If Cushing, Oklahoma's oil storage facilities are filled to capacity, why are gas prices rising? Because it's not scarcity that's driving up the price of crude - it's Wall Street.

Wonder why Obama is investigating speculation in commodity markets? Here's a primer.

Here we go again.

The wizards of Wall Street have figured out that it’s a lot easier to make a buck off of basic needs—commodities—than corporate paper, and they are fueling another commodities bubble that is pushing millions of people around the globe into poverty and despair. Not content with destroying America’s housing market, they are now forcing us to pay higher prices for gas and groceries.

It’s a Wall Street tax.

The mainstream business press would have us believe higher prices are being driven by the specter of Parson Malthus, who argued more than 200 years ago that food production could not keep pace with population growth. Wall Street analysts describe a “super cycle” in commodities being driven by growth in emerging market economies like Brazil, India, and China. While true to a certain extent, the facts are that the current upward trend in prices and increased volatility is mainly fueled by speculative investment activity from Wall Street. There’s nothing like a good bubble for Wall Street profits, and there’s nothing like profiting on the things people need. From 2000 to 2008, financial flows into commodities increased from $10 billion to $270 billion—an increase of over 2,500 percent! And these same forces that pushed oil and food prices up in 2008 are driving the current commodity bubble.

Recognizing this hot-button issue at the start his next election cycle, President Barack Obama announced he would appoint a taskforce to investigate possible speculation and fraud in the commodity markets. But they won’t find any devious manipulations. Instead, they will find financial alchemy and relaxed regulations which have financialized the commodity markets. Essentially, new financial instruments have allowed investors to circumvent restrictions and profit directly from the price increases in oil and other basic foodstuffs, and the more money that flows in, the higher prices go.

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Historically, there were only three ways to bet on commodity price increases. First, one could directly buy and store the good itself. For most people, this was limited to precious metals like silver or gold. Second, one could buy a futures contract on a commodity like oil which increases in value as the price of oil increases. A third, but indirect way, was to buy shares in the companies that grow/raise/mine products, because higher commodity prices lead to higher profits and therefore higher stock prices. It’s in the futures market where Wall Street alchemists have created instruments that make it easier for anyone to bet and profit from increases in commodity prices.

Futures markets, like the Chicago Mercantile Exchange (CME), were created to allow farmers and merchants to protect themselves against price movements. A futures contract is an obligation by the seller to deliver (or take delivery if one is a buyer) a given quantity of wheat (5,000 bushels, for example) at some point in the future (say, six months) at a price determined today (say $2/bushel). Rather than worry about what prices will be at harvest time, farmers can lock in a price today by selling futures contracts at the time they plant their crops. Note, in this example, the total value of the contract is $10,000 ($2 times 5,000 bushels), but the farmer is only required to put up about five percent of the value as collateral ($500 in this case), known as margin. With margins so low, futures markets naturally attracted speculators.

Here’s an important point: Speculators have always been welcome participants in futures markets because they provide liquidity—they make it easier to buy and sell contracts. However, since commodity markets are significantly smaller in size than other asset markets, they are easier to manipulate. Because of this, speculators were limited in the number of contracts they could hold, known as position limits. This was done to ensure that fundamentals—the underlying supply and demand from producers and consumers—determined commodity prices, not speculative activity. Note also, that true speculators make bets on price movements up or down.

While a futures contract obligates a seller to deliver or a buyer to take delivery of a product, in practice, it rarely happens. Speculators certainly don’t want the product, they want cash profits. The majority of all contracts are closed before expiration with what’s known as an offset transaction. While it’s a bit more complicated, in effect someone speculating on rising prices initially buys a futures contract, then sells it before it expires, eliminating the requirement to take delivery.

So here’s how futures markets are supposed to function: Producers like wheat farmers and oil drillers sell futures contracts to lock in prices for the month in which they expect to sell their product; buyers like grain merchants and refineries buy the contracts to lock in the prices they will pay for the goods; and speculators bet on either side of the market, providing liquidity (additional buyers and sellers), but with position limits that restrict their influence on prices. Given these restrictions, futures markets worked relatively well for over a hundred years.

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Things started to change in 1991 when Goldman Sachs (the usual suspect) created a commodity index (called the GSCI) to track the price movements in a basket of 24 commodities, with the majority of the index (78 percent) made up of energy-related goods like crude oil and natural gas. The important point is that the value of the index was based on futures prices of the commodities it included.

It wasn’t long before Wall Street created investment products related to the GSCI. First, the CME started trading futures contracts on the GSCI itself, so now a speculator could bet on the direction of commodity prices in general. This was all well and good, because speculators were still constrained by position limits.

Next, Goldman started selling something called commodity swap agreements on the GSCI which allowed hedge funds and other big investors to bet on its increase. More importantly, Goldman sold these swaps directly to hedge funds, not on a formal exchange like the CME. (Direct trading between players is affectionately known as the over-the-counter—OTC—market.)

Here’s how it works. For a fee, Goldman sells a GSCI swap agreement to a hedge fund, which requires Goldman to pay the hedge fund for any increase in its value. This leaves Goldman “exposed” to price increases on the GSCI, so Goldman “covers” its position through buying GSCI futures contracts on the CME. As the GSCI increases, Goldman has to pay the hedge fund, but it does so with profits it makes on the futures contracts. Goldman has eliminated its risk, and it makes money on the swap fees.

So why doesn’t the hedge fund simply buy futures contracts on the GSCI? Because of position limits. But what about Goldman and position limits? Goldman goes to the regulators, the Commodity Futures Trading Commission (CFTC), and applies for “waivers,” arguing that they are “hedgers,” not speculators. Goldman argues it isn’t taking speculative positions, it is hedging the swaps it sells directly to hedge funds, pension funds, and other investors. The CFTC agrees, and provides Goldman with waivers on position limits, which means they are free to sell as many swaps (and therefore buy as many GSCI futures contracts) as the market dictates.

This is a hugely significant innovation. If the hedge fund directly used the futures market to bet on commodities, it would have position limits; but in using OTC swaps from Goldman, there are no position limits on either firm. The hedge fund is no longer restricted in the number of bets it makes, which means speculative investment flows will have a greater impact on prices.

Now all of this is happening before 2000, which is when futures-related commodity investments really start to take off. So what else changed? While the money flows going into commodities is growing, things don’t really pick up until a couple of academic researchers publish a paper in 2004 that shows how a “passive” investment in commodity futures is negatively related to other assets. This means when stocks go down, commodity investments rise, stabilizing returns and lowering risk—a portfolio manager’s dream! Now big institutional money begins to flow, and the Wall Street banks are cashing in on the swap fees.

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There’s still one more important (and complicated) piece to the puzzle. At any given point in time, futures contracts are offered from one month to several years into the future. Under normal conditions, the future price of a commodity like oil will be less than today’s price, known as the spot price. When the spectrum of futures prices is lower than the current spot price, the markets are said to be in normal backwardation. This tends to be the “normal” situation because a lower (than spot) futures price is necessary to entice buyers to take the risk in paying for a good today that won’t be delivered until some point in the future.

However, sometimes, the spectrum of futures prices, relative to the spot price, is rising, and markets are said to be in contango.

Contango markets create a riskless profit opportunity for those who are able to buy a commodity in the spot market and store it over the life of the futures contract. For example, suppose the spot price of crude oil is $100/barrel and today’s futures price for delivery in six months (you can choose any time period offered by the futures market) is $105/barrel. In this situation, if the cost of storing oil for six months is less than $5/barrel—let’s say $2/barrel—then one can buy oil spot ($100), simultaneously sell the futures contract ($105), store the oil for six months, and make $3/barrel of risk-free profit. This arbitrage process is also what helps connect spot prices to futures prices, so if futures prices are rising, the spot prices will be pulled up along with them.

Historically the big grain merchants and oil firms were the only ones with storage facilities that gave them the capability to profit from contango, and it is surprising that it took so long for Wall Street to learn about this game, but learn they did. Since the mid 2000s, Wall Street banks have been investing in companies that transport and store commodities, “These days, the Wall Street banks are more like those grain traders than you might think,” Business Week reported last July. “They have equipped themselves to take delivery of raw materials when they choose to…Goldman owns a global network of aluminum warehouses. Morgan Stanley (MS) chartered more tankers than Chevron (CVX) last year.”

In other words, Wall Street banks are now commodity traders.

But it takes two to contango, and Wall Street needed chumps who would blindly increase demand for futures contracts. Enter the Exchange Traded Fund (ETF). An ETF is an investment product that is a hybrid of mutual funds and stocks. A mutual fund buys assets and sells “shares” to investors that can be bought/sold at the end of each day; an ETF buys a fixed bundle of assets, and sells shares which can be traded during the day like a stock.

The first commodity ETFs were created around 2001-2002 to invest in gold and silver. In the mid 2000s, ETFs were being created for any and all commodities, including indexes like the GSCI. Here’s how it works. A big Wall Street bank buys 5,000 June 11 futures contracts on West Texas Crude at $100 each, and each contract requires taking delivery of 1,000 barrels of oil. The total value of the investment is $500 million: 5,000 contracts times 1,000 barrels times $100. The bank then issues and sells, say, 10 million ETF shares, the value of which will trade for around $50/share: the $500 million value of the futures contracts divided by 10 million shares. The value of the ETF shares are supposed to increase as the price oil increases, which increases the value of the underlying futures contracts.

But there’s a catch. Since futures contracts expire, the managers of the ETF have to sell the contracts before expiration, then buy new contracts, which is known as the roll period. In steep contango markets ETFs can actually lose value from the roll, as the fund sells expiring oil contracts for, say, $102, then buys new ones at $105. They are selling low and buying high! This is why a Business Week headline called commodity ETFs “the worst investments in the world.” But they did serve their purpose for Wall Street.

Finally, just like a commodity swap agreement, the bank or mutual fund that creates and sells a commodity ETF is buying futures contracts to meet the obligations of the ETF shares, so they are classified as hedgers, exempt from position limits. Voila! Now anyone can speculate directly on the price of commodities by buying a share of a commodity ETF. And just like the swap agreement, this new product has eliminated position limits on the underlying futures contracts. Banks can sell as many ETFs (and therefore buy as many futures contracts) as the market dictates.

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Okay, if you’ve made it this far, here’s how the Wall Street commodity Ponzi scheme works. Commodity ETFs and swaps allow investors to circumvent position limits on futures contracts. As more money flows into these investments, the demand to purchase futures contracts increases, which increases their price, which increases the spot price of the underlying commodity. As more money flows in, prices will go higher.

Wall Street banks are also on both ends of the action. They generate fees by selling ETFs and swaps to investors, which requires them to buy futures contracts to hedge those obligations. As more money flows into these commodity investments, it creates contango markets because it increases the demand from more ETFs and more futures contracts backing them. On the other side of the market, the commodity trading arms of the big banks are buying oil spot, storing it, and selling futures contracts for a risk-free profit. The more they hype oil and commodities in general, the more they make on both ends.

This is essentially what Wall Street banks did in 2008 as they were literally hemorrhaging from the collapse of the housing bubble. Hmmm…need to make a quick buck, but where? Commodities! Normally the price of oil tends to be a bit higher in summer and trend down in fall, but after hovering around $70/barrel throughout the summer of 2007, the price of oil started a climb that peaked in July 2008. Certainly there was growing demand from emerging markets, which provided a nice cover story, but it was the flow of money into commodity swaps and ETFs by institutional and retail investors alike which was the main driver of prices. This speculative bubble was ended by the global recession, as the price of oil fell from a peak of $145/barrel in mid July 2008 to $35 in early 2009. Price swings that big certainly aren’t driven by so-called fundamentals.

The current oil price spike is being blamed on turmoil in the Middle East and North Africa (affectionately known as MENA) which is supposedly disrupting the supply of oil, causing gas prices to exceed $4/gallon. However, oil storage facilities in Cushing, Oklahoma, one of the largest in the US, are at capacity—it’s awash in oil. Why? Because contango markets make it profitable to buy and store oil, which is exactly what the big players, including Wall Street banks, are doing. Supply is not the problem. It’s the huge flow of speculative money betting on oil, and other commodities, causing increased prices and greater volatility. And, as I argued in a previous piece (“Paging Dr. Bernanke,” Artvoice v9n44), the Fed’s QE2 bond-buying program has added fuel to the fire by raising inflationary expectations, causing investors to put even more money into ETF commodity investments, thus creating a self-fulfilling prophecy.

Wall Street banks have taken control of the futures markets, and the regulators have let them. They make more money when markets are rigged to function more like casinos rather than providing the true economic function of price hedging. Speculative investment flows are the major influence on commodity prices now, and the more money that flows in, the higher prices go, and the more profits Wall Street makes.

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What can we do? Without regulation and position limits, there are only two limiting factors to this game. First, like any Ponzi scheme, the bubble bursts when money inflows stop or decline. The second is related to what economists call the price elasticity of demand, which is a measure of how sensitive demand is to a price change. Things that we need like oil and foodstuffs are said to be inelastic, which means demand doesn’t fall much when prices rise. However, at some point, high enough prices will cause us to change our behavior, like ride bikes or switch to foods that are cheaper. There is a tipping point that will cause demand to drop significantly, and the game will be over in a market that already has a glut of product in storage.

Obama’s taskforce won’t find any wrongdoing because the rules have been changed to meet the needs of investors, not producers and consumers. In fact, the taskforce isn’t really necessary because the CFTC, having taken testimony for the past few months, is about to pass new rules regarding more stringent regulation of the futures markets—like position limit rules and more transparency in trading. This is where the battle will been won or lost for consumers, and of course Wall Street is fighting against the more stringent regulations.

Here’s what has to happen. We need to turn back the clock and ban the products that have allowed huge investment flows into commodities via futures markets which directly impact the prices of goods. It doesn’t take an economist to explain what would happen to prices if the current $400 billion in bets made via the futures markets were reduced to $50 billion. Besides, there are other less pernicious ways for investors to bet on the things we need for survival—simply buy the stocks of the companies that produce things. Higher stock prices won’t kill us, but higher food prices are starving millions. According to World Bank president Robert Zoellick, since June, higher food prices have pushed another 44 million global citizens into poverty.

Unfortunately, the odds are that Congress and regulators will do what their Wall Street masters dictate. In that case, the only alternatives we have are to buy a bike or buy the farm.

Dr. Ted P. Schmidt is an associate professor in the Department of Economics and Finance at Buffalo State College.