Deliberately Looking Away – Ted Butler


by Ted Butler, Silver Seek:

There are two great evolutions underway in the world of commodities that, while in full view, are misunderstood or overlooked by most observers. So important are these two developments that they threaten serious market upheaval when they are addressed, as must inevitably occur.  Most remarkably, indisputable data published by the primary federal commodities regulator, the CFTC, prove beyond a doubt both occurrences are underway, even as the agency, along with the US Department of Justice, refuse to confront what is a clear violation of US commodity and antitrust law.

The two developments in focus include a broad artificial pricing scheme, or manipulation, affecting a wide swath of commodity markets and a more specific price manipulation involving JPMorgan in silver and gold.  The illegal pricing schemes did not evolve overnight, but over a multi-decade period of time. That’s one of the main reasons why so many have failed to appreciate what has occurred – it has been a gradual process. So gradual that, like a frog not jumping out of a pot of water being heated slowly, market observers and regulators alike have come to accept as normal the dramatic and illegal change in the price discovery process.

Simply put, commodity prices are now set and determined by excessive speculation in derivatives contracts by a handful of large traders and not by changes in actual commodity supply and demand. Derivatives contracts are entered into by two parties, a buyer and seller, and include futures and options contracts traded on listed exchanges and contracts traded over-the-counter, where futures contracts are called swaps. In essence, derivatives contracts are simply paper bets on price in the future and only rarely involve the physical delivery of the underlying commodity.

The problem is that the derivatives bets have become so large in the aggregate and so concentrated by the small number of traders engaged in them that they have come to take control of prices away from changes in physical supply and demand. The word “derivative” means derived from and derivatives’ pricing is supposed to be derived from the underlying host physical commodity markets. It was never intended that derivatives trading would become so large and concentrated among a relative handful of speculators that derivatives trading would dictate prices to the underlying host physical markets.  That’s akin to the tail wagging the dog. Yet that’s precisely the absurd state to which commodities have evolved.

In some derivatives markets, like COMEX silver and gold, actual bona fide hedgers are virtually non-existent, except in name only. In other markets, like crude oil, corn and copper, any legitimate hedging is done in direct reaction to what the big speculators are doing, not based upon the risk-offsetting needs of the hedgers. This is completely at odds with commodity law and the free law of supply and demand. How did the price discovery process of virtually all commodities come to be perverted and where big speculators now set prices?

As indicated above, it has been a gradual process, beginning 30 or more years ago. The origins are simple enough and trace to the same broad movement of individuals and institutions automating and indexing investments, which has led to the dramatic growth in index mutual funds, 401K’s, ETFs and other forms of passive, as opposed to active investment management. Just as investors have turned to more automated and passive vehicles for traditional investments, as opposed to actively trading individual stocks, they have done so in commodity derivatives, like futures trading.

There are now a proliferation of commodity ETFs (exchange-traded funds) which use the futures markets as the backing of their funds on a specific commodity basis. The late CFTC commissioner Bart Chilton referred to such funds as the “massive passives”, which took enormous long futures positions. More importantly, there has developed a number of large commodity trading advisors (CTA’s, registered with the CFTC), which pool funds from retail and institutional investors to actively trade in futures and other derivatives contracts, aptly classified as managed money traders in the weekly Commitments of Traders (COT) report. The movement away from individuals speculating in commodity futures to institutionalized commodity derivatives trading has been profound.

According to COT data for every actively traded commodity futures market, the trader category that has grown the most over the last 20 years has been the large non-commercial trading category (of which the managed money category, is, by far, the largest component). The non-commercial category has grown by hundreds of percent over this time, reflecting the broader move to indexing and passive investment. In fact, it can be proven that the commercial category has also grown only because the non-commercial (speculative) category has grown so large. Talk about the tail wagging the dog – commercial trading has only grown in order to keep up with the tremendous increase in speculative trading, not because legitimate hedging needs have increased.

Managed money commodity advisors are said to hold over $300 billion in total investor assets under management. Given the extremely low margin requirements (5% to 10%) applied to commodity futures contracts, the leverage and collective size of positions bought and sold by the managed money traders are so large as to be epic. And because most of the managed money trading advisors adopt a technical price momentum strategy, they all buy and sell, essentially, at the same time. Thus, when these traders buy, they drive prices higher and when they sell, prices invariably move lower. This, alone, explains the growing awareness of and interest in the COT reports.

Recent examples of egregious managed money trading activity on price include the following – the rally in corn prices by over 30% in little more than a month on managed money buying of 2.5 billion bushels of corn futures, nearly 20% of the US crop. The fall in crude oil prices from over $66 to $51 (23%) in little more than 6 weeks, due to managed money selling of 220 million barrels of NYMEX oil futures. The fall in copper prices of 10% in six weeks, due to the managed money sale of more than 935,000 tons of COMEX futures, nearly 5% of annual world copper production. The actual production and consumption of all three commodities changed very little, if at all, over this time, making it clear that the enormous amounts of managed money buying and selling caused the price changes.

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