Institutional Investor's Alpha Magazine - July/August 2008 - (Page 56)

Unhedged Commentary Speculating on Washington By Patrick Welton ashington, it seems, is worried. The House of Representatives and Senate have conducted more than 40 hearings on oil this year, as prices have skyrocketed in the past 12 months, recently surpassing $140 a barrel, and the new reality of $4-a-gallon gasoline has some American families spending more than 15 percent of their income to ﬁll their gas tanks. Currently, no fewer than nine separate bills focus on curbing oil speculation, as U.S. lawmakers try to provide some kind of relief. Even the Commodity Futures and Trading Commission, which oversees the futures markets, is conducting an investigation into energy speculation. As an active energy futures market participant for 20 years, I believe that the global fundamentals behind tightening oil supplies provide a reasonable explanation for today’s prices. Production, reﬁning and longer-term exploration have all failed to keep pace with the steady surge in demand from developing countries If done right, efforts like China and India. From 2002 by lawmakers on to 2007, spare oil production capacity fell about 50 percent, from Capitol Hill to bring 5 million to 2.5 million barrels a greater transparency day. Moreover, geopolitical instability in countries like Iran to energy trading and Nigeria serves only to amplify anxieties about potential could have a disruptions to the oil supply. All this, along with market forecasts positive effect. of limited public policy actions, helps to explain both the rapidity and the volatility of the price moves we’ve witnessed. Still, investment managers shouldn’t run when Washington comes calling. Policies that seek improved market conﬁdence should be the uniﬁed goal of market participants and lawmakers alike. If actions are taken that result in increased market conﬁdence through improved ﬁduciary trust, transparency and liquidity, all participants beneﬁt from potentially tighter bid-ask spreads, lower transaction costs and improved price discovery. Investigations into the role of speculators, especially “index speculators,” are perhaps most relevant given the adverse attention focused on them. These long-only indexers represent a new breed of commodity investor. Seeking diversiﬁcation, they view commodities as an asset class, investing with a long-only mind-set with the goal of capturing commodity market beta. Composed primarily of W institutional investors like pensions and endowments, this group has helped index-based funds tied to commodities grow 20-fold, from $13 billion in 2003 to $260 billion today — and that number is expected only to increase. Have U.S. retirees and endowment contributors inadvertently been manipulating oil markets with the simple intent of earning more diversiﬁed portfolio returns? I doubt it. The CFTC doesn’t think so either, but it has agreed to examine their impact further. Although some believe the presence of commodity indexers is inﬂating the price of a “paper barrel” of oil, it’s quite another step to establish a causal link between the market’s future forecasts and the cash price a reﬁner is willing to pay for an actual barrel of crude today. It is true that inﬂated futures prices could lead to hoarding behavior that would push up cash prices; however, inventory data does not seem to support this phenomenon. The inquiry process has spawned some encouraging activities. In June the CFTC and the Intercontinental Exchange in London agreed to share daily trading data on participants as well as to enforce U.S.-imposed position limits. In addition, the House overwhelmingly approved a bill to empower the CFTC to more closely police the energy markets. If handled properly, both actions could increase ﬁnancial trust, transparency and liquidity. I am cautious, however, of regulations that myopically focus on one narrow goal, such as reducing U.S. consumer gas prices, or that seek convenient scapegoats in what is a complex, global dilemma. Such policies may be ineffective at best and, at worst, distort the very supplyand-demand forces they claim to defend. One proposal that could have very harmful unintended consequences is a recently introduced bill prohibiting over-the-counter market participation by ﬁrms that cannot actually accept delivery of crude oil, effectively eliminating market access by the majority of current participants. Although unlikely to pass, the bill would severely reduce liquidity, widen spreads, push trading to other jurisdictions and further undermine U.S. interests. Public discourse is a necessary, even welcome process. If lawmakers can demystify the energy markets — without overstepping their bounds — we all stand to beneﬁt. Patrick Welton is a co-founder of Welton Investment Corp., a $500 million alternative-investment manager in Carmel, California, that specializes in a diversiﬁed array of managed futures and global macro trading strategies. 56 • INSTITUTIONAL INVESTOR’S ALPHA • JULY/AUGUST 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - July/August 2008

Institutional Investor's Alpha Magazine - July/August 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Mr. Big Goes Small The Good Guys: Adopt This School! Interview: Man's Great Hope Cover Story: The Gentleman Activist Strategies: The New Bankers Profile: Staying Alive Research Center: The Best of the East The Asian Sensations Alpha Bytes: Into the Light Unhedged: Commentary: Speculating on Washington

Institutional Investor's Alpha Magazine - July/August 2008

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