Can anyone explain how the index commodity funds stay long without taking delivery?

Discussion in 'Economics' started by vedantatrader, Jul 2, 2008.

  1. I m wondering if anyone can explain to me how these long "only" index commodity funds that are being blamed for the push up in oil price futures get around the delivery function of the commodity at the end of the future contract.

    I m one who does not believe that commodity prices are being pushed higher by speculators. I believe the price rises are down to...

    1. No meaningful way to increase daily supply due to inability of the to bring new supplies online fast enough. By the time the new supplies have been brought online, then the existing fields will be past peak production. So yes maybe there is alot of oil, however, this doesn t mean the daily production can meet daily demand

    2. I believe that the trends in future demand in the medium and longterm are rising. Some analysts tout the reason that demand destruction will occur. However, I believe that for countries like CHina the yuan will increase 4 or 5 fold which will increase to higher spending power per capita. Oil will become relatively cheaper in the future as the yuan appreciates which wil increase demand. I also believe this to be the case when the rest of the dollar pegged countries los faith in dollars and let their currencies appreciate.

    3. A monetary phenomenon, by the FED and Mr Bernanke. They talk a game of a strong dollar, but one only has to read his economic works that exist at the FED. His academic papers suggest he will do anything to prevent deflation...So, I think the perception of Bernanke as someone who will not credibly raise interest rates is leading to cash flowing into tangible assets such as gold and commodities which act as a store of value.

    4. Inelastic pricing of oil. Small increases in demand or small reductions in supply lead to proportionally larger moves in price. Example, a 1% reduction in supply can lead to a 7% price increase.

    as an example, this is what Bernanke wrote in an academic paper in 2002...

    "The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

    What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

    To me this is someone who has nutbar monetary policies. This seems like someone who will try to inflate the debt away.

    So my qustion is this, to all you guys who really understand the pricing and contract terms in futures.

    How do the index speculators avoid taking delivery of the oil. My reasoning would be that they would sell the oil near the end of the contract leading the price to revert back to a lower price. This is not happening which leads me to believe that speculation is not the culprit in the price rises, and if it is the price would fall when they sell to the hedgers who are taking real delivery of the oil and actually consuming it.

    Can anyone explain to me how index can hold commodity future contracts without taking delivery? Would love a good answer to this.

    Thanks inadvance.
  2. Seems to me they could keep rolling them over.
  3. While the expiring month price ends, the future months' prices take over.

    Thus it is the instantaneous demand of what is the current operable contract price that matters, thus the price is somewhat autoadjusting because the contract holders are investors not traders. This segment may hold these positions for years or months, and represent a constant demand.

    The fact that the label changes is moreless irrelevant.
  4. Ah, I see, thank you. That leads me on to the next question. However, even though these investment indexes are holding long contracts and rolling them over, surely the supply is still being consumed and the demand is still there. If world demand decreased, and the supply increased, surely this would be reflected in the prices falling...and the indexes would lose money. After all, any index can go down...

    I m still on the side that the index speculators are long for a reason, ie, supply and demand, and monetary phenomenon.

    Anyone else got a view? Is this just scapegoating?
  5. Many index speculators, pension funds especially, are not long because of oil's fundamentals. They are long because a growing body of academic research based on the last 3 or 4 decades of data has suggested that a portfolio with say 10-20% invested in commodities futures both increases portfolio return and lowers risk. The reason is that commodity futures have decent returns (a lot higher than bonds, not quite as high as equities) and yet are *negatively* correlated to equities and bonds. In other words, during environments when both bonds and equities get hit, commodities tend to perform well. This makes them a great portfolio diversifier when used in moderate amounts, raising the efficient frontier and thus giving the "free lunch" of higher returns with lower risk.

    That's why so many pension funds have put money in, and why Congress is making such a bad mistake trying to reverse this in a heavy-handed fashion (some guidelines may be ok, but not a blanket hostile ban IMO).

    Now, the fact that commodities are in a raging bull market I'm sure has not exactly dissuaded pension funds from getting in on the act. But there are sound reasons for having some commodities in a pension or any other buy & hold portfolio.

    The problem of course is that if enough investment money goes in, without regard to the fundamentals and valuation, then there is a serious risk of an eventual bubble. We saw it with passive S&P indexing in the late 1990s. Because index funds by mindlessly, with NO regard to valuation whatsoever, eventually they were piling huge amounts of money into absurdly overvalued S&P blue chips and techs. This contributed mightily to the bubble in big caps. The S&P and nasdaq from 2000 then massively underperformed stocks outside the indices for years.

    If something similar affects commodities (which it probably will in a few years, absent any legislation or industry common sense), then you'll get a giant speculative bubble and it will be time to sell or go short. But I doubt we are there yet, the sums committed so far are not really big enough.
  6. But the commodities markets shouldn't be a place for investors to put their money. It's a place for speculators to determine tomorrow's prices. Most commodities are perishable too. It's stupid to have long term investors in commodities markets.

    I would agree that either there's a limit to how much rollover you can do or to who can or cannot speculate in the market.