Thank you.
I appreciate the opportunity to speak with you today about a recent and never-before-seen phenomenon in the commodities futures markets. Historically, these markets have had two types of participants: one, physical hedgers, who are the actual producers and consumers of tangible, real-world commodities; and two, speculators, who trade commodities futures to try to make a profit.
The commodities futures markets were started by physical hedgers and exist to serve them, and traditional speculators are allowed to participate because they provide liquidity by actively buying and selling. However, in the last five years, large institutional investors have adopted the misguided belief that commodity futures are an asset class in which they can make a passive, broadly diversified, long-term investment in the form of commodity indices. I call this new and more damaging breed of speculator “index speculators”. They have been encouraged by Wall Street to think of an allocation to the S&P Goldman Sachs Commodity Index or the Dow Jones-AIG Commodity Index, which are the two leading indexes of commodity futures, in the same way as they think about the S&P 500 stock index. The problem is that commodity futures markets are not capital markets, and when deep-pocketed investors try to make passive, long-term investment in commodity indices, it causes great damage to the commodities futures markets and to the economy as a whole.
Institutional investors have poured hundreds of billions of dollars into the commodity futures markets, and assets tied to the commodity index investments have ballooned from $13 billion in 2003 to approximately $317 billion as of July 1, 2008.
As chart one in my written testimony shows, this has driven up prices for essential food and energy commodities by an average of more than 200% in the last five and a half years. In fact, the total open interest of the 25 largest and most important commodities upon which the indices are based was $183 billion in 2004. From the beginning of 2004 to today, index speculators have poured $173 billion into these 25 commodities. This is a very significant amount of money flowing into what amounts to a very small market.
As chart two in my written submitted testimony shows, this has caused futures prices to rise dramatically as the commodities futures markets were forced to expand in order to absorb this enormous new influx of capital. Index speculators have bought more commodity futures contracts in the last five years than both physical hedgers and traditional speculators combined. They are now the single most dominant force in the commodities futures markets today.
In 1998, physical hedgers on average outnumbered speculators by a greater than 3:1 ratio, according to the CFTC. Today speculators in general outnumber physical hedgers by more than a 2:1 ratio. This is a colossal shift in the balance of power. Physical hedgers' positions have grown more than 90% in the last 10 years, while speculators' positions have grown more than 1,300% in the same timeframe.
The worst thing about index speculator buying is that it has really nothing to do with true supply and demand fundamentals. As an example, when a $10 billion pension fund investment committee decides to put $500 million, or 5% of its portfolio, into the S&P GSCI commodity futures index, then the $200 million that consequently flows into WTI crude oil futures has absolutely nothing to do with the supply and demand for crude oil in the marketplace. More damaging still, because index speculators enter the commodity futures markets with a fixed amount of dollars to invest, they care little what price they pay per barrel as long as they can put all their money to work. They buy as many barrels as they can, at whatever price they have to pay, until all their money is fully invested.
As a result, the prices for commodities are pushed much higher and are amplified more than supply and demand dictate. This means that the price discovery function of the commodity futures markets is greatly damaged. In fact, because futures prices are the benchmark by which commodity prices are set in the real world, this raises the real-world prices for food and energy. So not only are the misguided actions of index speculators distorting the commodity futures markets, but they're hurting the worldwide economy because every participant in the spot market is forced to pay more for food and energy.
The U.S. government must take action to re-establish reasonable and rigid limits on speculation and to prohibit the damaging practice of index speculation. The world's economies cannot be held hostage by the investment whims of Wall Street.
This concludes my testimony.