After earning hefty profits on its commodities trading for nearly 18 years, heavyweight trader Goldman Sachs Group Inc. (NYSE: GS) now finds itself on the hot seat, defending this crucial source of revenue.
And while that may not be good for Goldman, it’s also bad for investors. Let me explain…
It all started back in 1991, when J. Aron & Co., Goldman’s commodities-trading division, recommended that a large institutional client invest about $100 million in commodities. The vehicle “du-jour” was Goldman’s own investment vehicle, the Goldman Sachs Commodity Index (now the S&P GSCI Commodity Index).
The GSCI is a 24-commodity dollar-weighted index, comprised of 70% energy (oil and natural gas), 8% industrial metals (aluminum, copper, lead, nickel and zinc), 3% precious metals (gold and silver), 14% agriculture (wheat, corn, soybeans, cotton, sugar, coffee and cocoa) and 4% livestock (cattle and hogs).
Goldman was to take the other side of the bet, meaning that should the index rise, Goldman would have to pay equivalent returns to the investor. In order to hedge, J. Aron needed to institute similar positions in the futures markets for those commodities.
But the plan had one wrinkle in it. At the time, the U.S. Commodity Futures Trading Commission (CFTC) – the agency that regulated the commodities sector – placed position limits on certain agricultural commodities, like wheat, corn and soybeans. Other commodities weren’t subject to these same limits. Yet it was necessary to hedge all the commodities concerned in order for this investment arrangement to work.
So with a large chunk of new business at stake, J. Aron asked the CFTC to grant it an exemption. Goldman contended that it was not a speculator, but was instead a true “hedger.”
The upshot: In October 1991, J. Aron was granted the sought-after exemption.
Inspired by J. Aron’s success, other members of the commodities-trading oligopoly followed suit, and soon had similar exemptions in hand.
The Global Commodities Boom
In the 18 years that followed the exemption grants, the commodities sector was all in all a pretty orderly place. Between 1990 and 2002, in fact, commodities prices essentially traded sideways.
Unfortunately, that stability wasn’t to last. Like a greyhound that sets out after the hare after having been penned up for too long a stretch, commodity prices started to surge – and ended up doubling over the next six years, albeit in a relatively orderly fashion.
Finally, last year, a market that had been simmering for far too long finally came to a full-fledge boil – and last summer boiled over. Food prices soared, intensifying inflationary fears here in the United States while prompting the leader of the United Nation’s World Food Programme to warn that a "silent tsunami" of hunger was threatening to span the globe.
It seems, though, that the actual boiling point was reached last summer when oil went into a near-vertical climb, surging 63% in just five months, and hitting an all-time high of $147 a barrel last July. Given that oil is in many ways the most relevant commodity to the general public (think fuel for transportation and heating), the new record price touched off a media feeding and prompted projections that crude oil could be headed for $500 a barrel.
As commodity prices were shooting skyward, however, U.S. stock prices saw their already-steep descent turn into a nearly vertical plunge – thank to a worsening of the deepest financial crisis since the Great Depression.
As a result of that crisis, the world’s largest banks, insurance firms and brokerages have been forced to take nearly $1.5 trillion in writedowns, Bloomberg News reported. Because of that and some other related problems, U.S. Treasury Secretary Timothy F. Geithner is pressing Congress to somehow restrain the $600 trillion worldwide derivatives market.
And that has set the stage for a showdown that pits the regulators against the speculators.
What Gensler Wants …
As the spotlight has increasingly been focused on Goldman in the last couple of years for its trading prowess, it’s been suggested on many occasions that the investment bank must be benefiting from some sort of a “special” relationship with the federal government.
The suggestion is understandable on several levels.
Only a month ago, for instance, when Goldman reported its financial results for the second quarter, the investment bank’s trading results helped it record all-time-record profits of $3.44 billion – a good 50% above what experts had been forecasting for what had been expected to be a “blowout” quarter for Goldman.
The stunning profit results once again reminded observers that Goldman Sachs alumnae seem to have a “knack” for landing in positions of high influence.
Former U.S. Treasury Secretary Henry M. “Hank” Paulson Jr., who held that position under former U.S. President George W. Bush – where he was widely viewed as the mastermind behind many of the bank bailout programs conceived last fall – was once the chairman and CEO of Goldman Sachs.
While he was serving as Treasury secretary, Paulson’s office calendar says he called Goldman Sachs Chairman Lloyd C. Blankfein roughly 24 times the week that the federal government opted to bailout out busted insurance giant American International Group Inc. (NYSE: AIG). Remember, had AIG been allowed to collapse, Goldman would have been left holding the biggest of all bags, because of the oversized bets they’d made on AIG’s financial insurance. Paulson, it seems, would have none of that.
The “Six Degrees of Goldman Sachs” doesn’t end there, either, as the many connections show. Geithner, the current Treasury secretary, was mentored by Goldman alumnus John Thain [the last chairman and CEO of Merrill Lynch before it merged with Bank of America Corp. (NYSE: BAC)]. Plus, Geithner just chose Mark Patterson, formerly a lobbyist for Goldman, as his top aide.
And don’t forget about Gary Gensler, the newly installed head of the CFTC whose resume includes a 20-year stint at Goldman Sachs. But interestingly – perhaps even ironically – Gensler’s new job pits him directly against Goldman, as the CFTC looks to rein in what some consider to excessive speculation.
During hearings held in July and August, attended by representatives from both Goldman Sachs and JPMorgan Chase & Co. (NYSE: JPM), Gensler commented that the CFTC “must seriously consider setting strict position limits in the energy market.” He also indicated that his staff had been instructed to determine “every authority available to the agency” to guard the interests of the public as well as the markets.
What Goldman Should Get
In its defense, Goldman has argued that setting position limits on trading commodities is likely to prove harmful, as restricting access could affect liquidity. (Highly liquid markets, or “deep” markets with large volume, are considered to be more fairly priced).
Steven Strongin, a managing director at Goldman, recently told a Senate hearing committee that “attempts to regulate volatility have rarely – if ever – succeeded. Yet they often have unintended and significant consequences.”
Although commodities trading accounts for a considerable part of Goldman’s revenue – some estimates place it at about 8% to 9% – making it a target for would-be reformers, Strongin’s cautionary words should serve as a warning to back off for one simple reason.
Because of the exemption granted to the trading houses, institutional investors have been better able to provide commodity diversification to their portfolios, thereby minimizing some asset and inflation risks.
United States Oil Fund LP (NYSE: USO) and the United States Natural Gas Fund LP (NYSE: UNG) – two ETFs that are among the largest such products in the world.
Though very popular, such exchange-traded funds (ETFs) as the United States Oil Fund LP (NYSE: USO) and the United States Natural Gas Fund LP (NYSE: UNG) could also be affected. They currently boast large volumes in the 12 million and 40 million units traded/day, respectively. That means that a limitation on futures positions – let alone an outright prohibition – would work against the best interests of individual investors.
Even producers and refiners of petroleum products could end up being squeezed, as well. These oil-sector players sometimes hedge risks by calling on the large commodities traders who can provide them with custom trades on demand. The dealer then turns around and wisely hedges its own risk. Now, doubt is being cast on the ability to perform these transactions.
So we know that Goldman, along with JPMorgan Chase) and others – as the largest owners of derivatives – have a lot to defend.
But there’s actually an even-bigger-picture view that argues against regulation – of any kind.
Who Needs Rules?
Government oversight, intervention, and insurance schemes usually lead to problems – often really big problems.
A simple example should be enough to make my point.
Just think back to what happened last year to mortgage giants Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). It doesn’t take an accounting degree to figure out that, by having their loans government guaranteed, management had no incentive to follow cautious lending practices.
After all, why should they? When a base salary is certain, a bonus is tied to sales or growth, and there are no consequences for bad results, why not take on more risk and just shoot for the moon? If you hit it out of the park, your bonus swells. If you strike out – even so badly that you even make “Mighty Casey” look like Henry Aaron – and you lose really badly and your company loses big, even to the point of bankruptcy or outright collapse, you still get your base salary.
Where’s the incentive to manage your risks?
In the case of a bank, there’s no incentive to be careful with depositor assets when the Federal Deposit Insurance Corp. (FDIC) is your bottomless backstop.
Clearly, the government does not always know better.
And that brings us back to Goldman Sachs.
Goldman Sachs: Unplugged, Unfettered, Unregulated
In the debate about regulating the commodities markets, I come down on the side of Goldman, reasoning that a free market – left unfettered – knows best, since the forces of supply and demand will ultimately price things fairly.
Inside an economic system as highly developed as that of the United States, everything operates at a level of complexity that no single person – let alone a government bureaucracy – can operate, or even fine tune. And as soon as anyone begins to tinker with it, there are always going to be unintended consequences. Which leads us back to the question of regulation.
According to, a noted global oil consultant, only a small portion of a commodity’s price, at any given point in time, can be attributed to speculators. He believes that speculators they are necessary to provide liquidity and that, in the end, the benefits speculators provide cancel out any of the negatives often ascribed to their marketplace activities.
If regulations with real “teeth” – in this case, position limits on energy futures – are actually put in place, U.S. financial leaders will end up playing the economic equivalent of Whac-A-Mole – an unwinnable game, and a dangerous one, at that.
While the final result is difficult – if not impossible – to picture, here’s my best guess: The financially lucrative, economically prestigious and strategically important commodities-trading business won’t fold up and disappear – it will just move to another country, where it’s better treated, and even nurtured.
Perhaps it will end up in Asia, as has been the case with so many other important businesses during the past couple of decades. And that, once again, will end up costing America jobs – these jobs high-paying and prestigious – at the worst possible juncture.
According to commodities guru Jim Rogers – who is frequently quoted here in Money Morning – “the three commodity exchanges in China are booming. Dalian trades more soybean contracts than Chicago does already, and that’s with a blocked currency [and] a closed market. Can you imagine what’s going to happen if and when they open that market up to foreigners? It’s going to explode.”
So as you think about “big bad trading firms” such as Goldman Sachs, and commodities speculators, remember the necessary role they play. And realize that restrictive regulations will end up being bad for consumers, investors, and the same free markets we should be defending.
[Editor's Note: If you're new to the commodities-investing arena, and are uncertain about the landscape - or even if you're an "old hand" at natural-resource stocks, but want some insights into the new profit plays and new players - consider hiring a guide: Money Morning Contributing Editor Peter Krauth, a recognized expert in metals, mining and energy stocks, is also the editor of the Global Resource Alert trading service, which ferrets out companies poised to profit from the so-called "Secular Bull Market" in commodities. A former portfolio advisor, Krauth continues to work out of resource-rich Canada, which keeps him close to most of the companies he researches. Against the growing global financial malaise, Krauth says that commodities are among the most-profitable and least-risky investments available, and notes that this may well be the most powerful bull market for commodities we'll see in our lifetimes. He makes a strong case. To read more about his strategies, and the sector plays he likes the most, please click here.]
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