thus fretting. Sub-prime and other junk credits have already caused market turmoil. But the commodity bubble, which has already placed cost burdens on factories, is another potential crisis in waiting.
According to the Bank For International Settlements, total outstanding commodity derivative contracts soared from US$1.4 trillion at the end of 2004 to US$7.6 trillion in June 2007. Including futures and options and other derivatives on Nymex and other exchanges, the global open commodity positions are now well in excess of US$10 trillion!
Former Bearish Analysts Now Bullish - Stats tell different story
Analysts, who were bearish when prices were depressed some five years ago, are now claiming that straightforward supply and demand fundamentals have driven prices to recent extreme heights. Several of them are claiming shortages. They are talking tosh.
Nexans, a major copper consuming company, and Resolve Inc's David Threlkeld, who warned the LME about the impending US$3 billion Sumitomo copper fraud, believe that there are huge secret metals stockpiles around the world. Those inventories will eventually be sold, but at what price?
Here are some oil statistics that put the China demand spin in perspective.
Total world oil demand has risen by 7.5 per cent since 2002. About five years ago, China's crude oil demand was around five million barrels a day or around 6.3 per cent of global demand. According to Opec's latest statistics, China's oil consumption has increased by 52 per cent to around 7.6 million barrels a day or around 9 per cent of overall consumption. This is an impressive increase, but not sufficient to cause the disproportionate rise in prices from US$20 a barrel in 2002 to around US$100 currently.
According to Opec, industrial stocks of oil are an adequate two months' supply.
Here are some more stats. The open position of oil on Nymex, the New York exchange that trades oil, is equivalent to 2.5 billion barrels. Speculators are largely owners of half those positions, that is, 1.25 billion barrels or 14 days' demand. And that's only part of the story as there are massive over the counter speculative positions in oil.
The figures speak for themselves.
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