Thursday, February 24, 2011

"How Institutional Investors Destabilize Commodity Markets"

This is the first time we've linked to Paul at his new gig so I'll link to the front page of the blog.
From Kedrosky at Bloomberg:
Interesting new paper arguing that institutional investors, not speculators, have destabilized commodity markets:
Rational destabilizing speculation, positive feedback trading, and the oil bubble of 2008
This article examines how the interaction of different participants in the crude oil futures markets affects the crude oil price efficiency. Normally, the commercial market participants, such as oil producers and oil consumers, act as arbitrageurs and ensure that the price of crude oil remains within the fundamental value range. However, institutional investors that invest in crude oil to diversify their portfolios and/or hedge inflation can destabilize the interaction among commercial participants and liquidity-providing speculators.
We argue that institutional investors can impose limits to arbitrage, particularly during the financial crisis when the investment demand for commodities is particularly strong. In support, we show that commercials hedgers had significantly reduced their short positions leading to the 2008 oil bubble—they were potentially aggressively offsetting their short hedges. As a result, by essentially engaging in a positive feedback trading, commercial hedgers at least contributed to ‘the 2008 oil bubble’. These findings have been mainly overlooked by the existing research.
We made this point in a non-empirical way a few dozen times during the 2008 price spike.
In particular I became obsessed by CalPERS  and other "Long-only index investors" and the shenanigans they and Goldman Sachs were playing with Goldman's "Commercial" designation, using swaps to evade position limits. It ended well though, Goldman bagged 'em on GS's $200 oil call and took their purported "clients" deep. From "It’s official, Goldman capitulates on oil":
...On Thursday, Goldman said it was ”closing” its recommendations for oil trades. Meaning that in a perilous time when the traders who pay attention to Goldman’s recommendations could use some guidance the most, Goldman has opted to give them the least. And some traders are furious about it, comparing the maneuver to then-strategist Abby Cohen’s decision to abandon her targets for equity indexes in the fall 2001, citing the uncertainties abounding in the market.

Goldman specifically talked about four trade recommendations it previously issued, and said clients shouldn’t put any stock in them any longer. One particular trade, a Nymex-WTI swap on the 2012 contract, issued in September, when crude already had declined to below $70, suggested that the contract would reflate to a range of $120 to $140. Obviously, that hasn’t happened....MORE
Good times, good times.
Some more of the GS/oil posts:
"Bread and Derivatives: Goldman’s control of market structure might just starve us, strand us, and leave us in the dark. Literally." (GS) 
Commodities: $50 bln in 'long-only funds' flees commods markets. And: Calpers says staying the course on commodities
Oil: the Market is the Manipulation