Here is one view of why commodities are so high.
I am unable to print the charts but this article gives you a flavor of what the professional traders are dealing with.
It is not the speculators that are driving prices up but the hedge funds and index funds.

Testimony of

Michael W. Masters
Managing Member / Portfolio Manager
Masters Capital Management, LLC

before the
Committee on Homeland Security and Governmental Affairs
United States Senate

May 20, 2008

Good morning and thank you, Mr. Chairman and Members of the Committee, for the
invitation to speak to you today. This is a topic that I care deeply about, and Iappreciate the chance to share what I have discovered.

I have been successfully managing a long-short equity hedge fund for over 12 yearsand I have extensive contacts on Wall Street and within the hedge fund community. It's
important that you know that I am not currently involved in trading the commoditiesfutures markets. I am not representing any corporate, financial, or lobby organizations. I
am speaking with you today as a concerned citizen whose professional background hasgiven me insight into a situation that I believe is negatively affecting the U.S. economy.
While some in my profession might be disappointed that I am presenting this testimonyto Congress, I feel that it is the right thing to do.

You have asked the question “Are Institutional Investors contributing to food and energy
price inflation?” And my unequivocal answer is “YES.” In this testimony I will explainthat Institutional Investors are one of, if not the primary, factors affecting commodities
prices today. Clearly, there are many factors that contribute to price determination in thecommodities markets; I am here to expose a fast-growing yet virtually unnoticed factor,
and one that presents a problem that can be expediently corrected through legislativepolicy action.

Commodities prices have increased more in the aggregate over the last five years than
at any other time in U.S. history.1 We have seen commodity price spikes occur in the
past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today,
unlike previous episodes, supply is ample: there are no lines at the gas pump and there
is plenty of food on the shelves.

If supply is adequate - as has been shown by others who have testified before thiscommittee2 - and prices are still rising, then demand must be increasing. But how do
you explain a continuing increase in demand when commodity prices have doubled ortripled in the last 5 years?

What we are experiencing is a demand shock coming from a new category of
participant in the commodities futures markets: Institutional Investors. Specifically,
these are Corporate and Government Pension Funds, Sovereign Wealth Funds,
University Endowments and other Institutional Investors. Collectively, these investors
now account on average for a larger share of outstanding commodities futures contracts
than any other market participant.3

These parties, who I call Index Speculators, allocate a portion of their portfolios to
“investments” in the commodities futures market, and behave very differently from the
traditional speculators that have always existed in this marketplace. I refer to them as
“Index” Speculators because of their investing strategy: they distribute their allocation of
dollars across the 25 key commodities futures according to the popular indices – the
Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG
Commodity Index.4

I’d like to provide a little background on how this new category of “investors” came to
exist.
In the early part of this decade, some institutional investors who suffered as a result of
the severe equity bear market of 2000-2002, began to look to the commodity futures
market as a potential new “asset class” suitable for institutional investment. While the
commodities markets have always had some speculators, never before had major
investment institutions seriously considered the commodities futures markets as viable
for larger scale investment programs. Commodities looked attractive because they have
historically been “uncorrelated,” meaning they trade inversely to fixed income and equity
portfolios. Mainline financial industry consultants, who advised large institutions on
portfolio allocations, suggested for the first time that investors could “buy and hold”
commodities futures, just like investors previously had done with stocks and bonds.

Index Speculator Demand Is Driving Prices Higher

Today, Index Speculators are pouring billions of dollars into the commodities futures
markets, speculating that commodity prices will increase. Chart One shows Assets
allocated to commodity index trading strategies have risen from $13 billion at the end of
2003 to $260 billion as of March 2008,5 and the prices of the 25 commodities that
compose these indices have risen by an average of 183% in those five years!6

According to the CFTC and spot market participants, commodities futures prices are the
benchmark for the prices of actual physical commodities, so when Index Speculators
drive futures prices higher, the effects are felt immediately in spot prices and the real
economy.7 So there is a direct link between commodities futures prices and the prices
your constituents are paying for essential goods.

The next table looks at the commodity purchases that Index Speculators have made viathe futures markets. These are huge numbers and they need to be put in perspective tobe fully grasped.

In the popular press the explanation given most often for rising oil prices is the
increased demand for oil from China. According to the DOE, annual Chinese demandfor petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billionbarrels, an increase of 920 million barrels.8 Over the same five-year period, IndexSpeculators' demand for petroleum futures has increased by 848 million barrels.9 The
increase in demand from Index Speculators is almost equal to the increase in demandfrom China!

In fact, Index Speculators have now stockpiled, via the futures market, the equivalent of
1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own
stockpile as the United States has added to the Strategic Petroleum Reserve over thelast five years.10
Let’s turn our attention to food prices, which have skyrocketed in the last six months.
When asked to explain this dramatic increase, economists’ replies typically focus on the
diversion of a significant portion of the U.S. corn crop to ethanol production.11 What
they overlook is the fact that Institutional Investors have purchased over 2 billion
bushels of corn futures in the last five years. Right now, Index Speculators have
stockpiled enough corn futures to potentially fuel the entire United States ethanol
industry at full capacity for a year.12 That’s equivalent to producing 5.3 billion gallons of
ethanol, which would make America the world’s largest ethanol producer.13

Turning to Wheat, in 2007 Americans consumed 2.22 bushels of Wheat per capita.14 At 1.3 billion bushels, the current Wheat futures stockpile of Index Speculators is enoughto supply every American citizen with all the bread, pasta and baked goods they can eatfor the next two years!
Demand for futures contracts can only come from two sources: Physical Commodity
Consumers and Speculators. Speculators include the Traditional Speculators who have
always existed in the market, as well as Index Speculators. Five years ago, Index
Speculators were a tiny fraction of the commodities futures markets. Today, in many
commodities futures markets, they are the single largest force.15 The huge growth in
their demand has gone virtually undetected by classically-trained economists who
almost never analyze demand in futures markets.

Index Speculator demand is distinctly different from Traditional Speculator demand; it
arises purely from portfolio allocation decisions. When an Institutional Investor decides
to allocate 2% to commodities futures, for example, they come to the market with a set
amount of money. They are not concerned with the price per unit; they will buy as many
futures contracts as they need, at whatever price is necessary, until all of their money
has been “put to work.” Their insensitivity to price multiplies their impact on commodity
markets.

Furthermore, commodities futures markets are much smaller than the capital markets,
so multi-billion-dollar allocations to commodities markets will have a far greater impact
on prices. In 2004, the total value of futures contracts outstanding for all 25 index
commodities amounted to only about $180 billion.16 Compare that with worldwide
equity markets which totaled $44 trillion17, or over 240 times bigger. That year, Index
Speculators poured $25 billion into these markets, an amount equivalent to 14% of the
total market.18

Chart Two shows this dynamic at work. As money pours into the markets, two things
happen concurrently: the markets expand and prices rise.

One particularly troubling aspect of Index Speculator demand is that it actually
increases the more prices increase. This explains the accelerating rate at which
commodity futures prices (and actual commodity prices) are increasing. Rising prices
attract more Index Speculators, whose tendency is to increase their allocation as prices
rise. So their profit-motivated demand for futures is the inverse of what you would
expect from price-sensitive consumer behavior.

You can see from Chart Two that prices have increased the most dramatically in the first
quarter of 2008. We calculate that Index Speculators flooded the markets with $55
billion in just the first 52 trading days of this year.19 That’s an increase in the dollar
value of outstanding futures contracts of more than $1 billion per trading day. Doesn’t it
seem likely that an increase in demand of this magnitude in the commodities futures
markets could go a long way in explaining the extraordinary commodities price
increases in the beginning of 2008?

There is a crucial distinction between Traditional Speculators and Index Speculators:
Traditional Speculators provide liquidity by both buying and selling futures. Index
Speculators buy futures and then roll their positions by buying calendar spreads. They
never sell. Therefore, they consume liquidity and provide zero benefit to the futures
markets.20

It is easy to see now that traditional policy measures will not work to correct the problem
created by Index Speculators, whose allocation decisions are made with little regard for
the supply and demand fundamentals in the physical commodity markets. If OPEC
supplies the markets with more oil, it will have little affect on Index Speculator demand
for oil futures. If Americans reduce their demand through conservation measures like
carpooling and using public transportation, it will have little affect on Institutional
Investor demand for commodities futures.

Index Speculators’ trading strategies amount to virtual hoarding via the commodities
futures markets. Institutional Investors are buying up essential items that exist in limited
quantities for the sole purpose of reaping speculative profits.

Think about it this way: If Wall Street concocted a scheme whereby investors bought
large amounts of pharmaceutical drugs and medical devices in order to profit from the
resulting increase in prices, making these essential items unaffordable to sick and dying
people, society would be justly outraged.

Why is there not outrage over the fact that Americans must pay drastically more to feed
their families, fuel their cars, and heat their homes?

Index Speculators provide no benefit to the futures markets and they inflict atremendous cost upon society. Individually, these participants are not acting with
malicious intent; collectively, however, their impact reaches into the wallets of every
American consumer.

Is it necessary for the U.S. economy to suffer through yet another financial crisis
created by new investment techniques, the consequences of which have once againbeen unforeseen by their Wall Street proponents?

The CFTC Has Invited Increased Speculation

When Congress passed the Commodity Exchange Act in 1936, they did so with the
understanding that speculators should not be allowed to dominate the commodities
futures markets. Unfortunately, the CFTC has taken deliberate steps to allow certain
speculators virtually unlimited access to the commodities futures markets.

The CFTC has granted Wall Street banks an exemption from speculative position limits
when these banks hedge over-the-counter swaps transactions.21 This has effectively
opened a loophole for unlimited speculation. When Index Speculators enter into
commodity index swaps, which 85-90% of them do, they face no speculative position limits.22

The really shocking thing about the Swaps Loophole is that Speculators of all stripes
can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with a Wall Street bank and then the bank buys $500 million worth of Wheat futures.

In the CFTC’s classification scheme all Speculators accessing the futures markets
through the Swaps Loophole are categorized as “Commercial” rather than “Non-
Commercial.” The result is a gross distortion in data that effectively hides the full impact
of Index Speculation.

Additionally, the CFTC has recently proposed that Index Speculators be exempt from all
position limits, thereby throwing the door open for unlimited Index Speculator
“investment.”24 The CFTC has even gone so far as to issue press releases on their
website touting studies they commissioned showing that commodities futures make
good additions to Institutional Investors’ portfolios.

Is this what Congress expected when it created the CFTC?
Congress Should Eliminate The Practice Of Index Speculation
I would like to conclude my testimony today by outlining three steps that can be taken to immediately reduce Index Speculation.

Number One:
Congress has closely regulated pension funds, recognizing that they serve a public
purpose. Congress should modify ERISA regulations to prohibit commodity index
replication strategies as unsuitable pension investments because of the damage that
they do to the commodities futures markets and to Americans as a whole.

Number Two:
Congress should act immediately to close the Swaps Loophole. Speculative position
limits must “look-through” the swaps transaction to the ultimate counterparty and hold
that counterparty to the speculative position limits. This would curtail Index Speculation
and it would force ALL Speculators to face position limits.

Number Three:
Congress should further compel the CFTC to reclassify all the positions in the
Commercial category of the Commitments of Traders Reports to distinguish those
positions that are controlled by “Bona Fide” Physical Hedgers from those controlled by
Wall Street banks. The positions of Wall Street banks should be further broken down
based on their OTC swaps counter-party into “Bona Fide” Physical Hedgers and
Speculators.

There are hundreds of billions of investment dollars poised to enter the commodities
futures markets at this very moment.26 If immediate action is not taken, food and
energy prices will rise higher still. This could have catastrophic economic effects on
millions of already stressed U.S. consumers. It literally could mean starvation for
millions of the world’s poor.
If Congress takes these steps, the structural integrity of the futures markets will berestored. Index Speculator demand will be virtually eliminated and it is likely that food
and energy prices will come down sharply.
APPENDIX: HOW TO CALCULATE INDEX SPECULATORS’ POSITIONS

If someone knows how much money is invested in the total index then it is easy to calculate how much must be in each commodity in dollars and in futures contracts.
Total Dollars Invested Weight Of Individual Dollars In Individual

And therefore if someone knows how many contracts are in an individual commodity
along with the dollar value of a contract and the weight of that commodity in the index
then you can calculate the total dollars invested in the index as follows:

# Of Contracts In An Dollar Value Of A Weight Of Individual Total Dollars Invested

Individual Commodity Commodity Contract Commodity In Index

The CFTC starting in January 2006 has been publishing the Commodity Index Trader
Supplement to the Commitments Of Traders report. This supplemental report shows
the reported positions of Index Speculators in 12 different agricultural commodities. Of
the 12, two commodities:, KC Wheat and Feeder Cattle, are part of the S&P GSCI (and
not the DJ-AIG) and one commodity: Soybean Oil, is part of the DJ-AIG (and not the
S&P-GSCI). Note that 95% of dollars indexed to commodities are replicating either the
S&P-GSCI or DJ-AIG.

Both the S&P-GSCI and DJ-AIG publish on a daily basis the individual weights of their
constituent commodities. Also futures market data providers like Bloomberg publish
daily closing prices for the commodities. Since the futures contract terms do not change
that enables someone to calculate the daily dollar values of the individual commodity
contracts.

So with these three data points it is simple to calculate the total dollars invested in the
S&P-GSCI and the DJ-AIG on a weekly basis. And once the total dollars invested in
these two indices is known then that results in the ability to calculate the number of
contracts held by Index Speculators in the other 13 non-agricultural commodities.

A detailed example of this 3 step process follows.
Step One - Estimate Total Amount Invested In S&P-GSCI and DJ-AIG
According to the CFTC’s January 17, 2006 CIT report, Index Specualtors had positiions
in KC Wheat, Feeder Cattle and Soybean Oil of 21366 , 5613 and 59264 contracts
respectively. Plugging in the weights and contract values from the appropriate sources
yields the following calculations:

21,366 X $18,762.50 / 0.82% = $48,887,753,049
5,613 X $56,137.50 / 0.68% = $46,338,204,044
59,264 X $12,732.00 / 2.77% = $27,240,045,054

So the S&P-GSCI had somewhere between $46 and $49 billion invested in it and the
DJ-AIG had around $27 billion invested in it. This corresponds well to the figures
published by Goldman Sachs and Dow Jones.

Step Two - Calculate Position Size For Other Commodities
If $47.6 billion is used as an estimate for the S&P-GSCI and then $27.2 billion is used
for the DJ-AIG it is possible to calculate (using the formulas above) Index Speculators
positions in all the other commodities. The table above shows the results.

Step Three - Compare With Actual CFTC Figures For Accuracy
The final column in the table shows the actual figures released by the CFTC. As you
can see in almost all cases the estimates generated using this method yield results that
are less than the actual reported results. That increases one’s confidence that this
method is in fact conservative.

Final Note

This method of calculating Index Speculators is almost identical to the methods used by
Philip Verleger (www.pkverlegerllc.com), Steve Briese (www.commitmentsoftraders.org)
and others. It is not clear who deserves the credit for developing it but it clearly is not
us.

ENDNOTES ENDNOTES
1 “Reserve Management, The Commodity Bubble, The Metals Manipulation, The Contagion Risk To GoldAnd The Threat Of The Great Hedge Fund Unwind To Spread Product.” Frank Veneroso, July 19, 2007,
pp. 5-6. http://www.venerosoassociates.net/Reserve%20Management%20Parts%20I%20andII%20WBP%20Public%2071907.pdf

2 http://hsgac.senate.gov/public/index.cfm?
fuseaction=Hearings.Detail&HearingID=dc7368c2-0ea1-4151-9fc5-06317a5bba79

4 For more information visit:
http://www.djindexes.com/mdsidx/?event=showAigHome for the DJ-AIG or for the S&P-GSCI
http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_gsci/
2,3,4,0,0,0,0,0,0,1,1,0,0,0,0,0.html

5 “Investing and Trading in the GSCI,” Goldman, Sachs & Co., June 1, 2005 and calculations based upon
the CFTC Commitments of Traders Report, CIT Supplement, see the Appendix for more information on
how to calculate Index Speculators' positions.

7 The CFTC states on its website that “In many physical commodities (especially agriculturalcommodities), cash market participants base spot and forward prices on the futures prices that are
.discovered' in the competitive, open auction market of a futures exchange.” - “The Economic Purpose ofFutures Markets and How They Work,” U.S. Commodities Futures Trading Commission, http://
www.cftc.gov/educationcenter/economicpurpose.html

As an additional example, when Platts, an energy markets pricing service, surveys crude oil pricing inphysical markets around the globe they are receiving bid and offer quotations from market participants
expressed as WTI Light Sweet Crude minus a spread. - “Platts Oil Pricing and Market-on-CloseMethodology Explained,” Platts - a McGraw Hill Company, July 2007. http://www.platts.com/Resources/
whitepapers/moc.pdf?a=i Note that if and when Platts receive price quotes as Brent Crude or DubaiCrude plus or minus a spread there is still a direct and stable relationship between WTI, Brent and Dubai.

8 Please remember if demand for oil stays the same then prices will stay the same. If supply is constantthen demand has to increase for prices to increase. That is why we examine increases in demand.

Increase In Chinese Demand For Petroleum
Last 5 Years

9 This table takes the numbers from the main table in the body of the statement and converts them to theirbarrel equivalents. The Petroleum consumption numbers that the DOE provides for Chineseconsumption include all forms of petroleum both crude and refined.

10 Energy Information Association - U.S. Department Of Energy.
http://tonto.eia.doe.gov/dnav/pet/pet_stoc_wstk_dcu_nus_a.htm

11 “The End Of Cheap Food,” The Economist, December 6, 2007 http://www.economist.com/research/
articlesBySubject/displaystory.cfm?subjectid=7216688&story_id=10252015

12 “Ethanol Reshapes the Corn Market,” Economic Research Service - U.S. Department Of Agriculture,
Allen Baker and Steven Zahniser April 2006. http://www.ers.usda.gov/AmberWaves/April06/Features/
Ethanol.htm

13 “Ethanol Production Could Be Eco-Disaster, Brazil's Critics Say,” Kelly Hearn, National Geographic
News, February 8, 2007, http://news.nationalgeographic.com/news/2007/02/070208-ethanol.html

14 Economic Research Service, U.S. Department of Agriculture, http://www.ers.usda.gov/Briefing/Wheat/
consumption.htm

15 see endnote #2

16 Because the base metals are traded on the London Metals Exchange, Bloomberg did not have openinterest data prior to 2005. Since prices and open interest expressed in contracts have been risingsteadily the last five years we took 2005's base metal data and added it to 2004 actual numbers to come
up with a conservative estimate for 2004 open interest. These are daily numbers averaged across theentire year.

17 CIA World Factbook. https://www.cia.gov/library/publications/the-world-factbook/geos/xx.html#Econ

18 There is no publicly available data that shows inflow data for commodity indexation trading strategiesbut some approximations can be made. The end of year “investment” figures are published by therespective index companies (or they can be calculated) and the annual performance is known. Therefore
the amount that the prior year's investment has grown or shrunk can be calculated. Then the difference
in the yearly change has to come from net inflows. When during the year the inflows occurred is notknown, so the assumption is made that all net inflows occurred evenly throughout the year. Changingassumptions on net inflow timing only affects the rate of growth for that year's inflow which never amounts
to more than a few billion dollars difference.

21 “And that actually happened in 1991 with a particular swap dealer that was hedging an OTC transaction
with a pension fund, and the swap dealer came to us, and we said, "yeah, that qualifies for a hedge
exemption," so we granted a hedge exemption to the swap dealer. And in the years since then, we've
done the same for other swap dealers, as well.”
(Remarks of Don Heitman, Division of Market Oversight, CFTC Agricultural Advisory Committee Meeting,
Washington, D.C., December 6, 2007)
(www.cftc.gov/stellent/groups/public/@aboutcftc/documents/file/aac_12062007.pdf)

22 “Commodities: Who's Behind the Boom?,” Gene Epstein, Barron's, March 31, 2008

23 “Similar hedge exemptions were subsequently granted in other cases where the futures positionsclearly offset risks related to swaps or similar OTC positions involving both individual commodities and
commodity indexes. These nontraditional hedges were all subject to specific limitations to protect the
marketplace from potential ill effects. The limitations included: (1) The futures positions must offset
specific price risk; (2) the dollar value of the futures positions would be no greater than the dollar value ofthe underlying risk; and (3) the futures positions would not be carried into the spot month.”
(72 FR 66097, Notice of Proposed Rulemaking, Risk Management Exemption From Federal SpeculativePosition Limits, , November 27, 2007.)
(http://www.cftc.gov/stellent/groups/public/@lrfederalregister/documents/file/e7-22992a.pdf)
(The language in 72 FR 66097 above also appears in 71 FR 35627, CFTC Request for Comments,
Comprehensive Review of the Commitments of Traders Reporting Program, June 21, 2006.)
(http://www.cftc.gov/foia/fedreg06/foi060621a.htm)

24 (72 FR 66097, Notice of Proposed Rulemaking, Risk Management Exemption From FederalSpeculative Position Limits, , November 27, 2007.)
(http://www.cftc.gov/stellent/groups/public/@lrfederalregister/documents/file/e7-22992a.pdf)

25 “CFTC Study Finds Independent-Moving Commodity and Equity Markets,“ December 19, 2007, http://
www.cftc.gov/newsroom/generalpressreleases/2007/pr5425-07.htmlhttp://www.cftc.gov/stellent/groups/public/@aboutcftc/documents/file/amarketofone.pdf

26 Pension fund consultants have been advocating portfolio allocations of between 5% and 12% tocommodities indices. Considering that worldwide institutional assets are about $29 trillion, if InstitutionalInvestors heed the advice of their consultants, index replication could easily reach $1 trillion. $1 trillion on
$29 trillion would represent an average allocation of just 3.5%.
“Investing In Collateralised Commodities Futures,” Russell's Research For Excellence, Yvonne Ooi and
David Rae, 2005
Strategic Asset Allocation and Commodities, Ibbotson Associates, Thomas M. Idzorek, March 27, 2006Pension Funds $26 trillion : “UK pension fund returns at five-year low,” IFAonline, Jennifer Bollen,
January 28, 2008. http://www.ifaonline.co.uk/public/showPage.html?page=698204Sovereign Wealth Funds $3 trillion : “Sovereign Wealth Funds,” Council On Foreign Relations, Lee
Hudson Teslik, January 18, 2008. http://www.cfr.org/publication/15251/

27 “WFP says high food prices a silent tsunami, affecting every continent,” World Food Program - United
Nations, April 22, 2008. http://www.wfp.org/english/?ModuleID=137&Key=2820

Assigned to category: commodities
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