"Bread and Derivatives: Goldman’s control of market structure might just starve us, strand us, and leave us in the dark. Literally." (GS)

Oh My Goodness.
For three years I was writing about Goldman's use of their designation as a "Commercial" trader to avoid and help their clients avoid the position limits that the CFTC applies to "Speculators".

I felt like the provebial [it's Matthew 3:2, not Proverbs -ed] voice crying in the wilderness,

A quick note on nomenclature. In commodity markets speculators provide a societal good.
Where things got interesting was GS being a "commercial" allowed them to take positions that they would put into index form and then swap with the true speculators. Or sometimes just straight swap the position.
These speculators included giants such as CalPERS and other public employee pension funds and University endowments. I'll have more after the jump.
From New Deal 2.0:

In 2008, before the financial system almost melted down and threatened an economic collapse of biblical proportions, some very odd events occurred in the market for commodities derivatives.  It is now clear that financial institutions and investors already understood that the mortgage market was teetering and that severe problems for the financial firms were on the horizon.  Stress was building, but how did this relate to the commodities markets?  We still do not know for certain, but we do know that it coincided with peak investment levels of $317 billion in several investment vehicles known as commodity index funds.
In 1991, Goldman Sachs invented the commodity index fund.  While several other firms have replicated the fund, Goldman has maintained a 60-75% market share.
A key factor in the success of commodity index funds was an exemption granted by the CFTC from limits on speculative positions. It allowed the fund holdings to grow enormously.  Whatever the rationale was at that time, the conditions have changed and history suggests that the decision was unwise.

Goldman would take in funds from clients and invest the proceeds in futures contracts, a portfolio of energy, agricultural, minerals and financial contracts. It would be a sponsor and manager of the structure, not a principal. Futures contracts fluctuate based on the price of a commodity at a specified date in the future. For example, a barrel of oil to be delivered in August might be worth $70 to both a buyer and a seller as of today. The futures contract between a notional buyer and seller is essentially a financial instrument which continuously tracks that price each day until August arrives and the final price is known. It is not about actual oil, but rather the price of actual oil on a future date.  A futures contract is the functional equivalent of a swap and is a derivative of the cash market for the given commodity.

The idea of the fund was not to trade short and long positions or hedge physical prices on delivery of the commodity. The fund ignored market views and only bought one side - the side on which value of the futures contract increased as the expected delivery price increased.  The fund sponsor rolled over each contract into a new contract before the notional delivery date occurred.  By rolling over the contracts, the fund became infinite, a rolling investment in an index of prices for commodities that never had an end date.

Goldman and other banks made plenty of money from fees and float (the cash paid by investors was mostly held by the banks as long as everything worked well).  A side benefit was the huge increase in the volatility of commodities markets.  By flooding the markets with one sided contracts (especially on roll over dates), price movements became more severe.  Absolute commodities prices trended relentlessly higher and higher.
Volatility is essential to profits for the trading operations of the banks. Traders make money from price movements; stable prices mean low potential for trading profit. The logic is that commodities index funds lead to volatility which leads to trading profits for the fund sponsors. Goldman and other banks discovered that the commodities index fund operation, originally designed as a product for clients interested in investing in commodities markets, changed the marketplace and allowed them to trade for their own accounts far more profitably.

In recent years, most fund clients were not directly interested in the underlying commodities.  In a 2005 paper by Gary Gorton and Geert Rouwenhorst, it was demonstrated that returns on commodities are inversely related to stock market returns.  This relationship is especially strong in early stages of a recession and when share prices are lowest.  If you believed that equity prices were going to go down (or if you wanted to hedge exposure to the stock market), you could make money by buying the index. By 2007/2008, as investors became concerned about returns on their equities investments, the commodities index funds grew rapidly as a hedge against a falling stock market and futures prices rose....MORE

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

HT: Clusterstock

Some of our posts:

July 2008 
Dear CFTC: About those Oil Markets. And: A Stock Tip

...The long-only index investors have created such a distortion in the market that very few speculators are willing to go short, which is one of the functions of speculators in the markets. Now, if you have program trading kicking in, only a fool would take the other side of a buy order. The CFTC has become the Nevada Gaming Commission....

October 2008 
Commodities: $50 bln in 'long-only funds' flees commods markets. And: Calpers says staying the course on commodities

...I am looking forward to CalPERS quarterly results. While the recent ugliness won't have an immediate impact on their ability to meet their promises to retirees, I'm guessing that it will end up being a good thing that they can make up any longer-term shortfall by taxing California residents. This could get serious.

Regarding the long only commodities "investors", look for a hit to Goldman's earnings. As proprietors of the GSCI they have at least half the "roll" business. Assuming 2% slippage (fees, spreads, commissions) on the $50 Bil. just removed from the markets and you have $500 mil. in gravy they won't get to put on their spuds....

October 2008 
Calpers fund down 25 percent for year

February, 2009
Danish Pension Fund Giant Investing 'up to $400 Million' in Hudson Clean Energy

...Instead, CalPERS' idea of alt investment is buying raw land top tick of the housing bubble ($1 Bil. write-off) or gunning commodity prices via long-only index investments and swaps*....
...*Goldman bagged 'em. I mean they took CalPERS deep! First they tout $200/bbl. oil, then after the collapse:
From Barron's, Nov. 20, 2008 via our post "It’s official, Goldman capitulates on oil"-...

February, 2009 
U.S. Oil Trust Investigated by CFTC (USO)

...The “speculator limits”, says Nymex are there to “effectively restrict the size of a position that market participants can carry at one time and are set at a level that greatly restricts the opportunity to engage in possible manipulative activity on NYMEX.”
The position limit during the last three days of the expiring delivery month on Nymex WTI is 3,000 contracts....MORE

June, 2009 
How commodity indices broke the wheat futures market

I've been beating the drum on the index investors in the commodities markets (especially oil) for over a year now, see link below the headline story. From Felix Salmon at Reuters...
... Here's a quick search of Climateer Investing for Calpers, long-only, index.

June, 2009 
Goldman Raises Year-End Crude Forecast by 31% to $85

Always, always be skeptical of anything Goldman says regarding commodities.*
J. Aron is one of the company's crown jewels and was the springboard for CEO Lloyd Blankfein.**...
...Goldman marketed the fact that CalPERS and other long-only index buying institutions could piggyback on GS's status as a 'commercial' to avoid position limits by entering into swaps with the bank. The institutions thought it was a sweet deal, until it wasn't. If it comes down to throwing customers under the bus or protecting the propritary trading, there's no decision.

**"When Blankfein asked about his title, a boss at J. Aron said, 'You can call yourself contessa if you want.'"
-Fortune, January, 2006 

July, 2009 
Goldman, Morgan Stanley Threatened by CFTC Review (GS; MS)

Spokesmen for both banks declined to comment, as did one from Barclays Plc. Spokesmen from JPMorgan Chase & Co. and Citigroup Inc. didn’t immediately return calls for comment....MORE

On the other hand we've never been shy about commenting, see:
June 16, 2008: Goldman, Morgan Stanley Profits Conceal Reliance on Commodities
June 25, 2008: Which Former Goldman Sachs Chairman Should We Listen to on Oil Market Speculators?
August 19, 2008: Goldman’s Oil Thesis: Timing is Everything
October 7, 2008: Goldman: We Got Our Shorts On, Oil not Going to $200.00
October 27, 2008: The Goldman Commodities U-turn, again
November 20, 2008: It’s official, Goldman capitulates on oil
December 2, 2008: Oil speculation: It's back
December 12, 2008: Goldman Cuts Oil Forecast to $45 (vs original $200) Sees Bottom
June 5, 2009: Are Goldman's Oil Swaps Clients Piling Back Into Oil? 

July, 2009 
Oil: the Market is the Manipulation

...Here's Chris Cook at TOD:
   ...When I joined the International Petroleum Exchange as Head of Compliance and Market Regulation in 1990, the growing market in oil derivative contracts (futures and options contracts the purpose of which is to manage oil price risk) took off dramatically with the first Gulf War, and the IPE never looked back....

...The manipulation in the oil market is taking place at a different “meta” level to the Leesons and Hamanakas. The Goldman Sachs and J P Morgan Chase's of this world do not break rules: if rules are inconvenient to their purpose they have them changed....

October, 2009  
CalPERS Playing with Fire

...In our July '09 post "CalPERS Clipped for $970 Mil. in Real Estate Fiasco" I said "It's called reaching for yield. And it's stupid, especially when a fiduciary does it."

We have dozens of posts on CalPERS. This outfit is going to cost the taxpayers of California billions over the next decade as markets refuse to accommodate the fund's requirement of 8.5% average annual returns. They have made promises to their public sector retirees that they won't be able to meet and are trying to make up the difference by engaging in behavior that no fiduciary should even contemplate, let alone execute.

If you recall, they were one of Goldman's* largest "long-only index investors" in oil and the GSCI, scaling back only after their commodity bets lost billions. They also engaged in loser hedge fund behavior, selling their most liquid investments at the bottom to prop up their non-trading investments....

October, 2009 
Short Interest Declines Again (and Why it Matters)
...*From our June 2 post "Markets: What Happened to the Bears?":

We are coming up on the anniversary of an event in the oil market that may bear [so to speak -ed] some resemblance to what has been happening in the equity markets.
On June 6, 2008 oil staged it's largest dollar gain in history....

...After talking to some folks who had been mauled [cute -ed] I decided that the short-sellers had just given up. It is no fun to be selling into the buying of Goldman and their long-only index clients, CalPERS, the universiy endowments et al.
So they said to hell with it. Oil continued to rise for another 33 days before peaking on July 9.
On July 29 I had this comment at Environmental Capital:

• 5:37 pm July 29, 2008
• Climateer wrote:

Mike @ 4:13,
Two separate thoughts in that first post.
As best as I’ve can tell approx. 40% of the move from $80 to $147 (25-28 bucks) came from “speculation”. I use quote marks because of the terminology problems most of the talking heads have when the subject is commodities. Speculators in commodity parlance take the other side of a hedgers trade, thus performing a societal good.
The problem was, until last week, the shorts had been beaten up so bad by the relentless flow of “investor” money that were out of the game. The $10.75 uptick on June 6 was their capitulation.
They covered and said screw it....

And many more.
We're no blogger come lately, no sirree.

If I were a betting man my money would say that one of the big reasons that gold has moved out of proportion to oil is that GS realized that continuing the same old game in consumables would result in such a hue and cry among the citizens that the politicians would be forced to shut down the game permanently.
Rather than risk that they went to something that people didn't get price quotes on every time they gassed up, or bought a loaf of bread.

"REVISITING SPECULATIVE COMMODITY BUBBLES" (GS)

We were firmly opposed to the Goldman Sachs spin machine, links below.
From Pragmatic Capitalism:

In June of 2008 Goldman Sachs released a research report titled “Speculators, Index Investors, and Commodity Prices”.  The report was intended to defend the growing role of speculators and “investors” in the commodities markets. If you’ll recall, it was around this time that many were wondering whether there wasn’t an irrational exuberance in the commodity space that was being largely driven by irrational participants.  Goldman, being one of the larger participants, defended their role in the markets and concluded that speculators were not driving prices beyond their fundamentals and that there was no evidence of a bubble in the commodity market  A single question and answer from the June 2008 paper succinctly summarized their position at the time:

“Q12: How do we know if fundamentals support prices at these levels, or how do we know this isn’t a speculative bubble?
A: If commodity futures price were too high relative to the underlying supply and demand fundamentals, we would expect to observe large inventory builds, which we do not observe.

The simplest way to address the question of whether the underlying supply and demand fundamentals support prices at these high levels is to ask what would happen if they did not. Suppose commodity prices were too high, then we would expect to see those high commodity prices curbing demand too much, bringing too much supply to the physical market and the resulting excess of supply over demand generating a large build in the physical commodity inventories. Consequently, increasing physical commodity inventories would be the main indicator that current prices are not supported by current fundamentals. The fact that across the commodity markets, we are not observing anything approaching sustained growth in physical inventory indicates that current prices are supported by supply and demand fundamentals.

Therefore, we find the concerns that commodity markets are in the midst of a speculative bubble unwarranted. Physical commodity inventories are not growing, and in fact remain near the bottom of the historical range for many commodities. Net speculative length in the petroleum futures markets has not increased significantly since 2004, even as WTI crude oil prices have risen from $40/bbl to near $140/bbl. In sum, the commodity markets are not behaving in a way that a speculative bubble would suggest.“ (emphasis added)

In retrospect, it’s clear that there were distortions in the commodity markets and that fundamentals were nowhere near in-line with actual market prices.  Speculators and irrational market participants were clearly helping to drive prices on both the way up and the dramatic way down in 2008.  Goldman later backed down from their 2008 comments admitting that speculators did indeed contribute to the speculative run-up...MUCH MORE

Previously:
Nov. 2010
"The financialisation of commodities"

June 2010
"Bread and Derivatives: Goldman’s control of market structure might just starve us, strand us, and leave us in the dark. Literally." (GS)
which had the following list of posts. As I said then, "We're no blogger come lately, no sirree".
The July 2009 post "Oil: the Market is the Manipulation" is worth a look, if you're into this type of thing:

...Here's Chris Cook at TOD:
   ...When I joined the International Petroleum Exchange as Head of Compliance and Market Regulation in 1990, the growing market in oil derivative contracts (futures and options contracts the purpose of which is to manage oil price risk) took off dramatically with the first Gulf War, and the IPE never looked back....

Some of our posts:

July 2008 
Dear CFTC: About those Oil Markets. And: A Stock Tip

...The long-only index investors have created such a distortion in the market that very few speculators are willing to go short, which is one of the functions of speculators in the markets. Now, if you have program trading kicking in, only a fool would take the other side of a buy order. The CFTC has become the Nevada Gaming Commission....

October 2008 
Commodities: $50 bln in 'long-only funds' flees commods markets. And: Calpers says staying the course on commodities

...I am looking forward to CalPERS quarterly results. While the recent ugliness won't have an immediate impact on their ability to meet their promises to retirees, I'm guessing that it will end up being a good thing that they can make up any longer-term shortfall by taxing California residents. This could get serious.

Regarding the long only commodities "investors", look for a hit to Goldman's earnings. As proprietors of the GSCI they have at least half the "roll" business. Assuming 2% slippage (fees, spreads, commissions) on the $50 Bil. just removed from the markets and you have $500 mil. in gravy they won't get to put on their spuds....

October 2008 
Calpers fund down 25 percent for year

February, 2009
Danish Pension Fund Giant Investing 'up to $400 Million' in Hudson Clean Energy

...Instead, CalPERS' idea of alt investment is buying raw land top tick of the housing bubble ($1 Bil. write-off) or gunning commodity prices via long-only index investments and swaps*....
...*Goldman bagged 'em. I mean they took CalPERS deep! First they tout $200/bbl. oil, then after the collapse:
From Barron's, Nov. 20, 2008 via our post "It’s official, Goldman capitulates on oil"-...

February, 2009 
U.S. Oil Trust Investigated by CFTC (USO)

...The “speculator limits”, says Nymex are there to “effectively restrict the size of a position that market participants can carry at one time and are set at a level that greatly restricts the opportunity to engage in possible manipulative activity on NYMEX.”
The position limit during the last three days of the expiring delivery month on Nymex WTI is 3,000 contracts....MORE

June, 2009 
How commodity indices broke the wheat futures market

I've been beating the drum on the index investors in the commodities markets (especially oil) for over a year now, see link below the headline story. From Felix Salmon at Reuters...
... Here's a quick search of Climateer Investing for Calpers, long-only, index.

June, 2009 
Goldman Raises Year-End Crude Forecast by 31% to $85

Always, always be skeptical of anything Goldman says regarding commodities.*
J. Aron is one of the company's crown jewels and was the springboard for CEO Lloyd Blankfein.**...
...Goldman marketed the fact that CalPERS and other long-only index buying institutions could piggyback on GS's status as a 'commercial' to avoid position limits by entering into swaps with the bank. The institutions thought it was a sweet deal, until it wasn't. If it comes down to throwing customers under the bus or protecting the propritary trading, there's no decision.

**"When Blankfein asked about his title, a boss at J. Aron said, 'You can call yourself contessa if you want.'"
-Fortune, January, 2006 

July, 2009 
Goldman, Morgan Stanley Threatened by CFTC Review (GS; MS)

Spokesmen for both banks declined to comment, as did one from Barclays Plc. Spokesmen from JPMorgan Chase & Co. and Citigroup Inc. didn’t immediately return calls for comment....MORE

On the other hand we've never been shy about commenting, see:
June 16, 2008: Goldman, Morgan Stanley Profits Conceal Reliance on Commodities
June 25, 2008: Which Former Goldman Sachs Chairman Should We Listen to on Oil Market Speculators?
August 19, 2008: Goldman’s Oil Thesis: Timing is Everything
October 7, 2008: Goldman: We Got Our Shorts On, Oil not Going to $200.00
October 27, 2008: The Goldman Commodities U-turn, again
November 20, 2008: It’s official, Goldman capitulates on oil
December 2, 2008: Oil speculation: It's back
December 12, 2008: Goldman Cuts Oil Forecast to $45 (vs original $200) Sees Bottom
June 5, 2009: Are Goldman's Oil Swaps Clients Piling Back Into Oil? 

July, 2009 
Oil: the Market is the Manipulation

...Here's Chris Cook at TOD:
   ...When I joined the International Petroleum Exchange as Head of Compliance and Market Regulation in 1990, the growing market in oil derivative contracts (futures and options contracts the purpose of which is to manage oil price risk) took off dramatically with the first Gulf War, and the IPE never looked back....

...The manipulation in the oil market is taking place at a different “meta” level to the Leesons and Hamanakas. The Goldman Sachs and J P Morgan Chase's of this world do not break rules: if rules are inconvenient to their purpose they have them changed....

October, 2009  
CalPERS Playing with Fire

...In our July '09 post "CalPERS Clipped for $970 Mil. in Real Estate Fiasco" I said "It's called reaching for yield. And it's stupid, especially when a fiduciary does it."

We have dozens of posts on CalPERS. This outfit is going to cost the taxpayers of California billions over the next decade as markets refuse to accommodate the fund's requirement of 8.5% average annual returns. They have made promises to their public sector retirees that they won't be able to meet and are trying to make up the difference by engaging in behavior that no fiduciary should even contemplate, let alone execute.

If you recall, they were one of Goldman's* largest "long-only index investors" in oil and the GSCI, scaling back only after their commodity bets lost billions. They also engaged in loser hedge fund behavior, selling their most liquid investments at the bottom to prop up their non-trading investments....

October, 2009 
Short Interest Declines Again (and Why it Matters)
...*From our June 2 post "Markets: What Happened to the Bears?":

We are coming up on the anniversary of an event in the oil market that may bear [so to speak -ed] some resemblance to what has been happening in the equity markets.
On June 6, 2008 oil staged it's largest dollar gain in history....

...After talking to some folks who had been mauled [cute -ed] I decided that the short-sellers had just given up. It is no fun to be selling into the buying of Goldman and their long-only index clients, CalPERS, the universiy endowments et al.
So they said to hell with it. Oil continued to rise for another 33 days before peaking on July 9.
On July 29 I had this comment at Environmental Capital:

• 5:37 pm July 29, 2008
• Climateer wrote:

Mike @ 4:13,
Two separate thoughts in that first post.
As best as I’ve can tell approx. 40% of the move from $80 to $147 (25-28 bucks) came from “speculation”. I use quote marks because of the terminology problems most of the talking heads have when the subject is commodities. Speculators in commodity parlance take the other side of a hedgers trade, thus performing a societal good.
The problem was, until last week, the shorts had been beaten up so bad by the relentless flow of “investor” money that were out of the game. The $10.75 uptick on June 6 was their capitulation.
They covered and said screw it....

And many more.
We're no blogger come lately, no sirree.

If I were a betting man my money would say that one of the big reasons that gold has moved out of proportion to oil is that GS realized that continuing the same old game in consumables would result in such a hue and cry among the citizens that the politicians would be forced to shut down the game permanently.
Rather than risk that they went to something that people didn't get price quotes on every time they gassed up, or bought a loaf of bread.

The Best News of the Day: Hedge Funds Go 'Long Only'

If this works out like the long-only commodity index funds we are within a year of a major equity downturn.
In the commods the friendly Goldman salesman would come knocking on the CalPERS' or Common Fund's  door and pitch them on getting exposure to the 'asset class' by way of the GSCI and the funds would dip their toes in and then by the Spring of 2008 the salesman didn't even have to make outgoing calls, the 'investors' were demanding the product.
We documented the whole thing so if interested use the search blog box with some combination of the above keywords.
From The Wall Street Journal:
'Long-Only' Funds Lose Their Hedge

What do you call a hedge fund that doesn't hedge?

The latest growth area for the industry.

On the heels of a multiyear market rally, a slew of hedge-fund firms are launching "long-only" funds betting that at least some stocks have further to climb. The moves come amid a brutal stretch for short bets against companies, traditionally a key strategy for hedge funds.

The new funds also represent a shift by hedge-fund managers—known for their sophisticated tactics and exclusivity—into the kind of old-fashioned stock picking more associated with Main Street mutual funds.

But some wonder if the latest craze is merely a grab for fees, or perhaps even a sign of the top of the stock market.

The new entrants to the field include several firms with ties to Julian Robertson's investment firm Tiger Management, including Tiger Global Management and Coatue Management. Tiger Management-backed Hound Partners is planning to launch one of its own next year, according to people familiar with the firm.

Craig McBeth, a protégé of Todd Combs, a former hedge-fund manager handpicked by Warren Buffett to help manage his company's investments, left Berkshire Hathaway Inc. this year to launch a fund that will make bets on a handful of companies. "We anticipate short positions will be rare: we believe they are inherently inferior to our best long ideas," said a marketing document for Mr. McBeth's new Judson Founders Fund that was viewed by The Wall Street Journal.

Other managers are considering similar plans.

"We're seeing a big movement and we think it's going to continue," said Joseph Larucci of Aksia, a hedge-fund consultant to institutional investors such as pension funds. He said the launches are being driven largely by demand from investors as they look to replace some of their underperforming mutual-fund and traditional long-only managers.

Most stock hedge funds are designed to outperform in downturns but underperform in bull markets. But investors can get antsy after years of watching their high-priced hedge-fund managers lag the broader market.

Hedge funds investing in stocks gained 11.3% through October, on average, compared to 25.3% by the S&P 500 index, including dividends, according to data tracker HFR.

Long-only funds typically replicate bets on companies held by the firms' main hedge funds, though they might hold fewer stocks or hold onto them for longer periods. In exchange, investors pay lower fees than for the managers' hedge funds—though they still far outstrip fees for actively managed mutual funds.

Hedge funds have historically charged investors about 2% of assets under management and taken around 20% of the investment profits, an arrangement known as "two and 20," though that model has come under pressure recently.

Actively managed stock mutual funds charge investors an expense ratio of 1.4% on average, according to Morningstar Inc., and don't take a percentage of the profits.

The spurt of launches is raising some eyebrows, with skeptics—including hedge-fund managers not launching such products—saying the new funds are late to the party.

Indeed, short seller Bill Fleckenstein, who closed down his short-only fund in early 2009 after notching big gains in the 2008 financial crisis, is preparing to launch a new short-only fund early next year. He hopes to amass a war chest to deploy for what he expects will be a sharp market correction. "It happened in early 2000…it happened in [2007], and it'll happen again," Mr. Fleckenstein said.

Bruce Zimmerman, chief executive of the $30 billion University of Texas Investment Management Co., was among the first big investors to push hedge funds for long-only options about five years ago.

He said these funds can still make sense for investors, but that would-be buyers should figure out whether the products are a grab for assets and fees, or display a thoughtful approach focused on generating profits for investors.

"You know, it's kind of human nature to chase after what's hot," Mr. Zimmerman said. "But if you're going to make money, you want to buy low—which means buying what no one else is buying."...MORE

How Goldman Sachs Created the Food Crisis (GS)

Huge thanks to a sharp eyed reader for emailing this piece which explains in less than 2000 words a topic that I've spilled billions of electrons over.
From Foreign Policy:

Demand and supply certainly matter. But there's another reason why food across the world has become so expensive: Wall Street greed.

It took the brilliant minds of Goldman Sachs to realize the simple truth that nothing is more valuable than our daily bread. And where there's value, there's money to be made. In 1991, Goldman bankers, led by their prescient president Gary Cohn, came up with a new kind of investment product, a derivative that tracked 24 raw materials, from precious metals and energy to coffee, cocoa, cattle, corn, hogs, soy, and wheat. They weighted the investment value of each element, blended and commingled the parts into sums, then reduced what had been a complicated collection of real things into a mathematical formula that could be expressed as a single manifestation, to be known henceforth as the Goldman Sachs Commodity Index (GSCI).

For just under a decade, the GSCI remained a relatively static investment vehicle, as bankers remained more interested in risk and collateralized debt than in anything that could be literally sowed or reaped. Then, in 1999, the Commodities Futures Trading Commission deregulated futures markets. All of a sudden, bankers could take as large a position in grains as they liked, an opportunity that had, since the Great Depression, only been available to those who actually had something to do with the production of our food.

Change was coming to the great grain exchanges of Chicago, Minneapolis, and Kansas City -- which for 150 years had helped to moderate the peaks and valleys of global food prices. Farming may seem bucolic, but it is an inherently volatile industry, subject to the vicissitudes of weather, disease, and disaster. The grain futures trading system pioneered after the American Civil War by the founders of Archer Daniels Midland, General Mills, and Pillsbury helped to establish America as a financial juggernaut to rival and eventually surpass Europe. The grain markets also insulated American farmers and millers from the inherent risks of their profession.....

...But Goldman's index perverted the symmetry of this system. The structure of the GSCI paid no heed to the centuries-old buy-sell/sell-buy patterns. This newfangled derivative product was "long only," which meant the product was constructed to buy commodities, and only buy. At the bottom of this "long-only" strategy lay an intent to transform an investment in commodities (previously the purview of specialists) into something that looked a great deal like an investment in a stock -- the kind of asset class wherein anyone could park their money and let it accrue for decades (along the lines of General Electric or Apple). Once the commodity market had been made to look more like the stock market, bankers could expect new influxes of ready cash. But the long-only strategy possessed a flaw, at least for those of us who eat. The GSCI did not include a mechanism to sell or "short" a commodity.....MORE

If you do a search of Climateer Investing using GSCI or Goldman + oil as keywords you can find a lot of backround material. We've been beating this drum for a few years now.
Another keyword search would be long-only index investor.

Whoa! Has The Small-Cap Premium Disappeared? That Would Leave Only Momentum in the Tried-and-True Anomaly File!

There are two anomalies that have become touchstones:
1) Momentum...the Only Practical Anomaly?
2) Small cap excess return.

Here's more on the second from Index Universe:

There has been some recent discussion calling into question the existence of the size premium. With that in mind, I thought it worth taking an in-depth look at the issue. The first of my three installments will start with the beginning of the small-cap premium research. Before we start, I ask that you keep the following quote from Mark Twain in mind: "The rumors of my death have been greatly exaggerated." Its relevance will become apparent as the data are explored.

The original research on the small-cap premium was done by Rolf Banz. Banz's paper was published in 1981. Among his findings was: "The results show that, in the 1936-1975 period, the common stock of small firms had, on average, higher risk-adjusted [emphasis mine] returns than the common stock of larger firms."

Professors Eugene Fama and Kenneth French looked at the evidence in their famous 1992 paper, "The Cross-Section of Expected Stock Returns." Their study covered the period 1963-1990. Their findings were different from Banz's. While they did find that small stocks had higher average returns, they believed the higher returns were compensation for risk, citing several papers that provided risk-based explanations. They certainly didn't state and—to my knowledge, have never stated—that small stocks provided higher risk-adjusted returns....MUCH MORE

And:
Talking About Small-Cap Premium, Part 2
See also Dimson and Marsh 1999

And regarding the first, from Optimal Momentum:

Interest in momentum is growing as it gains recognition as the premier market anomaly. Our purpose here is not to report on every item or research finding related to momentum. We prefer instead to point out those that are most important or interesting often because they seem exceptionally good, or, occasionally, because they seem exceptionally bad.

One exceptionally good piece of research is the working paper by Israel and Moskowitz (I&M) called "The Role of Shorting, Firm Size, and Time on Market Anomalies." This paper has important implications not only for momentum investors, but also for those who are interested in size and value  investment tilts. I&M look at all three with respect to firm size, long or short market exposure, and results stability over time.

Most research papers on relative strength momentum present it on a long/short basis where you buy  winning stocks and short losing ones. In some papers, you can find some long-only results buried in a table somewhere. Except in my papers, it can be challenging to find visual representations or detailed analyses of long-only momentum. However, I&M offer insightful analysis of long-only momentum. It is important to look at long-only results for two reasons. First, most investors are interested only in the long side of the market. Second, in the words of I&M:

Using data over the last 86 years in the U.S. stock market (from 1926 to 2011) and over the last four decades in international stock markets and other asset classes (from 1972 to 2011), we find that the importance of shorting is inconsequential for all strategies when looking at raw returns. For an investor who cares only about raw returns, the return premia to size, value, and momentum are dominated by the contribution from long positions.

Therefore, even if you are open to shorting, it does not make much sense from a return perspective. 

I&M charts and tables show the top 30% of long-only momentum US stocks from 1927 through 2011 based on the past 12-month return skipping the most recent month. They also show the top 30% of value stocks using the standard book-to-market equity ratio, BE/ME, and the smallest 30% of US stocks based on market capitalization. 

 

...MORE

HT on momentum, I don't remember who sent it but the blog is new to us.

"Commodities for the Long Run?"

Absolutely not. 

As Dylan Grice, then at Société Générale pointed out, their expected long-term real rate of return is not appealing. Here's our introduction to 2010's Société Générale's Dylan Grice-"Commodities: ‘Their Expected Long-Run Real Return is 0%’" (please ignore the supercilious "Well duh", I was in my haughty Valley Girl phase, better now):

Well duh.
Commodities are for tradin' not investin'.
Which makes one wonder how CalPERS and the other big institutions got snookered by Goldman Sachs into being "Long-Only Index Investors".

Do you, gentle reader, think for one minute that Goldman's crown jewel, Alaron Trading, just buys and socks the stuff away?
Of course not. Alaron makes directional bets, both long and short, to take advantage of the movement.
To a competent trader, volatility is your friend.

In the case of the grains the darn things are mean-reverting.
If wheat doubles in price, the acreage devoted to wheat goes up and prices come down. The substitution effects at the producer level are predictable if not timable:
better net profit for soybeans than corn? Beans it is boys!

In the metals and in energy the more important substitutions are at the user level. If a utility's cost of a BTU is cheaper when gas-fired, the coal orders slow down.
And over-arching everything is the point that Mr. Grice is making. Human beings are adaptable....

And from the CFA Institute's Enterprising Investor blog, July 8: 

If you focus only on returns and covariances over a one-year investment horizon, you may conclude that commodities have no place in an investment portfolio. The efficiency of commodities improves dramatically over longer investment horizons, however, especially when using expected returns and maintaining historical serial dependencies.

We’ll demonstrate how allocations to commodities can change across investment horizon, especially when considering inflation. Our analysis suggests that investment professionals may need to take a more nuanced view of certain investments, especially real assets like commodities, when building portfolios.

This is the third in a series of posts about our CFA Institute Research Foundation paper. First, we demonstrated that serial correlation is present in various asset classes historically. Second, we discussed how the risk of equities can change according to investment horizon. 

Historical Inefficiency of Commodities

Real assets such as commodities are often viewed as being inefficient within a larger opportunity set of choices and therefore commonly receive little (or no) allocation in common portfolio optimization routines like mean variance optimization (MVO). The historical inefficiency of commodities is documented in Exhibit 1, which includes the historical annualized returns for US cash, US bonds, US equities, and commodities from 1870 to 2023. The primary returns for US cash, US bonds, and US equities were obtained from the Jordà-Schularick-Taylor (JST) Macrohistory Database from 1872 (the earliest year the complete dataset is available) to 2020 (the last year available). We used the Ibbotson SBBI series for returns thereafter.

The commodity return series uses returns from Bank of Canada Commodity Price Index (BCPI) from 1872 to 1969 and the S&P GSCI Index from 1970 to 2023. The BCPI is a chain Fisher price index of the spot or transaction prices in US dollars of 26 commodities produced in Canada and sold in world markets. The GSCI — the first major investable commodity index — is broad-based and production weighted to represent the global commodity market beta.

We selected the GSCI due to its long history, similar component weights to the BCPI, and the fact that there are several publicly available investment products that can be used to roughly track its performance. These include the iShares exchange traded fund (ETF) GSG, which has an inception date of July 10, 2006. We used the two commodity index proxies primarily because of data availability (e.g., returns going back to 1872) and familiarity. The results from the analysis should be viewed with these limitations in mind.

Exhibit 1. Historical Standard Deviation and Geometric Returns for Asset Classes: 1872-2023.

Source: Jordà-Schularick-Taylor (JST) Macrohistory Database. Bank of Canada. Morningstar Direct. Authors’ calculations.

Commodities appear to be incredibly inefficient when compared to bills, bonds, and equities. For example, commodities have a lower return than bills or bonds, but significantly more risk. Alternatively, commodities have the same approximate annual standard deviation as equities, but the return is approximately 600 basis points (bps) lower. Based entirely on these values, allocations to commodities would be low in most optimization frameworks.

What this perspective ignores, though, is the potential long-term benefits of owning commodities, especially during periods of higher inflation. Exhibit 2 includes information about the average returns for bills, bonds, equities, and commodities, during different inflationary environments....

....MUCH MORE

If interested see also "From Boom to Bust: A Typology of Real Commodity Prices in the Long Run" Plus a Compendium of Dylan Grice at Société Générale, 2009-2012

Here's the Internet Archive with Dylan Grice Full  "Cred and Credulity:A collection of Popular Delusions essays from 2009 to 2012". 

2008's "Classic Paper: Returns from Commodity Futures" came to a similar first-pass approximation conclusion:

Over the long term, the average annualized excess returns (above the risk-free rate) on futures for individual commodities is approximately zero, and these returns are largely uncorrelated with one another. There is little evidence of long-term return persistence among individual commodity futures.

With a trading strategy of monthly rebalancing of a portfolio of commodities you can grind out abnormal returns, until you rebalance into a string of losers.

Oil: Imagine, Something Called "The Goldman Sachs..." Didn't Do Well For Muppets

In this case the Muppets included $257.4 billion assets CalPERS (still down from Oct. '07 top-tick $260.6 bil). Here's a post from a while back:
October 2008 
Commodities: $50 bln in 'long-only funds' flees commods markets. And: Calpers says staying the course on commodities

...I am looking forward to CalPERS quarterly results. While the recent ugliness won't have an immediate impact on their ability to meet their promises to retirees, I'm guessing that it will end up being a good thing that they can make up any longer-term shortfall by taxing California residents. This could get serious.

Regarding the long only commodities "investors", look for a hit to Goldman's earnings. As proprietors of the GSCI they have at least half the "roll" business. Assuming 2% slippage (fees, spreads, commissions) on the $50 Bil. just removed from the markets and you have $500 mil. in gravy they won't get to put on their spuds....

We have a couple hundred posts on Goldman and the index buyers but we weren't the only ones. Here's Izabella from March 2009:
Oil: Beware the Rolls of March. And: Spreaders Heed Schork (USO)

Oil-invested index funds like the Dow Jones AIG commodity index, the S&P GSCI and the United States Oil Fund begin to rollover their positions from the April front-month WTI contract to the May one this Friday.....

And looking at the similar effect on the USO a month earlier:
U.S. Oil Trust Investigated by CFTC (USO)

Appropriately enough, here's Izabella with the latest.
From FT Alphaville:

How the dumb money was set up for commodity failure

Here’s a great chart from Emad Mostaque, a strategist at Ecstrat, a new research company set up by Mostaque and former head of EM strategy at Deutsche Bank John-Paul Smith:

As Mostaque explains, even though commodities are at double the level they were in 2003, any investors who assigned money to commodity GSCI products in that period on a total return basis may be sitting on zero returns.

In fact, the relative return of the S&P GSCI Total Return versus the spot index for the last decade shows an astonishing -12 per cent annualized “cost of ownership” on the roll yield up to the Arab Spring of 2011. This is a level far beyond that which would have been implied by the curve structures, he says.
As Mostaque further notes:

Indeed, even with energy commodities, which make up the bulk of the index in huge and unsustainable levels of backwardation since 2011, the total return index still hasn’t managed to achieve a reasonable roll yield. For investors this has been a painful experience and one would question why anyone would invest in a commodity index even if they believed in the story. This is likely to drive further definancialisation and improve overall market function, even if prices overshoot near term.

What’s worth bearing in mind, of course, is that much of this will have been a zero-sum game, meaning for all those who lost there were others who gained.

If the theory is correct, the sell-off we’re experiencing in commodities now could thus be part of a greater commodity definancialisation effect — the dumb money effectively figuring out just how they’ve been gamed and refusing to carry costs and losses further.

How this process came about, notes Mostaque, was through the well finessed practice of selling products linked to commodity indices to “real money” investors on the basis of three stories:

1. Emerging Markets would buy all the commodities in the world, presumably leading to a Mad Max type scenario eventually but riches for investors in the meantime

2. Commodity returns were uncorrelated with other asset classes, something highly regarded by those that followed the Yale Endowment Model

3. Commodities tended to normal backwardation, where the front end of the curve was above the back end, essential as investors would not own the physical commodities but rather the futures. By selling high and buying low investors would realize a nice gain on their positions even if commodities were flat

...MORE

Remember, there are only three places to get a profit in commodities:

1) The interest on your collateral
2) The roll yield
3) The change in price

If you are at zero or negative on the first two you had better be very good at figuring out number three.

Related:
"CalPERS fails to make money in commodities: John Kemp"
The GSCI is heavily weighted toward the oil complex, maybe not the place to be in a declining market.
Watch out for those fast-talking product pushers. 
 
Cassandra Does Alt Investing the CalPERS Way
This is beautiful..
From Cassandra Does Tokyo:

Valued Advice

Memorandum

To:         Bea Wethervane, Senior Consultant, Coxbridge Associates

From:     Hugh G. Shortphall, Florida University & College Teachers Pension Fund (FUCT)

Date:      31st May, 2013

Subject:  Hedge Fund Allocations

_____________________________________________________________

I've appreciated your valuable advice to our plan over the years. As you know, the path to changes in orthodox investment policy in a plan such as ours is often long and arduous, particularly when trustees and oversight committees are involved. Witness our struggle to add mortgage derivatives, or expand our equity allocations with a dedicated BRIC component which we finally received approval for, and implemented in 2007. Our campaign to add a GSCI Commodity Index component, as per your recommendation, was not easier, though with your help, we finally gained approval for and deployed it in mid-2008.  Your 2009 advice to implement a dedicated equity tail-risk program - one that we finally allocated to in Sep 2011 - was a big-step forward towards insuring our Board, Trustees (and plan members) could worry less about funding levels in the event of a market crash.

...MORE
See also "Public Employee Pensions Face Up to the Scam of 'Commodities as an Asset Class'"
and the FT in 2007 "Goldman Sachs and its magic commodities box".

Barron's Says "Time to Buy Commodities"

They've also said "time to buy oil and oil producers" for the last year, something we mentioned in February 24's "Wait For the ‘Second Low’ Before Buying Energy Stocks" (XLE; XOP):

After touting the hydrocarbon equities for the last six months, Barron's may have caught on to the fact that the decline in prices is a sea-change and that listening to some hipster analyst, whose long-term frame of reference maybe goes back to 2009 and who may not have the intellectual chops to figure it out, might prove dangerous to their readers.
XLE $80.34; XOP $51.69; WTI $49.17.
Good on Ben Levisohn for posting this, the first cautionary piece I can remember....

There were dozens of articles along the lines of December 20, 2014's cover story "5 Oils to Buy".

Two of those Buy rec's, Chevron and Schlumberger, are top three holdings of the S&P 500 Energy Sector ETF. Throw in EOG, the old Enron Oil & Gas and you have three of the top five. Here's how the ETF has performed:

FinViz

For most investors there is no need to call the bottom.

One of the problems a lot of analysts seem to encounter is understanding the long cycles of investment and capital destruction in commodities. Another conceptual problem folks have is grasping that the long term return on commodity futures investment is ~0%.

This is exactly the point on which Goldman et al screwed their idiot clients CalPERS et al when they introduced the concept of "Long-only commodity index investing".

Self-referencing again, mainly because I explicate so cogently (note the first sentence in this excerpt) here's 2010's:
Société Générale's Dylan Grice-"Commodities: ‘Their Expected Long-Run Real Return is 0%’

Well duh.
Commodities are for tradin' not investin'.
Which makes one wonder how CalPERS and the other big institutions got snookered by Goldman Sachs into being "Long-Only Index Investors".

Do you, gentle reader, think for one minute that Goldman's crown jewel, Alaron Trading, just buys and socks the stuff away?
Of course not. Alaron makes directional bets, both long and short, to take advantage of the movement.
To a competent trader, volatility is your friend.

In the case of the grains the darn things are mean-reverting.
If wheat doubles in price, the acreage devoted to wheat goes up and prices come down. The substitution effects at the producer level are predictable if not timeable:
better net profit for soybeans than corn? Beans it is boys!

In the metals and in energy the more important substitutions are at the user level. If a utility's cost of a BTU is cheaper when gas-fired, the coal orders slow down.
And over-arching everything is the point that Mr. Grice is making. Human beings are adaptable....

Anyhoo, all that being said, we try to remain alert to the possibility a countertrend trade could pop up at any moment.

From Barron's Cover:

Sentiment on energy and gold -- and oil and metals stocks -- may be nearing capitulation. Now is a good time to lean against the wind and start to buy.

It’s time to consider commodities. While the Standard & Poor’s 500, Nasdaq Composite, and other key equity indexes are near record levels, commodity stocks, including energy shares, are way below their peaks. Commodities are probably the most out-of-favor industry group in the stock market.  

“The commodities space represents great value versus the rest of the market,” says Roland Morris, a commodity strategist and portfolio manager at Van Eck Global, a New York firm with most of its investments in commodity-related stocks. “There has been no place to hide -- gold, industrial metals, and energy have all been weak. The underperformance versus the broader market has been dramatic. Unfortunately, he adds, “that doesn’t tell you when it will change.” 

Energy giants such as ExxonMobil (ticker: XOM), Chevron (CVX), and Royal Dutch Shell (RDSA) now trade at multiyear lows. Chevron has been hit hard after a disappointing earnings report in July. Down 24% this year, to a recent $85, it is the worst-performing stock in the Dow Jones Industrial Average. 

OIL HAS TUMBLED 25% since late June, to $45 a barrel, and is off 55% in the past year. Gold has dropped below $1,100 per ounce, down 8% this year and 43% below its 2011 high of $1,900 an ounce. Silver, copper, iron ore, and natural gas all are in bear markets, with “Dr. Copper” -- so-called because of its predictive value for the economy -- hitting a six-year low of $2.30 a pound last week. Iron ore, at about $55 a ton, is down 70% from its 2011 high. The energy-heavy S&P GSCI commodity index is less than half of its 2011 peak, and the Bloomberg commodity index is below its 2009 low.

The consensus view is that there is no rush to buy because commodity prices will be “lower for longer.” Reduced production costs are cutting break-even prices, and demand is being dampened by slowing economic growth in China and much of the rest of the formerly commodity-hungry developing world.

A strong dollar is helping commodity producers outside of the U.S., because their revenue is usually in dollars and their costs are in local currencies. Many say commodities won’t rally until the dollar weakens and the U.S. economy’s stronger performance compared with other developed countries makes the prospect of a dollar decline less likely. 

WHILE CALLING A BOTTOM is dangerous, we think it’s prudent to start adding commodities to your core portfolio at these prices. And we’re not alone in saying it’s time to lean against the wind.

“Investors finally appear to be capitulating on energy for the first time since energy prices started falling,” says Gina Adams, equity strategist at Wells Fargo Securities. “Investors had been trying to time a bottom and found themselves riding a steep downward slope.” She says the recent selloff could be a sign that a bottom is near. She also cites fund flows into energy and resources mutual funds, which have turned negative in recent weeks after steady positive flows earlier this year.

Says Scott Colyer, chief executive of Advisors Asset Management in Monument, Colo. “Now is the bottom of the commodity cycle. Nearly every central bank in the world is stimulating and trying to create inflation. That suggests it’s time to be a buyer of the asset class and not a seller.”

Others aren’t so certain. Goldman Sachs commodities analysts, who were correctly bearish earlier this year, remain cautious, writing in a report last month that what they call “the 3Ds” would likely keep a lid on prices: deflation in costs “following a decade of investment in commodity productive capacity”; divergence in growth between a stronger U.S. and the rest of the world, which lifts the dollar and pressures commodity prices; and deleveraging, as emerging economies focus more on balanced economic growth than on commodity-heavy expansion pegged to areas such as infrastructure spending and housing....MUCH MORE

Time to Buy Commodities

As is our wont when making our own predictions we'll give prices to make future comparisons easier, here are Friday's closing quotes. The GDX is the gold miners ETF:
Brent   $48.61
WTI     $43.75
Gold    $1093.30
Corn    $373'4
Wheat  $513'0
GDX     $13.40
XLE      $67.03

If interested take a look at "Classic Paper: Returns from Commodity Futures" from way back in 2008.

A couple other Barron's stories that got an "It's too early" (our catch-phrase for most of the decline) but have plenty of names when the time is right:
Feb. 2015
It’s Not Too Late to Buy These Stocks for an Oil Recovery
Feb 2015
Oil Prices: Four Experts Size Up the Energy Market

Finally an interesting little basket of stocks:
Commodity Producers Still Struggling (CRBQ) 

Cassandra Does Alt Investing the CalPERS Way

This is beautiful..
From Cassandra Does Tokyo:

Valued Advice

Memorandum

To:         Bea Wethervane, Senior Consultant, Coxbridge Associates

From:     Hugh G. Shortphall, Florida University & College Teachers Pension Fund (FUCT)

Date:      31st May, 2013

Subject:  Hedge Fund Allocations

_____________________________________________________________

I've appreciated your valuable advice to our plan over the years. As you know, the path to changes in orthodox investment policy in a plan such as ours is often long and arduous, particularly when trustees and oversight committees are involved. Witness our struggle to add mortgage derivatives, or expand our equity allocations with a dedicated BRIC component which we finally received approval for, and implemented in 2007. Our campaign to add a GSCI Commodity Index component, as per your recommendation, was not easier, though with your help, we finally gained approval for and deployed it in mid-2008.  Your 2009 advice to implement a dedicated equity tail-risk program - one that we finally allocated to in Sep 2011 - was a big-step forward towards insuring our Board, Trustees (and plan members) could worry less about funding levels in the event of a market crash.

...MORE
See also "Public Employee Pensions Face Up to the Scam of 'Commodities as an Asset Class'":

Wow.
In 2007-2008 Goldman and the other banks went forth and proclaimed commodities an asset class, basing the pitch on the move over the prior five-six years of most commods (if I recall correctly, gold bottomed at $252 in the Spring of 2001).

The so-called investment professionals at the behemoth funds (CalPERS topped out at $260.6 billion before getting their butts kicked), along with University endowments thought this was the easiest money they would ever make. Commodities are only going to go up and here was Goldman Sachs touting "Long-only Index Funds" In Goldman's case the index was their very own GSCI but if the index "investing" didn't give you enough action the pensions could evade position limits by entering into swaps deals to piggyback on Goldie's designation as a "commercial".

Good times. More below the jump....MORE

Or a hundred others, all timestamped:

"CalPERS fails to make money in commodities: John Kemp"  

"Harvard and Stanford Nearly Make Up Financial Crisis Losses" (CalPERS still playing catch up)

FAIL: CalPERS Posts 1% Return for Fiscal Year Ended June 30, 2012.

Pension Funds Drive Growth Of Alternative Assets. And: CalPERS Up 68% on Commodities; Down 31% on Real Estate. Action, Baby, Action!
Stat du Jour: "99% of pension funds outperform CalPERS"
CalPERS Playing with Fire
 From our Oct. 26, 2008 post, "Calpers Sells Stock Amid Rout to Raise Cash for Obligations":

This is hedge fund behavior, selling your most liquid investments to prop up the illiquid....

Commodities: $50 bln in 'long-only funds' flees commods markets. And: Calpers says staying the course on commodities