Wray: Stresses Seen at the Outer Surface of the Ballooning Commodities Complex

We've discussed this topic before on Benzinga Radio, with respected market analysts like Dan Dicker (again) and Fadel Gheit--financialization of commodities markets. At issue: massive institutional inflows into paper commodities, which end up factoring into prices much more than, say, real supply and demand for the physical assets. The result? A bubble. That term--bubble--gets thrown around pretty loosely these days, and it's often a contentious issue, especially in the commodities context. We've spoken to several others on Benzinga Radio, including successful investors like Jim Rogers and Marc Faber, who are outspoken advocates of the long commodities trade in the coming years. The question now, with evidence of a coming global slowdown increasingly in focus, is whether commodities will continue to outperform. The last few trading sessions, going back a week or so, certainly seem to have raised concerns. Dr. Randy Wray, a respected economist at the University of Missouri, Kansas City, was commissioned by congressional offices in 2008 to look into the commodities markets as prices marched to record highs during early summer before crashing in July. He spoke with us on Benzinga Radio, raising several interesting points about the evolving dynamics of the commodities markets and the statistical significance of the change in prices we've seen over the last several years. What piques your interest in the "commodities story" from a statistical perspective?

Of course, you can get a shortage of supply of some commodity. That happens. In the face of rising demand, the price can spike up really significantly, and that causes conservation of the use of it, substitution into some other commodity, and it will induce suppliers to supply more. So, some variability of commodity prices is not an unusual thing. There are 33 basic commodities, indexes that include the 25 most important ones, and if you look across the whole spectrum of commodities, what is unusual is that they are all just exploding together. On the surface of it, that makes it appear to be pretty unlikely. Why would we have supply shortages across the full range of commodities and exploding demand across the full range of commodities? It causes you to look a little more closely and compare the increases of individual commodities' prices with, say, the past century's experience in each one of those. What you find is that individually, the price increases are extremely improbable. In the case of iron ore, it's a once-in-a-two-million-year event. Then, when you take the whole basket of commodities, and you think about how likely each one of these is, and multiply all of that together--what has happened just is impossible.

So, should we call it a "bubble?"

It is just the historically unprecedented rise of price of so many commodities all at one time. That makes you very suspicious that there might be something going on. Then, if you look at, say, the way that financial markets have changed, the way that laws have been changed that allow financial [players] to get in to commodities, you find out that there is actually an extremely close correlation in the timing of when financial markets were liberalized so that they could start speculating in commodities. You match that with the flow of funds into commodities markets, and what you see is that the correlation is 100 percent. It matches absolutely perfectly with the flows from the financial sector into commodities. That is when this completely historic boom in prices began, and it continued up through fall of 2008, and then the flows began anew. They are back in, and we have another commodities price boom.

How did this all start?

Everyone remembers that we had the high-tech bubble and then the collapse. Money managers started trying to find an asset class that wasn't highly correlated with stock prices. You don't want to "put all of your eggs into one basket," into the stock market or things that are correlated with the stock market. You want to diversify into something that is not correlated with the stock market. The CFTC--commodity futures regulators--and the industry itself did empirical studies, and they showed that commodities prices had not been correlated with the stock market, up to that point. They went around the country and they told money managers--like people who manage pension funds--that, "Hey! Commodities prices aren't correlated with the stock market. You've got to diversify." Then, Congress, in its infinite wisdom, deregulated pension funds. They actually wrote the law in a way that pretty much forced [pension fund managers] to diversify into commodities. So, the pension funds started flowing in the early 2000s into commodities. This sort of caught my attention in the mid 2000s. I started looking at it, and you started having the strange thing that financial market participants were buying up, or renting, grain silos to store the wheat they had been buying. They actually were diversifying into the physicals. The problem with that is that it costs money to store the physical commodities. Storage costs hit an all-time peak, so they looked around. How could they buy commodities without storing them? Well, you do it in the futures markets. So what pension funds did is they decided, "We're going to diversify, just like we're supposed to, into commodities. We're going to buy pieces of paper rather than the commodities. What we'll do is allocate, let's say, 5 percent of our total assets into commodities." Now, that all sounds good, but you have to remember that pension funds are huge. Pension funds have assets equivalent to 75 percent of GDP. So even if it's only 5 percent of total pension fund assets, it's huge amounts of money, and you can easily get five times as many dollar bets as there actually is of a physical commodity. As long as pension funds are continually allocating ever more money into commodities, they will drive the price up. It's a self-fulfilling prophecy because the financial flows will drive the prices up.

The principal counterargument to this story is that emerging markets are generating extraordinary demand for these hard assets as those economies grow.

I looked into this in detail back in 2008, because [demand pressures] was the story that was given by almost all economists. I was approached by staffers of a senator and a congressman because, they said, "We cannot find a single economist who doesn't just tell us it's supply and demand." And that is still the story. So I said I'd look at it. The problem was that it just didn't fit the truth. Back then, oil had gone to $150 per barrel. I looked at the actual use of oil. It had declined--our economy was already slowing in fall of 2008. It just wasn't true. It is true that Chinese demand has been increasing, but U.S. demand had been falling, and it offset that. There had been no increase in consumption of oil, while prices had almost tripled. There was an investigation in Congress. I wrote my paper, and a guy named Mike Masters was testifying in Congress. He was a commodities market expert, saying, "It's simply not true. It's not supply and demand. It is the flow from pension funds and others into futures contracts that is driving the price up." The funny thing is that right after the release of these reports and the testimonies in Congress, what happened to the price of oil? It fell by 2/3--below $50 a barrel, immediately. If you look at the financial flows, again, the correlation is perfect. Pension funds pulled 1/3 of their money out of commodities because they were afraid that Lieberman and Stupak were going to push through laws in Congress that were going to limit pension funds' abilities to buy commodities. They were also worried about the public relations fallout if their own members of these pension funds found out that it was pension funds that were driving up the price of gasoline at the pump. So they pulled the money out. Of course, then we had many other problems in our economy to worry about, Congress went on to other things, no laws were passed to limit speculation in commodities, real-estate markets went bust. There was no place for pension funds to put their money--other than commodities and the stock market--so they started flowing back into there and the prices started going up again.

What about the counterargument involving the Federal Reserve and its easy-money policy?

There's also the argument that, you know, "Helicopter Ben is dropping so much cash into the economy. We're going to get hyperinflation sooner or later, and we know that commodities are a very good hedge against inflation." That is false. Commodities are a terrible hedge against inflation; just look at the price of gold. Even with this huge, speculative boom in the price of gold, in inflation adjusted terms, is still below where it was in 1980. Commodities are not a good inflation hedge, and they never have been. If you go back over the past century, this 33-commodity basket has declined at a rate of over 1 percent per year, inflation adjusted. In other words, it's always been a bad bet to buy commodities as an inflation hedge, but it's become the conventional wisdom, and it is part of the explanation for the flows into commodities.

How bad will it be when this bubble bursts again?

Let's say a pension fund has 5% of their assets in commodities. Let's say commodities fall in price by half. They are hurt a little bit, but it's not a catastrophe. How can this possibly lead to a financial collapse? Furthermore, consumers are going to be better off as commodity prices come down. We are finally going to get some relief at the gas pump, and so on. So won't it be a good thing? Here's the problem. There are many ways that this can affect the economy. First, yes, the pension funds take a hit. Second, other kinds of financial institutions that are into commodities markets to the extent that it hits banks--well, banks have already been hit by all sorts of whammies. All across the asset spectrum, they're in trouble. They're probably insolvent. This will only make those problems worse. Third, it hurts the producers. In 2008, when commodities prices collapsed, that really hurt U.S. farmers. U.S. farmers are already suffering. So they get into trouble. They can't repay their debts. That brings down their banks, and so on. Fourth, we know that there is high leverage and layering throughout the financial sector so that one financial institution owes another financial institution. If you go way back to the early 1980s, some will remember that the Hunt brothers had cornered the silver market. They thought they were really brilliant. They were borrowing money, buying silver, and they figured that once they cornered the market, they would have complete control over silver, and they could set any price they wanted. They got collateral calls that they had to meet. They needed to sell some assets. They sold silver, but they also sold their other assets. It turns out that the Hunt brothers were cattlemen. They started selling cattle. The price of cattle collapsed. Now, no one would have thought that silver and cattle are highly correlated commodities, but it turns out they were. The same thing will happen. Anyone holding commodities is going to sell commodities, and when that doesn't cover their loans, they're going to have to start selling other stuff. So, because of the linkages, we get very strange correlations. Other markets are going to get hurt too as commodity prices fall, and people have to sell commodities and then sell other assets too.

Tell us about "money manager capitalism," a phrase you've used in your writing about all this.

The problem is that we have way too much money chasing way too few good assets. The total amount of financial bets out there is way over $600 trillion around the world. There just aren't enough good investments to absorb that amount of money. So, what happens is they blow up--one asset after another. Then, those inevitably crash. The only reason we got out of the 2008 crash is because of Washington. Washington bailed out the financial sector to the amount of about $29 trillion. The Dodd-Frank legislation makes it very difficult to repeat that performance. I'm not saying that they won't find a way around the rules, or they won't find a way to do it again. They might, but it's going to be very politically unpopular. I'm not sure they are going to be able to do it again. Once prices start tumbling, all of the asset markets are actually linked. Even though it's not obvious, they really are. It will tumble across all of them. And it's not clear that we will be able to stop it this time. At least, not as easily as last time.