Agsight: CFTC vs. ETFs - Agriculture Takes The First Hit
09/15/2009 08:50AM
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So much for idle threats. The CFTC made good on its pledge to move swiftly and decisively to reign in index funds. For example, representative comments made by CFTC Commissioner in an interview with Carl Quintanilla on CNBC’s Squawk Box: “Last year we didn’t have complete data…and secondly I think we spun it to say that speculators had no influence…[this year] we’re not going to minimize the role speculators are playing.” That sentiment parallels findings of a recent Senate report (Excessive Speculation in the Wheat Market), that asserts that, “…there is significant and persuasive evidence to conclude…activities of commodity index traders, in the aggregate, constituted “excessive speculation” in the wheat market under the Commodity Exchange Act.”
Action by the CFTC wasn’t unexpected; after all, the CFTC broadcast its intentions well ahead of time (as introduced in last month’s AgSight). However, the chosen route was unexpected. It was widely anticipated the CFTC would first move in the energy arena. In fact, several key funds have anticipated such action – all energy related – and announced intention to halt issuance of new shares in the future including U.S. Natural Gas Fund (UNG), iPath Dow Jones-UBS Natural Gas Subindex Total Return ETN (GAZ), and PowerShares DB Crude Oil Double Long ETN (DXO).
The CFTC didn’t focus there. Rather, several important agriculture funds found themselves being the target of new limits on exchange traded funds (ETFs). The Commission revoked position limit exemptions in wheat and corn for two Deutsche Bank AG PowerShares commodity funds (Commodity Index Tracking Fund – DBC, and the DB Agriculture Fund – DBA, the largest agricultural ETF). Such limits will become effective at the end of October.
To be objective about index funds it’s useful to provide some basic review of their unique characteristics. First, they are passively managed and operate within a predefined framework. For example, the base allocation for DBA is equally weighted across four separate commodities: corn, wheat, soybeans, and sugar. (Current weightings at end of August were approximately 18, 25, 37 and 20 percent, respectively. Under normal circumstances funds will regularly reallocate investment funds to get back in line with the initial index strategy.) Second, index funds operate without financial leverage. Third, and most importantly, commodity ETFs typically assume “long-only” positions in the market; the focus is on the buy side.
And therein lies the predominant concern about index funds; there’s a pervasive perception that index funds, because of their persistent long position, are artificially driving markets to unprecedented levels, not to mention trepidation about excessive market volatility and problems surrounding convergence.
Lots of resources have been committed to studying the issues and outcome of index fund influence upon the commodity markets. My intention is to provide some overview of that research in coming months. In the meantime, though, Adam Sieminski, Chief Energy Economist Deutsche Bank, summarized the situation in a recent interview (Bloomberg on the Economy, August 3). Mr. Sieminski discussed various factors driving the oil market leading up to last summer’s peak – they include global economic growth, supply challenges, absence of OPEC spare capacity, shortage of refining capacity and weakness in the U.S. dollar. He then explained the impact of the recession upon global oil demand and reason for oil’s sharp reversal during the summer of 2008:
When incomes go into the tank there’s a much, much faster response of consumers to demand. When prices go up people look for ways to save a little here and there and they’ll make some minor changes. But if you lose your job, if your income goes down you just stomp on the brake right then and there and that’s why demand plummets.
Fair enough, but what’s ultimately important here is influence (or perception thereof) of ETFs and speculation upon the oil market; Sieminski’s response is as follows:
I think that can make a difference in the short run but it doesn’t seem to me that ultimately sets the price. We can look at the Deutsche Bank suite of index products (ETFs and ETNs) – so we know these numbers are right because they’re our own internal figures - and there’s more money in the ETF and ETN products now than there was last July, yet oil prices are half of where they were last year and natural gas prices are really in the tank. So if it was speculators and all the flow of money into the exchange-traded funds and so on that was driving up oil and gas prices up last summer, why isn’t it having exactly the same or even a bigger impact this year? My answer is it’s the fundamentals. It’s really supply and demand economics that make the biggest difference ultimately to the price.
Last month I addressed political impetus surrounding policy decisions going forward. Unfortunately, a bulk of coverage relative to the issue proves to be strictly emotive and/or reactive. And that provides rationale for many to vilify large index funds for any price move that doesn’t go your way. The outcome of that approach is inaccurate assessment of the functioning of futures markets (price discovery and risk management) and the role of various players within that framework. But even more important here are the implications! That is, the potential for unintended consequences upon market participants (including consumers!) of further regulation.
That issue was recently addressed by Dave Nadig, Associate Editor, and Matt Hogan, Editor-in-Chief in the August 10 Hard Assets Investor podcast. The two discussed overarching misperceptions about the role of ETFs. Mr. Hogan argues added restrictions by the CFTC will ultimately divert funds to less regulated exchanges and for investment firms to drive:
…legitimate hedging business overseas to other markets with different regulations, it’s going to drive it essentially underground – these are going to be bilateral swaps that are extraordinarily difficult to regulate. And now what you end up doing is creating this giant counter-party house of cards which right now, blissfully, ETF’s are largely devoid of. We don’t really have to worry so much about who’s on the other side of your ETF.
And so where does that leave us?
The CFTC has proclaimed its obligation to “protect the American public from fraud, manipulation and excessive speculation”. Clearly, further position limits are pending. Meanwhile, other index funds will likely limit issuance of new shares (investment) in the coming month (the most recent example being Deutsche Bank’s double-long oil fund – DXO, Sept 1).
That type of response curbs investor interest and ability to participate in futures markets. Clearly, the immediate outcome is reduced liquidity in the market. Secondarily, CFTC action has introduced “tracking error” into consideration: the spread between fund value and the underlying investment. Regardless, agricultural producers and end-users need to monitor and understand potential developments which derive from further regulatory moves by the CFTC. It could potentially mean diminished opportunity for active, viable price discovery. And risk management becomes more difficult in that environment.
This will continue to shake out in the months to come. Next month we’ll pick up with some basic premise and principles of future markets for further perspective.
Source: Nevil C. Speer, PHD, MBA, Western Kentucky Unversity