Natural Gas Prices: The Impact of Speculative Greed

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1 What happens if buyers and sellers BOTH want higher prices? The inevitable higher prices. There is substantial talk about price manipulation in commodity markets but if each transaction involves one buyer and one seller, there should be an inherent protection against price manipulation right? But what if the interests of some buyers and sellers somehow align? What if a buyer actually wants higher prices? Hypothetically, this could provide the environment for a seller to get a higher price than what would have been acceptable to a buyer who wants lower prices couldn t it? While these scenarios seem a bit absurd, we believe this is precisely what is happening with crude oil and natural gas commodity prices. This analysis provides an in-depth look at the futures market, the purpose that it provides to various market players, how it is being used today for speculative greed, how long higher prices may last, and recommended actions that natural gas buyers should consider in today s marketplace. We are pleased to share our findings with you, but want to emphasize that our findings represent our opinion only and cannot be guaranteed. Table of Contents Analysis Overview...2 Introduction...3 Futures Basics Today s Market Conditions...11 Government Actions...12 Commodity Index Funds...13 The Rise of the Index Speculator...14 Commercial Trader Trading Patterns...19 Non-Commercial Trader Trading Patterns...20 A Plan for Natural Gas Buyers Disclaimer: The information contained herein is the opinion of Energy Solutions, Inc. The information, views and opinions contained herein are presented for the convenience of the reader and are provided on the condition that errors or omissions therein, or reliance thereon, shall not be made the basis of a claim, demand or cause of action. The views and opinions expressed herein are for informational purposes only, are in no way guaranteed, are expressed as of a specific time and are subject to change at any time without notice. Published: June 10, 2008

2 How Long Can Speculators Control Prices? Analysis Overview The extended outage of the Independence Hub provided the uncertainty that the speculators needed to keep natural gas prices elevated into hurricane season and this means price pullbacks will likely be minimal or short-lived until fall. The natural gas market has entirely ignored any signs of improved or adequate supply. Any bearish news, such as the return of the Independence Hub or a triple digit storage injection, has been shrugged off. Conversely any bullish news, even if it is very small such as a weak tropical storm, has resulted in large price gains. This is a disturbing sign of what the market may be capable of doing during hurricane season and stretches of hotter weather. Natural gas supply and demand is not out of balance, but that has taken a back seat to the new money finding its way into commodities through Index Funds. This new money, not underlying fundamentals of supply and demand, is the primary culprit for the recent price rise in natural gas. In order for the upward momentum to stall, there needs to be a slowing of or reduction in the new money being invested into Commodity Index Funds. Until this occurs, the bias is for higher natural gas prices. Government intervention or renewed strength in the stock and equity markets would serve as one factor that could detract some of this Commodity Index Fund money back into equity markets, but this isn t something that is going to happen quickly. The Federal Reserve has indicated that it is done with its aggressive rate-cutting campaign, but now inflation has taken over and the U.S. Dollar continues to struggle. Those struggles have been further complicated by other countries raising interest rates to keep the value of their currency up. As a result, the U.S. Dollar is making little ground in strengthening against other currencies and thus there is little reason for investors to divert dollars from Commodity Index Funds back into the stock market. Price stability is not a favored environment for speculators and the next few months tend to be the most volatile time of the year for natural gas prices. Speculators know this and will thrive on it. While the current price rise in natural gas has been caused by a speculative influence, Energy Solutions, Inc. concludes that since prices have been sustained at higher levels into the month of June, even with the return of the Independence Hub, the likelihood that natural gas prices will remain over $10 per MMBtu, and maybe even $11 per MMBtu, for the next 90 days has increased substantially as speculators await opportunities to drive prices to new highs. This means buyers need to have a plan to protect against even greater upside. Price action in 2008 is still viewed as a speculative bubble that will have an exaggerated response to the downside when it bursts. The reasons behind this opinion are fully articulated in this analysis. Specific natural gas buying recommendations relative to current price levels and market conditions are not included in this analysis, but for more insight into what we believe is prudent action for buyers, click here to check out a free trial to The Advisor, a weekly and monthly publication specifically written for commercial and industrial businesses. June 10, 2008 Energy Solutions, Inc. Page 2_

3 Introduction The purpose of this analysis is to provide commercial and industrial businesses with a better understanding of: Why natural gas prices (and other commodity prices) have continued to rise in Why the price rise in 2008 is substantially different from past rallies. How the futures market is supposed to work versus how it is working today. Why an Index Speculator is different from a Traditional Speculator. At what point will the fundamentals of supply and demand again control market prices. What needs to occur in order for natural gas prices (and other commodity prices) to decline. It has and continues to be the opinion of Energy Solutions, Inc. that current price levels for natural gas have been driven primarily by speculative investors. However, unlike past times where speculators were seeking a quick return, the price rise for natural gas, as well as other commodities, is due in part to a new type of speculator, who really isn t seeking a quick return but instead is looking at the commodities market as one that has long-term gain. The perception of this long-term gain is quite similar to why people invest in the stock market to have their investment portfolios increase in size. As the stock market struggled, institutional investors found an investment tool with higher returns. The success of this investment tool, which is Commodity Index Funds, takes on the look of the stock market but it deals with commodity prices. The strength of Commodity Index Funds has grown exponentially in 2008 as large returns are attracting more investor dollars and this investment tool is exactly at the heart of the current run-up in numerous commodity prices. This makes today s price rally substantially different from past rallies. This analysis takes an in-depth look at how the futures market works and how Commodity Index Funds are impacting natural gas prices. This analysis was published on June 10, 2008, and is therefore based on available information as of that date. Information contained within this analysis is believed to have been obtained from accurate, reliable industry resources, however that data has not been individually verified by Energy Solutions, Inc. There is a lot of data in the analysis and the first part of the analysis, Futures Basics, deals specifically with the inner workings of the futures market and is designed for those who do not have a familiarity with the futures market. However, for those that already feel they have a good handle on the futures market and want just the quick details, simply read the Quick Recap sections at the bottom of each page and then go right to page 21, A Plan for Natural Gas Buyers. June 10, 2008 Energy Solutions, Inc. Page 3_

4 Futures Basics The majority of information found in this section was taken directly from which is a great financial educational resource. With rising commodity prices, some of the examples may not reflect current day price levels, but nevertheless the examples still support the underlying concept of how the futures market works. The futures market is a place where buyers and sellers mutually agree on the underlying price of a physical commodity. For every buyer there is a seller and because the interests of these two parties should be different, there should be an inherent protection against market manipulation. But the futures market has grown into a complex financial tool that now provides more than simply a place for buyers and sellers to come together through Commodity Index Funds, it now also acts as a substitute for what investors used the stock market for. What is a Futures Commodity Contract? A futures commodity contract is a financial instrument or financial contract in which two parties agree to buy and sell a physical commodity for future delivery at a particular price. For natural gas futures on the New York Mercantile Exchange (NYMEX), futures contracts can be bought and sold as far out as December 2020 although there is typically little activity that far into the future. The majority of trading appears to take place in just the first two months being traded. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. While the futures market has a physical delivery point for the underlying commodity, typically less than 1% of all transactions actually reach physical delivery. Buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods, which is the primary activity of the cash or physical spot market. Basically, the futures market is a centralized marketplace for buyers and sellers from around the world. Pricing can be based on an open cry system (something like an auction process). Pricing can also be completed electronically with the matching of electronic bids (buying price) and electronic offers (selling price). Regardless of the process, once a transaction is completed, the contract price and date of delivery are considered firm. QUICK RECAP What is a Futures Commodity Contract? A futures contract is a firm financial contract between a buyer and seller for a physical commodity for future delivery at a particular price. June 10, 2008 Energy Solutions, Inc. Page 4_

5 Futures Basics (cont.) How the Futures Market Works Let's say, for example, that you decide to subscribe to cable TV. As the buyer, you enter into an agreement with the cable company to receive a specific number of cable channels at a certain price every month for the next year. This contract made with the cable company is similar to a futures contract in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price for now and the next year - even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices. This would make you a hedger in the futures market. In the futures market, instead of a cable TV provider, a producer of wheat may be trying to secure a selling price for next season s crop (i.e. producer of the commodity), while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit (i.e. consumer of the commodity). The farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. It is this contract - and not the grain per se - that can then be bought and sold in the futures market. In this example, the buyer and the seller have differing viewpoints about the value of the underlying commodity and this brings balance to the establishment of the price for the underlying commodity. The transaction isn t completed until the buyer and seller reach agreement on what that value is. A futures contract is an agreement between two parties. The party assuming the short position is the party agreeing to deliver the commodity (the seller). The party assuming the long position is the party who agrees to receive a commodity (the buyer). In the above scenario, the farmer/producer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long position (agreeing to buy). Every contractual transaction for a futures contract involves both positions. QUICK RECAP How the Futures Market Works: One of the most difficult concepts to understand is how can prices be manipulated on the futures market if there is always a buyer (who assumes a long position) and seller (who assumes a short position) for each transaction. If a buyer (such as a bread maker) feels the offer price is too high, they may defer the purchase of a wheat futures contract. In order to complete the transaction, the seller (the farmer/producer of wheat) would have to consider reducing its selling price ( offer ) to a level that would match or attract a buyer s price ( bid ) in order to secure a price for next season s crops. A transaction isn t completed until both a buyer and seller agree on the contractual price. Because the buyer and seller have different interests and different views on what the value of the underlying commodity is worth, it should be difficult for buyers and sellers to manipulate futures prices. June 10, 2008 Energy Solutions, Inc. Page 5_

6 Futures Basics (cont.) Initial Margin When you buy a stock, the cost of that stock is paid upfront. If the stock grows in value, the benefit is the difference between the upfront acquisition cost and the higher price value. If the stock declines in value, there is no out of pocket additional money required on the part of the stockholder, but it is possible that the stock could decline in value to zero, and the loss to the stockholder could turn out to be their entire investment. Unlike the stock market, when you open a futures contract, only a portion of the value of the contract needs to be paid upfront. This original deposit of money is called the initial margin and it is only a small fraction of the total value of the underlying commodity. For example, a natural gas futures contract of 10,000 MMBtus at a per unit price of $12 per MMBtu yields a total value of $120,000, but the initial margin to make this purchase is just $10,000. Margin requirements apply to all players regardless of size or type. Initial margin amounts are continuously under review and at times of high market volatility, initial margin requirements can be raised. Day to Day Price Changes and Margin Maintenance The price of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, let s return to the prior scenario where a farmer/producer of wheat and bread maker entered into an agreement for 5,000 bushels of grain at a price of $4 per bushel. Each day as the price of the grain fluctuates the profit or loss to each party is calculated. With a $1 rise in the price of the wheat, the farmer, as the holder of the short position (seller), has lost $1 per bushel because the selling price just increased from the future price at which he is obliged to sell his wheat. The bread maker, as the holder of the long position (buyer), has profited by $1 per bushel because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat. Unlike the stock market, daily price changes are reconciled each day. Losses are deducted from the margin and profits are added to the margin. The dollar amount in a contract holder s margin account changes daily as the market fluctuates in relation to futures contract transactions and each holder also has a minimum-level or maintenance margin to maintain. When a series of loses causes the value of a margin account to drop below the minimum-level, a margin call occurs requesting the holder to provide additional funds to bring the account back up to the initial margin level. When a margin call is made, funds usually have to be delivered immediately. If funds are not quickly available, they are usually attained through either a liquidation of some positions to come up with the needed funds or a liquidation of the futures contract so that the margin requirements would no longer apply. QUICK RECAP Margin Requirements and Price Changes: Anyone that holds a long or short position on a futures contract must have an account that holds a stated amount of money (margin account). This good faith account is designed to cover any losses occurring and if it declines to below that minimal level, the holder of the futures contract will be required to deposit more money in it. June 10, 2008 Energy Solutions, Inc. Page 6_

7 Futures Basics (cont.) Contract Liquidation Each contract has a defined timeframe and when liquidated, the holder is refunded the initial margin plus or minus any gains or losses that occurred over the span of the futures contract. As indicated earlier, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash or physical spot market. If we return to the example of the farmer and break maker, if the contractual price of the futures transaction was $4 per bushel and the contract was liquidated at $5 per bushel, the farmer would lose $5,000 on the futures contract (Sold at $5, liquidated (bought) at $4 = 5,000 bushels x $1 loss) and the bread maker would have made $5,000 on the contract (Bought at $4, liquidated (sold) at $5 = 5,000 bushels x $1 profit). For those that entered the futures market to establish the sale or purchase price of the underlying commodity, contract liquidation is just step one as these players will still need to purchase the physical commodity in the marketplace. If the two parties had been speculators, rather than a farmer and a bread maker, liquidation would finalize the transaction. The short speculator (seller) would simply have lost $5,000 while the long speculator (buyer) would have gained that amount. There are no further transactions completed by speculators because they used the market as an investment tool and do not need the physical underlying commodity. The Purchase of the Physical Commodity Step two for farmer and the bread maker involve the purchase of the physical commodity. After the settlement of the futures contract, the bread maker still needs wheat to make bread. The liquidation price was $5 per bushel, and therefore it is assumed that the price in the physical market is also $5 per bushel. The bread maker purchases the product in the physical market at the going rate of $5 per bushel for 5,000 bushels. The bread maker previously made $5,000 profit ($1 per bushel) in the futures market, thus the bread maker s total cost is $20,000 ($25,000 for the physical product less $5,000 in profits in the futures market for $20,000 for 5,000 bushel or $4 per bushel). Similarly, the farmer sells the product in the physical market at the going rate of $5 per bushel for 5,000 bushels. The farmer previously lost $5,000 ($1 per bushel) in the futures market, thus the farmer s revenue is $20,000 ($25,000 for the physical sale less the $5,000 in losses in the futures market for $20,000 for 5,000 bushel or $4 per bushel). QUICK RECAP Contract Liquidation and Price Convergence: The futures market is supposed to be representative of supply and demand so as a futures contract nears expiration, the price in the physical spot market and the futures market at a comparable delivery point should merge into one price level because all that is left is physical supply and demand requirements. Therefore, high prices in the physical market should represent demand exceeding supplies and low prices in the physical market should supplies exceeding demand. June 10, 2008 Energy Solutions, Inc. Page 7_

8 Futures Basics (cont.) Hedgers and Speculators The players in the futures market fall into two categories: hedgers and speculators. Anyone directly involved in the production, merchandising or consumption of the physical commodity is a hedger. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks. The holders of the long position in futures contracts (the buyers of the commodity) are trying to secure as low a price as possible. The holders of the short position in futures contracts (the sellers of the commodity) will want to secure as high a price as possible. Speculators are very much different than hedgers. They do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. Speculators aim to profit from the very price change that hedgers are protecting themselves against. QUICK RECAP Hedgers and Speculators: Hedgers want to minimize their risk no matter what they re investing in because they have an interest in the underlying price moves of the physical commodity, while speculators want to increase their risk and therefore maximize their profits. The overall concept behind how prices are established on the futures exchange is that the player taking the long position has a contrary view of the player taking the short position. Thus, a short position and long position should have contradicting outlooks of the future and this helps to make sure the establishment of prices is balanced. Hedger Hedger Speculator Speculator Short Position Long Position Short Position Long Position Secure a selling price to protect against future price declines (owner/seller/producer of the commodity) Secure a purchase price to protect against future price increases (consumer/buyer of the commodity) Secure a price now in anticipation of declining prices (sell high, buy low) Secure a price now in anticipation of rising prices (buy low, sell high) June 10, 2008 Energy Solutions, Inc. Page 8_

9 Futures Basics (cont.) Futures Market Regulation The U.S. futures market is regulated by the Commodity Futures Trading Commission (CFTC), an independent agency of the U.S. government. The market is also subject to regulation by the National Futures Association (NFA), a self-regulatory body authorized by the U.S. Congress and subject to CFTC supervision. The CFTC breaks hedgers and speculators into three categories: (1) Non-commercial (large speculators); (2) Commercial (large hedgers); and (3) Non-reportable (small speculators and small hedgers). The CFTC is charged with the responsibility of making sure futures markets are protected from manipulation, abusive trade practices and fraud. The CFTC requires that clearing members, futures commission merchants, and foreign brokers file daily reports with the CFTC. The third category of traders that use the NYMEX are small hedgers and small speculators whose positions fall below the reportable category. The goal of the reporting requirements is to ensure that no single player gains too much control, however, the CFTC has no oversight over foreign exchanges or financial transactions relating to commodities conducted outside of the typical commodities market environment, a loophole that has existed since the demise of Enron and has yet to be closed by legislative action. The CFTC does not care about what type of positions are being taken or why they only get involved if positions held start to exceed certain limitations. One way that speculators can get around the oversight of the CFTC is to go to Wall Street Banks to complete transactions. The CFTC has granted Wall Street Banks an exemption from speculative position limits when these banks hedge transactions over-the-counter (OTC). OTC trading involves the trading of financial instruments, such as stocks, bonds, commodities or derivatives directly between two parties. In essence, OTC trading can produce the same results as the use of the futures market, but it is conducted outside of the futures exchange, and therefore flys under the radar of the CFTC. QUICK RECAP Futures Market Regulation: The futures positions held by single players are monitored and regulated by the Commodity Futures Trading Commission (CFTC) but there continues to be a number of loopholes, i.e. electronic trading or the use of foreign exchanges, that allow players to conduct business outside of the CFTC oversight. June 10, 2008 Energy Solutions, Inc. Page 9_

10 Futures Basics (cont.) The Amaranth Lesson When the positions of hedge fund Amaranth Advisors resulted in margin calls (defined on page 6), and the money was not readily available, they were forced to liquidate some of their positions to raise needed cash. If they were holding a long position, this meant to liquidate they needed to sell a contract for the same delivery timeframe. The investigation into the workings of Amaranth uncovered that at one point they held as many as 100,000 natural gas futures contracts. They initially bet that winter 2007 prices would be higher than summer 2006 prices, and to support that strategy they bought January 2007 while selling November Thus, they were on both sides of the market (long and short), but in different months. They also bought March 2007 contracts while selling April 2007 contracts under the same investment strategy. In addition to margin calls, Amaranth was required to reduce its positions because it was exceeding certain limitations, and it did so on the New York Mercantile Exchange (NYMEX), but simultaneously increased its positions on a foreign exchange, the InterContinentalExchange (ICE), which is not regulated by the CFTC. As it turned out, because Amaranth held both long and short positions, albeit for different contract months, when they tried to liquidate they found a shortage of other players willing to offset their transactions. The liquidation of contracts by Amaranth in September 2006 drove the October 2006 natural gas futures contract from close to $7 per MMBtu to just over $4 per MMBtu and the losses pushed Amaranth into bankruptcy. QUICK RECAP The Amaranth Lesson: Amaranth is an excellent example of speculation out of control. As both a buyer and seller in the marketplace, Amaranth had to distort prices because they no doubt had a single view point and tried to take advantage of that outlook from both a buying and selling perspective. In September 2006, the collapse of Amaranth led to a collapse in the October 2006 natural gas futures contract on the NYMEX. Amaranth was a true Technical Speculator entering the market as both a buyer and seller seeking profit opportunities. We ll learn shortly how Technical Speculators are considerably different from Index Speculators. Lastly, the same loopholes in law that existed during the demise of Enron and Amaranth still exist and the investigation into Amaranth is still ongoing, so the laws haven t been tightened in any way to limit similar abuses. June 10, 2008 Energy Solutions, Inc. Page 10_

11 Today s Market Conditions Because the majority of the talk these days focuses on crude oil price manipulation, we first want to take a look at today s market conditions. After reaching a record high of $ per barrel on May 22, 2008, the frontmonth NYMEX crude oil contract lost a lot of momentum, falling to $ per barrel by June 5, Some say the price decline was the result of lower demand caused by changing consumer habits, pointing to a recent report by the Department of Transportation that indicated Americans drove 11 billion less miles in March 2008 than in March Many expect demand to continue to decline particularly with unemployment rising to 5.5% in May, marking the largest jump in unemployment in over 20 years this means 8.5 million are jobless at this time. Plus with consumer confidence at its lowest level since October 2002 and with over 1 million homes in foreclosure, the highest rate ever recorded, it would seem that a decline in demand is really quite reasonable. Others say the recent price slide that took place between May 22 and June 5 has nothing to do with demand but instead was the result of the strengthening dollar and corresponding comments by Federal Reserve Chairman Ben Bernanke on June 3 indicating the rate-cutting campaign would come to an end as concerns of inflation heightened. But, price action on June 5-6 is anything but easy to explain. On Thursday, June 5, 2008, the July 2008 crude oil NYMEX contract gained $5.49 per barrel in a single day, posting the biggest single-day gain in dollar terms for the crude oil contract in NYMEX history. The price move up was chalked up as reaction to an announcement by a Morgan Stanley analyst calling for $150 per barrel crude oil prices by July 4 th and strength in the euro which rallied sharply against the dollar following comments from European Central Bank President Jean- Claude Trichet that the bank could implement an interest rate increase at its next meeting on July 3. However, what was even more astonishing is the fact that the July 2008 crude oil NYMEX contract rallied another $10+ per barrel on Friday, June 6, reaching as high as $ per barrel another new high. The only factor that can be pointed to as a reason for this rally is renewed weakness in the U.S. Dollar. Similar to crude oil, natural gas is experiencing a similar number of day-to-day illogical price movements. So, while this section focuses primarily on crude oil, the outcome applies equally as much to natural gas. QUICK RECAP Today s Market Conditions: Historically, significant price rallies for commodities occur when there is a major supply disruption, but that wasn t the case for this recent two-day rally of crude oil. Some believe price fluctuations in crude oil are the result of investors looking to crude oil commodities as a hedge against the weaker dollar. However, it probably goes much further than that and it is going to take many more factors than just a strengthening dollar to bring commodity prices down for crude oil, as well as numerous other commodities. June 10, 2008 Energy Solutions, Inc. Page 11_

12 Government Actions On May 29, the CFTC disclosed that it is in the middle of a six-month investigation into possible oil market manipulation. It also disclosed that it will be taking a number of initiatives to increase transparency in energy futures markets indicating that the measures will expand the amount and quality of information received from energy traders to further the integrity and oversight of our nation s futures markets. Details of this their initiative can be found at: The CFTC also convened its first meeting of its Energy Markets Advisory Committee on Tuesday, June 10, 2008, to receive input from a variety of sources on key energy market issues. The Committee, which includes a wide-range of representatives of energy industry participants, will focus on the issue of transparency in the energy markets, and will include discussions on the role of index trading and energy trading on foreign boards of trade The CFTC also recently announced that on June 11-12, it will be hosting an International Energy Market Manipulation Conference gathering with senior enforcement officials from around the world who are responsible for prosecuting manipulative conduct affecting prices of energy commodities and derivatives. This is the second annual conference (the first was held in October 2007) and this conference will focus on global trading in the energy markets and will ultimately be a way to share information. The latest information on potential government intervention was released on June 5, 2008, when Dow Jones reported that the chairman of a Congressional energy panel said markets were being manipulated by the biggest trading houses in the futures markets, though he said a probe hasn t uncovered illegal activity. Bart Stupak, D-Mich., named Goldman Sachs (GS) and Morgan Stanley (MS) as two of the trading houses. He said the U.S. House Energy Oversight Committee hasn t subpoenaed the banks and is basing its findings on data from the CFTC. Stupak said initial results of his committee s investigation into skyrocketing oil and product prices had found loopholes in current laws that were allowing the biggest traders in the futures market to game the system. He said the committee would hold a hearing to announce full results of the investigation on June 23. As our investigation goes further, we are really starting to unravel quite a web of I am trying to say collusion, but I wouldn t quite go that far but you can certainly see manipulation of the price in places we ve never seen before, he said. QUICK RECAP Government Action: Historically, when the government announced any type of investigation, market players who were concerned about becoming the focus of an investigation reduced their position holdings and many times just the threat of an investigation helped prices return to some sort of normalcy. However, crude oil prices did just the opposite and gained more than $15 per barrel within two days even as the government identified that large firms like Goldman Sachs and Morgan Stanley were gaming the system. This time the announcement of the investigation has done nothing to curb any of the wild price swings in crude oil and this suggests that this time is different because either the players are just so much larger or because the players are confident that they aren t doing anything illegal. June 10, 2008 Energy Solutions, Inc. Page 12_

13 Commodity Index Funds Technical vs. Index Speculators Speculators have long existed in commodity markets. Speculators are supposed to add liquidity to commodity futures trading. Liquidity is characterized by a high level of trading activity. However, some believe that the speculative influence in commodities has now transitioned from a role of providing liquidity in the market to a role of almost controlling the market. The primary reason for this is cited in recent testimony to the Congress by former hedge fund operator Michael Masters. Masters says there are now two classes of speculators, the Traditional Speculator who has long been active in commodity markets and is a major factor in providing market liquidity because they are the players most often willing to take on the risk from the other players who want to hedge (owners of the commodity want to hedge their selling price and buyers of the commodity want to hedge their purchase price) and the new class of speculator referred to by Masters as an Index Speculator who adds virtually no benefit and looks to the commodities market as an alternative to the stock market using Commodity Index Funds as a primary investment tool. Mutual funds are comprised of a variety of individual investment sources, including stocks, bonds, short-term money market instruments and/or other securities. As the value of these investments move around the value of the mutual funds rises accordingly. Similarly, Commodity Index Funds are comprised of a basket of traded commodities and if the commodities that make up this basket rise, the value of the Commodity Index Fund rises accordingly. Commodity Index Funds aren t a new concept but the attraction to them is. Masters full testimony can be found at and it goes into great depth on the market manipulation caused by the Index Speculators use of Commodity Index Funds and the recommended steps that government should take to stop this manipulation. There are a number of Commodity Index Funds that are traded on exchanges. Goldman Sachs Commodity Index (GSCI), Reuters CRB Commodity Index, Dow-Jones-AIG Commodity Index, and the Oppenheimer Real Asset Fund are just a few. Many of these funds cannot be invested in directly by average investors, and some require more than $100,000 as an initial investment. Many who disagree with Masters point out that unless there is some sort of massive collusion between buyers or sellers, the futures market is difficult to manipulate because for every buyer there is a corresponding seller. However, when you take a closer look at this, while there may not be collusion occurring, the interests of an Index Speculator as a buyer may be too closely aligned with the interests of sellers, and thus while market manipulation may not actually be occurring, as these interests align it could damage the way the futures market is supposed to work. QUICK RECAP Traditional vs. Index Speculators: When a Commodity Index Fund enters the futures market initially, it is always a buyer except when it needs to liquidate a position prior to the contract expiration. It means that this fund never initially enter the market as a seller (acquire a short position). It is always considered a buyer (basically like a consumer who needs the physical product) regardless of price conditions. Masters refers to these players as Index Speculators and they are substantially different from the Traditional Speculator who is considered both a buyer and seller depending on the price environment. June 10, 2008 Energy Solutions, Inc. Page 13_

14 Commodity Index Funds (cont.) Commodity Index Fund Performance The GSCI is traded on the Chicago Mercantile Exchange. It is made up of a basket of 24 commodities. When looking at the composition of GSCI, it is based on 24 commodities and is currently weighted 78.11% energy commodities, 5.99% metal commodities, 1.74% precious metal commodities, 11.11% agricultural commodities and 3.04% livestock commodities. Of the overall composition, it is weighted 40.33% in crude oil. By comparison in July 15, 2005, the GSCI was weighted 29.55% in crude oil commodities. So, in the past three years, the composition of the GSCI has changed and is now weighted 10% more in crude oil commodities alone. By comparison, the Reuters CRB Commodity Index consists of a basket of 17 commodity prices and is much more equally weighted with just 17.6% earmarked for commodities. Each Commodity Index Fund is based on a basket of commodities that are traded on futures exchanges. The composition of the commodities utilized and the weighting of each, is really up to the manager of the individual Commodity Index Fund. Ultimately, the performance of the Commodity Index Fund is directly related to what is happening with commodity prices. So, if certain commodity prices are moving up, Commodity Index Funds containing those commodities will experience a similar price trend. Those that have invested in Commodity Index Funds are seeing large returns and are happy. The large returns are due to climbing commodity prices and the large returns attract move money as investors continue to pull money out of the stock market and direct it toward Commodity Index Funds. The charts on the next page show the performance of the GSCI Fund and the performance of the CRB Commodity Index fund since From 1978 to 2001, you ll see that the value of these funds held relatively constant, but there was explosive growth in 2002 concurrent with what many believe was the start of the rise in commodity prices. The value of these funds continued to climb as commodity prices rose, but their value has exploded in QUICK RECAP Commodity Index Fund Performance: As commodity prices have risen the value of the Commodity Index Funds that are made up of basket of commodities have provided very good returns to investors. In essence, the Commodity Index Fund is looked at as an alternative to the stock market. The large returns have attracted more investment money and the Commodity Index Fund concept is flourishing. The catch-22 is trying to determine whether the price rise in commodities seen particularly in 2008 is due to underlying supply and demand issues or whether it is due to an increase in demand for futures contracts from Commodity Index Funds. June 10, 2008 Energy Solutions, Inc. Page 14_

15 Commodity Index Funds (cont.) Commodity Index Fund Performance Commodity Index Funds (cont.) Index Fund Performance (cont.) June 10, 2008 Energy Solutions, Inc. Page 15_

16 The Rise of the Index Speculator Index Speculator Demand Is Driving Prices Higher Master s says if supply is adequate and prices are still rising it means demand must be increasing as well. But Masters suggests that the increase in demand is not coming from the physical side, but rather from Index Speculators. Specifically, Masters says these Index Speculators are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Masters says these investors now account for on average, a larger share of outstanding commodities futures contracts than any other market participant. In the early part of this decade some institutional investors who suffered large losses in the stock market began to look to the commodity futures market as a potential new asset class suitable for institutional investment. Never before had major investment institutions seriously considered the commodities futures markets as viable for larger scale investment programs. Commodities looked attractive because they were going up in value while equity portfolios were declining in value. As a result, financial industry consultants started suggesting for the first time that investors could buy and hold commodities futures, just like investors previously had done with stocks and bonds. This buy and hold mentality creates an artificial demand. Masters says assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March 2008, and the prices of the 25 commodities that compose these indices have risen by an average of 183% in those five years. Because commodities futures prices are the benchmark for the prices of actual physical commodities, if Index Speculators have been able to drive futures prices higher, Masters concludes that they have driven physical prices higher as well. In a market driven by fundamentals, as prices rise, demand should start to wane. However, Masters points out that with the Index Speculator demand for futures contracts actually increases when the price of the underlying futures commodity contracts increase. Rising prices attract more Index Speculators and more money into the commodities markets because the rising prices have created larger returns for investors using Commodity Index Funds. So for futures markets contracts, the profit-motivated demand from Index Speculators has the inverse impact on commodity prices from what you would expect to see from price-sensitive consumer behavior. Under basic economics of supply, rising prices should result in declining demand. QUICK RECAP Index Speculator Demand is Driving Prices Higher: As the value of Commodity Index Funds rise and the stock market struggles, investors redirect even more money toward these funds. The money is automatically invested into the commodities markets based on the commodity composition of the fund regardless of the price of the individual commodities. This investment in commodities is in the form of buying futures contracts, which creates an ongoing and artificial demand for futures contracts even if prices continue to rise with absolutely no sensitivity to price level. June 10, 2008 Energy Solutions, Inc. Page 16_

17 The Rise of the Index Speculator (cont.) Differences Between Index and Traditional Speculators Demand for futures contracts can only come from two sources physical commodity consumers and speculators. Traditional Speculators provide liquidity by both buying and selling futures contracts, often taking the risk that the hedger (producer or consumer) wants to avoid. Traditional Speculators are seeking to profit from buying low and selling high or selling high and buying low. Thus, Traditional Speculators do look at price levels and will make decisions accordingly and therefore, they are an important component in making the futures market work. However, unlike Traditional Speculators, Index Speculators enter the market initially ONLY as a buyer. When an Index Speculators has new money to invest, they buy the underlying commodities based on how the Commodity Index Fund is weighted. It is our opinion that new money is the primary driver behind driving commodity prices higher. An Index Speculator s demand for futures contracts arises purely from portfolio allocation decisions. When an Institutional Investor decides to allocate 2% to commodities futures they have a set amount of money that they wish to invest. 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 the money has been put to work. Index Speculators have an insensitivity to prices. For example, if Goldman Sachs is receiving a lot of new investment money for their GSCI fund, to put the money to work they are buying the basket of commodities based on the composite make-up of their fund, which right now is weighted 78.11% in energy commodities. These purchases are made upon receipt of the new money and have nothing to do with price levels. The timeframe under which to purchase the commodities is really up to the Index Speculator, so they may be buying the underlying commodity contracts for six months into the future or two or more years into the future. While they may not care about the underlying price, they do need to be sure to liquidate their position prior to expiration to avoid having to take delivery of the underlying commodities. Eventually, any long positions must be liquidated, but the Index Speculator then turns right around and re-enters the market, rolling their long position into another month. It is our opinion that this rolling behavior provides price support, not necessarily new upward price momentum. QUICK RECAP Differences Between Index and Traditional Speculators: A Traditional Speculator watches commodity prices with the goal of buy low, sell high or sell high, buy low. That is how a Traditional Speculator reaps their profits. An Index Speculator enters the futures market as a buyer whenever they receive money from investors to be invested into a Commodity Index Fund. They invest the money based on the individual funds weighting regardless of price level. Never before has there been a player in the futures market with so much insensitivity to price levels. June 10, 2008 Energy Solutions, Inc. Page 17_

18 The Rise of the Index Speculator (cont.) When the Interests of Buyers Align with Sellers Higher Prices are Inevitable Let s assume Index Speculator A buys a June 2008 commodity taking a long position and Producer B of course likes higher prices and is more than willing to sell at higher price levels taking a short position. As commodity prices move higher AND there are no underlying problems with supply and demand, the number of buyers should start to decline, causing Producer B to have to offer lower prices for the underlying commodity. However, as commodity prices rise, more investors direct money toward Commodity Index Funds and this in turn causes more buying in the futures market by Index Speculators or an increase in demand for futures contracts. This increase in demand for futures contracts only serves to drive commodity prices higher even if there is no correlation to an increase in underlying physical demand. Overall, when a buyer does not care about the individual per unit price of the commodity, sellers can continue to command higher prices. What s wrong with this picture? Of course, Producer B has an interest in higher prices because they are truly a seller of the underlying commodity. But, Index Speculator A also has an ancillary interest in higher prices because while they are paying more for the underlying commodity, it is having a positive impact on their Commodity Index Fund. The Index Speculator is in a winning situation here as commodity prices have risen, their Commodity Index Funds are providing great returns, plus as an initial buyer of the commodity, with rising prices any liquidation prior to expiration is likely to provide a profit as well. Prior to expiration both Index Speculator A and Producer B need to get out of their positions or be ready to make and accept physical delivery of the product. However, once those positions are liquidated, Index Speculator A immediately returns as a willing buyer to the market (rolling its position from one month to the next) and Producer B, or perhaps even Traditional Speculator C continues to be willing to sell at higher price levels. When commodity prices move higher, the Index Speculator has even more money for investment. Masters points out that commodity prices have increased the most dramatically in the first quarter of 2008 noting that Index Speculators flooded the markets with $55 billion in just the first 52 trading days of this year. Here is one way that flood of money may have worked. If Index Speculator A bought a June 2008 crude oil futures contract at $120 per barrel and prior to expiration, it liquidated at $125 per barrel then they experienced a $5 per barrel gain. Meanwhile, because the price of commodities rose, the price of the underlying Commodity Index Fund rose providing a secondary or ancillary profit from the rise in commodity prices. The $5 profit is immediately re-invested into commodities regardless of price levels and the performance of the Commodity Index Fund continues to attract new money as well for investment. Considering that crude oil prices have risen by $35 per barrel since the start of the year, the Commodity Index Funds are outperforming most other investments and until there is a change there is no reason to believe the behavior and trading patterns of Index Speculators will change. QUICK RECAP When the Interests of Buyers Align with Sellers, Higher Prices are Inevitable: Index Speculators not only have new money to invest, they also likely have the profits from contract liquidations to invest. They are strong players right now and without some sort of new development, such as government intervention or a dramatic decrease in demand, there is no reason to believe their trading behavior is going to change in the near future and this could mean even higher prices. June 10, 2008 Energy Solutions, Inc. Page 18_