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Commodity and Crude Oil Prices: Supply and Demand No Longer Matter?
By: Jeff Pritchard, Altavest Worldwide Trading, Inc.

-- Posted Monday, 2 June 2008 | Digg This ArticleDigg It! | Source:

The historical record increase in crude oil prices, which peaked last Tuesday, the 22nd of May, at $135.09 per barrel for the July contract, has opened the door to all sorts of debate as to what is actually driving prices. Free market enthusiasts consistently justify rising prices by showing the correlation to either a decrease in supply, or an increase in demand.  History has consistently shown, over time that given the chance, the free market is the most efficient mechanism for determining “fair value”.  It’s no surprise that as developing nations like China and India continue to grow, their hunger for crude oil follows.  This growth has without a doubt increased the overall demand for crude oil and thus increased prices.  On the supply side, it’s also important to note that drilling and refining of crude in the United States has been politically stifled for numerous years, thereby further limiting supplies available on the global market. 


What is most interesting however is that crude oil prices have increased almost 50 percent this year alone, while overall demand has remained relatively constant.  This paradox has resulted in some interesting research that officially came to light on May 20th of this year when Michael W. Masters, a long-short equity hedge fund manager of 12 years, addressed the United States Senate. Instead of focusing on the traditional fundamentals of supply and demand, Masters revealed what he calls “Index Fund Speculation” as having been partially responsible for the rapid price appreciation of crude oil and other commodities.


Before we go any further it’s important to understand that speculators are absolutely necessary in the futures market.  Without speculators, hedgers would have no way to reduce their exposure to price movements against their held assets.  Masters though, speaks of a different kind of speculator.  This new commodity index fund (defined as a fund that has exposure across 25 different commodity markets) speculator, who entered the commodities market after the equity bear market that ended in 2002, was looking to allocate portions of their portfolios in a new market with the same type of traditional “buy and hold” strategy they had used in the past with equity index funds.  Unlike traditional speculators who have the ability to go both long and short, index fund speculators are “long only” traders. Their goal, as Masters puts it, is to “buy as many futures contracts as they need, at whatever price is necessary, until all of their money has been ‘put to work.’” 


Masters’ research reveals some amazing statistics. At the end of 2003, institutions had allocated $13 billion to commodity index trading strategies.  By March 2008 that number had ballooned to $260 billion.  Looking at crude specifically Masters noted that during that same timeframe, and as China’s demand for crude oil increased by 920 million barrels, the demand created by index fund speculation increased by 848 million barrels almost matching the demand created by China’s growth.  Lastly, it’s also interesting to note that the last five years these index fund speculators have been pouring money into commodities futures market, and the prices of the 25 commodities that are included in the indices have each increased by an average of 183 percent.


Given the information presented the question is no longer, “Are index-fund-only speculators driving up the price of not only crude oil, but other commodities as well?”  Clearly, these funds have had a large impact on commodity prices, but quantifying how much and for how long the effect will persist is difficult to ascertain.  If these long only positions begin to exit the market as prices fall, will this selling create a snowball effect and end the biggest commodity bull market in history?  Only time will tell.


The bigger question is; “What, if any, regulations should be imposed to mitigate such pricing distortions?”  As history has proven, often times the political/regulatory “solution” to what appears to be a problem simply results in one hole being plugged while two others emerge.  Over the long run, despite potential short term influences of long only hedge funds, markets eventually purge excesses, whether it be the stock market mania of the 1920s or the current housing market, market bubbles eventually collapse under their own weight. 


For more information, you may read Masters’ testimony at the following link


In our next article we will explore what trading alternatives exist for the average retail commodity trader in such an environment.




Jeff Pritchard

ALTAVEST Worldwide Trading, Inc.

-- Posted Monday, 2 June 2008 | Digg This Article | Source:


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