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Now, a Commodities Conundrum

By Steven Pearlstein
Wednesday, April 30, 2008

The global financial system these days is beginning to look like a giant Whac-a-Mole game -- when we think we've knocked down one speculative bubble, another one just like it pops up.

The latest is the commodities bubble -- everything from oil and natural gas to gold, copper, wheat and rice. As with the credit bubble before it, the explosion in commodities prices has its origins in a global savings glut and massive trade imbalances. Like the credit bubble, this speculative bubble in commodities has badly distorted the workings of key markets and sectors of the global economy. And as with the other, this bubble is creating vast new wealth for some, including brokers, traders and investment houses who have gorged on fees and trading profits.

The difference this time, however, is that even before it bursts, this bubble is causing economic discomfort for households and businesses around the world, and misery for hundreds of millions of hungry people who suddenly cannot afford a bowl of rice or scrap of meat. The Post's eye-opening series this week on the global food crisis has provided a grim reminder that the global economic ecosystem has become so interdependent that a drought in Australia, a tax credit in the United States, French farm subsidies and export controls in India can wind up forcing a desperate African farmer to eat his seed corn.

Although commodity prices are notoriously volatile, the price increases in the past year are off the chart: rice up 122 percent; wheat, 95 percent; soybeans, 83 percent; crude oil, 82 percent; corn, 66 percent; gold, 37 percent.

Behind each of these increases is a particular story of supply that has been constrained or demand unleashed. To varying degrees, all of them reflect the fact that the global economy has just gone through one of its strongest growth periods in a generation, one that has lifted hundreds of millions of people out of poverty and made middle-class consumers out of hundreds of millions more in places like China, India and Brazil. Given those realities -- and the long lead time required to clear farmland, drill oil wells and open new mines to meet the surging demand -- a bull market in commodities was almost inevitable.

But what turned a bull market into a bubble was the sudden arrival of large numbers of new investors and an array of new investment vehicles, many of them involving derivative instruments traded outside the confines of regulated markets.

Speculators have always played a prominent role in commodities markets, but in the past year, they have literally overwhelmed them, causing a dramatic increase in trading volume, volatility and prices and disrupting many of the normal relationships between producers and end-users.

Many of these were the same hedge funds and hot-money investors who had gorged on sovereign debt of developing countries, tech and telecom stocks, subprime mortgages and commercial real estate and now needed a new thing to focus on. Others -- including, it is said, some sovereign wealth funds -- looked to commodities as a hedge against the falling dollar. But perhaps the biggest push came from pension funds, foundations and university endowments whose managers had all gone to the same conferences and read the same academic papers, suggesting that a basket of commodity futures would provide a good hedge against stock and bond market declines.

To meet the needs of these investors, Wall Street and Chicago's commodities houses came up with all sorts of new vehicles, including exchange traded funds, index funds and structured investment vehicles -- the commodities equivalent of mortgage pools and asset-backed securities.

There are various estimates of how much of this new investment money flowed into these vehicles in the past two years. Philip Verleger, an economist who closely studies commodity markets, estimates that the inflow was running at an average of $100 million a day during most of 2006 and 2007, rising to as much as $1 billion a day during the frenzied trading days of February and March. J.P. Morgan put the amount at between $150 billion and $270 billion. And the Bank for International Settlements estimates that the value of all the derivative contracts traded on the unregulated over-the-counter markets surged from about $3 trillion in the spring of 2005 to more than $8 trillion today.

Whatever the number, it's hard to imagine that it wasn't a significant factor in skyrocking prices that have created problems for many of the nonfinancial players who rely on the commodity futures markets for selling products, assuring adequate supplies and hedging against price fluctuations. Many farmers and grain elevators are reluctant to sell their product on futures markets out of fear they won't have the cash to meet the ever-escalating margin calls, while giant users like Cargill are reportedly also cutting back on the their use of futures contracts to lock in supplies.

On many commodities markets these days, the cash or spot market are often below that of futures market -- a condition known as "contango" that usually signals that something other than market fundamentals are at play.

Perhaps the best proof of all that there's a speculative bubble in commodities that may be about to burst: ConAgra, the 147 year-old food professor, last month sold its commodity trading division to a hedge fund for $2.1 billion. Cash.

Indeed, the only people who don't believe speculation is driving a commodities bubble are the big commodity traders and the commodities exchanges, which are profiting handsomely from the soaring prices and trading volumes, and the regulators at the Commodities Futures Trading Commission, whose economists cannot seem to find statistical evidence that financial investors have had much of an impact on commodity prices.

To its credit, the commission last week decided to hold off on plans to raise the limits on how much any one fund can speculate on any commodity. Ostensibly this is out of concern, in the words of the acting chairman, "that additional speculative pressures not exacerbate the anomalies we are experiencing in these markets."

I suspect what's really going on is that the industry, which has always called the tune at the CFTC, fears a backlash in Congress that could usher in an era of tough new regulation of commodities trading as part of a broader package of financial regulatory reforms.

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