George Soros, the billionaire financier, stood before US lawmakers early this month and witheringly described the current boom in commodity markets as a "super-bubble" that could result in instability.
Mr Soros told the Senate commerce committee that institutional investors were inflating a bubble by investing in commodity indices.
He said investing in these indices was based on a "misconception" and was "intellectually unsound, potentially destabilising and distinctly harmful in its economic consequences."
"When the idea was first promoted there was a rationale for it . . . but the field got crowded and that profit opportunity disappeared," he said.
His comments come amid an intensifying debate about whether fundamentals - supply and demand - or speculators are the main force driving the sharp increases in commodities prices. Earlier, the Commodity Futures Trading Commission (CFTC) revealed a wide-ranging investigation into crude oil trading practices amid increasing congressional concern over the role of speculators in record energy prices.
Commodities indices have proved the most popular way for institutional investors to gain exposure to rising oil, metals and agriculture prices. As an asset class, they have comfortably out-performed returns on both stocks markets and bonds, helping attract huge new investor inflows.
Lehman Brothers estimates total assets under management (AUM) in commodity indices have ballooned from about $70bn at the start of 2006 to $235bn by mid-April this year. It calculates that of this $165bn increase, about $90bn is due to new financial inflows with the remaining $75bn stemming from price appreciation in the original investment.
Mr Soros's comments raise two separate issues. Are commodities prices being driven higher by speculation and should institutional investors avoid commodity indices?
Analysts at Barclays Capital are strong supporters of the view that fundamentals are the main driver of all commodity prices. Noting that the latest data from the CFTC showed a 48.5 per cent drop in speculative bets on rising oil prices, Barclays says speculative long positions now account for only 2.0 per cent of open interest (the combined total of all long and short positions) and yet oil continues to trade higher than $120 a barrel.
The CFTC, the main regulator of US futures trading, has long argued that supply and demand fundamentals are exclusively responsible for the rise in oil and other commodity prices. But that was before the investigation it announced recently.
Traders say the CFTC has been forced to act because Congress has already asked another agency, the Federal Trade Commission, to look into possible price manipulation.
The criticisms by Mr Soros will inevitably fuel the already palpable sense of unease among policymakers that another potentially avoidable financial crisis could be looming .
"We are currently experiencing the bursting of a housing bubble and, at the same time, a rise in oil and other commodities which has some of the hallmarks of a bubble," said Mr Soros who views these two developments as linked in a "super-bubble."
Stressing that he was not an expert in oil markets, Mr Soros said the bubble was super-imposed on an upward trend in oil that had strong fundamental underpinnings.
Mr Soros said that a crash in the oil market was "not imminent" but described commodity index buying as "eerily reminiscent" of a similar craze for portfolio insurance which led to the stock market crash of 1987.
Portfolio insurance is a term for the computerised hedging strategies that were supposed to protect investors from losses but failed as institutions rushed for the exit once selling took hold across global stock markets in October 1987.
Mr Soros warned the Senate committee that a similar crash to 1987 was possible if investors tried to exit commodity markets en masse.
His criticisms follow similar comments from another influential oil market analyst.
Ed Morse of Lehman Brothers has drawn a parallel between the dotcom boom for internet stocks and developments in oil prices.
"As in the dotcom period, when 'new economy' stocks became popular, a growing number of Wall Street analysts have been repeatedly raising their forecasts as oil prices have risen," says Mr Morse: "These revised forecasts have been partially responsible for new investor flows, driving prices to perhaps unsustainable levels."
Mr Morse does not expect a crash in oil prices either but warns: "when peak prices hit, they are also likely to fall precipitously. "
But with crude oil hitting over $135 a barrel, retail prices for petrol breaching the $4.0 a gallon level in the US and heating oil also reaching record levels recently, the pressure on lawmakers to act before there is a potentially dramatic turning point in the market has clearly intensified.
Mr Soros argues lawmakers should actively discourage commodity index trading as it is inflating the current bubble and recommends several practical steps, including raising margin requirements to deter speculation.
He also suggests that US public pension schemes should be disqualified from buying commodities. But Calpers, the largest US pension fund, has since said that the impact of public pension funds investing in commodities has only had a small impact on the market.
Mr Soros's views on commodity indices fly in the face of a widely accepted body of academic evidence, which suggests that an allocation to commodities in a portfolio of stocks and bonds can improve returns for any give level of risk appetite. One of the earliest proponents of investing in commodities markets was Bob Greer of Pimco which manages $16bn in commodity mandates. He argues supply problems and infrastructure constraints are driving prices higher, not speculators. Mr Greer's academic work and similar studies have encouraged a growing number of pension fund managers to shift some of their assets into commodity markets.
Mr Soros has also called for a ban on the various techniques that speculators have used to avoid position limits.
This appears to be a coded call for greater regulation of the ICE Exchange which comes under the jurisdiction of the UK's Financial Services Authority even though it has US headquarters and trading infrastructure.
About 30 per cent of trades in US WTI are now done via ICE and the rapid growth in its trading volumes has excited suspicion that hedge funds are using its facilities to exceed the ordinary speculative limits that apply on the Nymex exchange in New York.
Michael Greenberger also testified to the Senate on the same day as Mr Soros. After working for two years for the CFTC, Mr Greenberger now teaches as a Professor at the University of Maryland School of Law. One of his courses examines how poorly regulated futures trading leads directly to "needlessly high prices which energy consumers pay because of the high probability of excessive speculation, illegal manipulation and fraud."
The CFTC looks set to come under increasingly critical scrutiny in its role as the main US regulator of energy futures trading. Whether this will lead to stricter rules for commodities trading could depend on the outcome of this year's presidential election and whether the Democrats manage to win control of both the senate and the congress. (Under syndication arrangement with FE)
Soros paints bleak picture on commodity price 'bubble'
Chris Flood | Published: June 15, 2008 00:00:00 | Updated: February 01, 2018 00:00:00
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