360. WHEN INDEX SPECULATORS SELL...
As noted in #357, Michael Masters sparked a whirlwind of debate by pointing out the role of long-only index speculators in pumping commodity prices.
With oil prices as high as they are, this topic is still hot, so let's look at a specific example where index speculators liquidated a large position, and see what effect it had on the market. It occurred in 2006, and I learned about it from this article by Mack Frankfurter:
In addition to the issue of index funds accumulating long positions and thereby imputing an upward bias to commodities, there is another opportunity for market manipulation with respect to the construction and rebalancing of prominent commodity benchmarks such as the Goldman Sachs Commodity Index (GSCI).I find this extremely interesting. Institutional investors were forced to liquidate their unleaded gasoline futures due to a change in the composition of the GSCI, and gasoline dropped 82 cents in a month.
As reported by the New York Times on September 30, 2006 Goldman Sachs significantly readjusted in August of that year the GSCI's gasoline weighting. Index products tracking the GSCI, and representing an estimated $60 billion in institutional investor funds, were forced to rebalance their portfolios resulting in an unwinding of positions. Originally, unleaded gasoline made up 8.75 percent of the GSCI as of 6/30/2006 , but this was changed to just 2.3 percent, representing a sell-off of more than $6 billion in futures contracts.
As a result, gasoline fell 82 cent in the wholesale market over a four-week period, an unprecedented move; and crude oil, which in July 2006 traded over $79 per barrel for August delivery—at the time an all-time record—subsequently fell to around $56 by January 2007.
Many at the time argued that these moves were due to fundamentals, but… it should also be noted that the U.S. was in the midst of mid-term elections with Republicans facing a major fight to retain control over both Houses. According to a Gallup poll at the time, 42% of respondents thought that the Bush administration “deliberately manipulated the price of gasoline so that it would decrease before the elections.”
While the notion of a president single-handedly having the power to muscle a global market is highly questionable, the downturn in prices was welcome news for the then ruling party. Subsequently, Goldman Sachs sold its index business to Standard & Poor's including the GSCI commodity index family.
Unsurprisingly, the visibility of the GSCI brought Goldman Sachs unwelcome attention, especially given the coincidence of its former chairman's appointment as Secretary of Treasury, and an unscheduled GSCI rebalancing that forced a dramatic sell-off in the gasoline and crude oil futures market.
The New York Times article Frankfurter refers to is online here: Change in Goldman Index Played Role in Gasoline Price Drop.
Goldman Sachs, which runs the largest commodity index, the G.S.C.I., said in early August that it was reducing the index’s weighting in gasoline futures significantly. The announcement did not make big headlines, but it has reverberated through the markets in the weeks since and some other investors who had been betting that gasoline would rise followed suit on their weightings.This information strengthens my view that institutions/individuals investing in commodities through index products should be strictly regulated.
“They started unwinding their positions, and those other longs also rushed to the door at the same time,” said Lawrence J. Goldstein, president of the Petroleum Industry Research Foundation.