KBC: Index funds lift oil prices

Sam Fletcher
Senior Writer

A growing market force is floating crude prices above levels justified by the simple fundamentals of supply and demand, said analysts at KBC Market Services, a division of KBC Process Technology Ltd. in Surrey, UK.

In an Aug. 3 report, KBC analysts asked, “How can it be that $60/bbl was justified when supply was trailing demand in the period 2004-06 and [is again] justified today when supply is so greatly exceeding demand?” As they astutely pointed out, “Something has clearly changed in the energy market.”

The primary change they see is “the rapid inflow of cash from index funds that, beginning in 2004, have greatly increased their energy market exposure.” KBC analysts said, “This cash is coming from passive index funds that now dominate, but do not entirely dictate, global energy prices.”

Index funds are not among the speculators now being damned before Congress for jacking up oil prices for fun and profit. Administrators of index funds “care little for the absolute price of oil; professional money managers seek only the benefits that the commodity energy market offers in terms of their overall portfolio of investments,” the analysts explained. However, they said, “Through their dominant size, and because they are always net buyers, all of the petroleum commodity instruments have moved higher in price to accommodate the significant incremental demand for oil represented by these index funds.”

Assuming current oil market fundamentals justify a crude price of $30-40/bbl, KBC analysts estimate the market impact of index funds, together with more active participation in oil futures markets by the large hedge funds, may add $30/bbl.

“We believe that the activity of financial investors has exerted a strong upward bias on crude oil prices that is essentially permanent—provided they remain in the market,” said KBC analysts. “Furthermore, the ‘long’ only nature of the index position leads to a strong ‘contango’ bias time curve. The fact that these investors are required to indefinitely roll their positions by selling near term and buying further out has not escaped notice. The ‘zero sum’ nature of the market is only too willing to profit from these monthly costs for just as long as the index investors are willing to pay for that privilege.” The indices put similar upward pressure on prices in the gasoline and heating oil markets.

CFTC hearings
Responding to changing political winds, a new proactive administration, and the consequences of high energy prices in 2007, the Commodity Futures Trading Commission has clearly signaled its intent to review and revise market regulations. KBC analysts said, “As Congress and the CFTC begin this period of comment and likely change to commodity regulations, we suggest a measured response. It is unlikely there will be any meaningful change to a very significant inflow of index funds without a change in position limits. However, that is precisely what the chairman [Gary Gensler] is focusing on.

The CFTC had hearings July 28-29 concerning the roles of a variety of participants in various commodity markets. The third and last hearing was scheduled Aug. 5. In the earlier hearings, witnesses warned adoption of too strict regulations could damage the futures markets. Some participants said speculation should not be blamed for the big changes in energy prices.

“We have not seen empirical evidence that index funds and speculators distort prices, as has been widely alleged, nor is there any proof that putting position limits on these market participants will have any positive effect,” said Craig Donohue, chief executive of CME Group, the parent company of the New York Mercantile Exchange, the Chicago Mercantile Exchange, and the Chicago Board of Trade. “We are deeply concerned that inappropriate regulation of these markets will cause participants to move to dark pools and other unregulated markets, causing irrevocable harm to the entire US economy” (OGJ Online, July 28, 2009).

Testifying for the Air Transport Association of America, Ben Hirst, senior vice-president and general counsel for Delta Airlines, said, “The objective should be to allow sufficient speculation to provide sufficient liquidity to enable the market to function efficiently, and no more. While it may not be possible to determine this limit with scientific precision, a reasonable surrogate might be the level of speculative activity on regulated exchanges 10 or more years ago, before the recent explosion of speculation in commodities.”

Steven Strongin, managing director of Goldman Sachs, told an earlier Senate committee hearing attempts to regulate market price volatility “have rarely if ever succeeded.” But such attempts “often have unintended and significant consequences," he said.

(Online Aug. 3, 2009; author’s e-mail:

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