Commodity "investors" redux

Moming Zhou over at MarketWatch files this report on a subject that regular readers know is near and dear to my heart - commodity "investors" and the imminent persecution of this group by the CFTC (Commodity Futures Trading Commission).

Recall that in Commodity investors: speculators or hedgers? from last week, the question was asked whether long-term investors in hard assets such as crude oil and corn weren't more "hedgers" than "speculators".

The fact that this group is hedging against a currency decline rather than for a business enterprise that produces or consumes a commodity has apparently been unimportant to the CFTC thus far ("investors" are currently classified as "speculators"), however, it's possible that this may change as a result of hearings that are being held this week.

What's interesting about Moming's report is that this argument - hedging against a currency decline - was made some 18 years ago when position limit sizes were first relaxed.

The entire article is worth a read, including details of how commodity trading factors into Goldman Sachs' profit machine and some assorted historical tidbits, but skipping right to the part about "hedging by investors" shows that what appeared here last week, while original, was almost two decades late to the game.

To wit:

At the crux of the debate are the so-called commodity index investments, the total value of which has been estimated by MarketWatch at about $150 billion. See earlier story on the analysis.

The business started in 1991, when Goldman advised a big pension fund to invest $100 million in commodities by tracking the widely followed GSCI, as the Goldman Sachs Commodity Index has come to be known.

The investment was essentially a bet on the index: If the index rose, Goldman would be required to make payments to the pension fund. To protect itself against the risk, Goldman, through its commodities-trading arm J. Aron & Co., planned to establish similar buying positions in commodities futures markets.

If commodity prices rose, Goldman's gain in futures markets would offset the payments it had to make to the pension fund.

The so-called swap plan had a major obstacle. Federal rules limit the number of positions a trader can take in some agriculture commodities, such as corn, wheat and soybeans.

While no limits were set in other commodities, the agricultural limits would sabotage the whole swap plan, since index investment covers a range of commodities and a limit in one represents a limit in the whole investment plan.

J. Aron applied for an exemption, arguing that the firm should not be treated as a speculator but as a "bona fide hedger" -- a classification usually reserved for farmers, processors or food producers that enter the futures market to hedge their risks in physical commodities trading.

The CFTC, in a letter to J. Aron dated on Oct. 18, 1991, granted J. Aron the exemption. A copy of the letter was obtained by MarketWatch. See the CFTC letter.

Similar exemptions were granted to other swap dealers, most of them big investment companies.

With the help of swap dealers, more institutional investors have diversified their portfolios into commodities to hedge against inflation and a weaker dollar. Their positions have grown so large that legislators and analysts said the trend was pushing commodity prices to levels that couldn't be justified by fundamentals. See earlier story on passive investment.

While the feeling of being aligned with Goldman Sachs in an instance like this is quite odd indeed (particularly since Goldman traders are said to exploit the company's own clients by "front-running" the futures contracts roll for the commodity index fund every month), there is a legitimate point to be made here about investing for the long-term and hedging against a decline in value of paper money during a secular bear market for equities.

Hopefully, the CFTC will address this point in some way during their hearings.