Are Index Investors Driving Up Commodity Prices?
By Michael W. Masters

You have asked the question "Are Institutional Investors contributing to food and energy price inflation?" And my unequivocal answer is "YES." In this testimony I will explain that Institutional Investors are one of, if not the primary, factors affecting commodities prices today. Clearly, there are many factors that contribute to price determination in the commodities markets; I am here to expose a fast-growing, yet virtually unnoticed factor, and one that presents a problem that can be expediently corrected through legislative policy action.

Commodities prices have increased more in the aggregate over the last five years than at any other time in U.S. history.¹We have seen commodity price spikes occur in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today, unlike previous episodes, supply is ample: [T]here are no lines at the gas pump and there is plenty of food on the shelves.

If supply is adequate—as has been shown by others who have testified before this committee²—and prices are still rising, then demand must be increasing. But how do you explain a continuing increase in demand when commodity prices have doubled or tripled in the last 5 years?

What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.³

These parties, who[m] I call Index Speculators, allocate a portion of their portfolios to "investments" in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as "Index" Speculators because of their investing strategy: They distribute their allocation of dollars across the 25 key commodities futures according to the popular indices—the Standard & Poor's - Goldman Sachs Commodity Index [S&P GSCI] and the Dow Jones - AIG Commodity Index.⁴

I'd like to provide a little background on how this new category of "investors" came to exist.

In the early part of this decade, some institutional investors who suffered as a result of the severe equity bear market of 2000-2002, began to look to the commodity futures market as a potential new "asset class" suitable for institutional investment. While the commodities markets have always had some speculators, never before had major investment institutions seriously considered the commodities futures markets as viable for larger-scale investment programs. Commodities looked attractive because they have historically been "uncorrelated," meaning they trade inversely to fixed income and equity portfolios. Mainline financial industry consultants, who advised large institutions on portfolio allocations, suggested for the first time that investors could "buy and hold" commodities futures, just like investors previously had done with stocks and bonds.

Index Speculator Demand Is Driving Prices Higher
Today, Index Speculators are pouring billions of dollars into the commodities futures markets, speculating that commodity prices will increase. [Figure 1] shows Assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March 2008,⁵ and the prices of the 25 commodities that compose these indices have risen by an average of 183% in those five years!⁶

According to the CFTC and spot market participants, commodities futures prices are the benchmark for the prices of actual physical commodities, so when Index Speculators drive futures prices higher, the effects are felt immediately in spot prices and the real economy.⁷ So there is a direct link between commodities futures prices and the prices your constituents are paying for essential goods.

[Figure 2] looks at the commodity purchases that Index Speculators have made via the futures markets. These are huge numbers and they need to be put in perspective to be fully grasped.

In the popular press, the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels.⁸ Over the same five-year period, Index Speculators demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

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