High commodity prices? Blame Wall St

By Barani Krishnan - Analysis

NEW YORK (Reuters) - Speculators are likely the first to be blamed in any discussion of today's soaring commodity prices.

But the people who profit without taking delivery of a single barrel of oil, ounce of gold or bushel of corn may not have taken these assets to record highs without the encouragement and products of Wall Street banks and firms, according to some.

"The ugly truth is that the securitization of commodities has eased the way for money flows to raise commodity prices beyond that which the current fundamentals of the global economy can sustain over the long term," Michael Frankfurter, a fund manager at California's Cervino Capital Management, told a conference on base metals in New York last week.

Securitization of commodities refers to Wall Street's method of repackaging futures on commodity exchanges into products that can generate investment banking fees, not unlike subprime mortgages and municipal bonds.

The spotlight has again shifted to commodity speculators after crude oil hit a peak of $112 a barrel and corn $6.40 a bushel in U.S. trading this week. U.S. oil and gold futures have already seen record highs more than a dozen times this year. Wheat and soybeans have also hit repeated tops.

Industry observers cite huge fund inflows into commodities as a reason for such rises. The surge of such funds, often called speculative or hot money, has led to high prices in everything from gasoline to bread and clothing, enraging consumers around the world.

"There is an orgy of speculation in futures markets," U.S. Sen. Byron Dorgan, a North Dakota Democrat, told Congress last week. "This is a 24-hour casino with unbelievable speculation."

EASY TO PARTICIPATE

Investors with little or no interest in activities like oil exploration, copper mining or grain cultivation traditionally participated in commodities through futures exchanges, buying and selling raw materials contracts without taking delivery of any products.

Now, commodities investors who are "noncommercial," such as hedge funds, pensions, endowments and wealthy individuals, are pouring money into multiple new derivatives products created by Wall Street. These products include exchange-traded funds, or ETFs, where investors can buy or sell a whole basket of commodities securities like a stock.

"The good news is that in creating a vehicle that makes commodities look like stocks, Wall Street has made it easy for investors to participate in the rally," said Jeffrey Korzenik, chief investment officer at VC&C Capital Advisers.

"The bad news is that commodities are not stocks, and the differences hold some very important, real-world implications," Korzenik wrote in a commentary on how Wall Street was manufacturing inflation.

He cites one implication: Gold purchased under ETFs and similar instruments exceeded all the jewelry demand from China in 2006. Last year, ETF demand for gold was just slightly below U.S. jewelry demand.

With commodity ETFs, Korzenik said, investors were also buying more than they were selling -- creating bigger long positions, which push prices up, than short positions, which suppress prices. Many futures markets also exhibit similar trends, thanks to a surge in interest for long-only commodity indexes -- another favorite play of noncommercials.

According to Wall Street estimates, the money following commodity indexes grew by $30 billion in just the first two months of this year. This is in addition to the estimated $55 billion tracking commodity exchange-traded notes, another popular spin-off from ETFs.

The bias to long-only investing has made prices too much for commercial users of commodities who once relied on futures markets to hedge their supplies. "In this environment, the marketplace is ill-equipped to efficiently absorb more investment capital," the National Grain and Feed Association said of U.S. agricultural markets in February.

OVERBLOWN?

Some argue that the role of speculators in commodities has been overblown. "I just don't buy the argument that hedge funds are responsible for the sizable moves in all commodities, especially oil," said Bank of America's head of alternative investments, David Bailin, who works closely with hedge funds.

The Commodity Futures Trading Commission, the U.S. futures markets regulator, says speculators account for only 37 percent of outstanding contracts in U.S. crude oil. But it is holding of a meeting of agricultural market players later this month to study the problem in grains markets.

Those debunking the theory about runaway speculation in commodities cite fundamental reasons for current prices. These include the economic boom in heavily populated countries like India and China, where people want to eat and live better; gleaming new infrastructure demanded by oil-rich territories like Dubai and Abu Dhabi; and the rising popularity of biofuel produced from corn and other crops as the world seeks alternatives to Middle Eastern crude oil.

Some also say speculators have become convenient whipping boys for policymakers who want to deflect blame from the poor resource-planning that led to current prices.

"One man's terrorist could be another man's freedom fighter," a hedge fund manager in New York said. "In this case, someone you call a speculator could just be an investor."

(Editing by Matthew Lewis)