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February 4, 2015

FT Alphaville: Michael Masters on speculation, oil, and investment

“Back in May 2008, nobody — especially regulators — had a clue about what was causing crude oil prices to spike to $100-per-barrel-levels, and mostly everyone was inclined to either blame “China” or “speculators” or some combination of the two.

“But Michael Masters, a portfolio manager at Masters Capital Management, had a simple proposition. In the Senate committee hearings organised to figure out exactly what was going on, Masters testified that it was his belief that a new class of investor — one he dubbed the passive “index speculator” — had bulldozed his way into the market and distorted the usual price discovery process.

“This index speculator, he argued, differed to the usual sort in two major ways; their strategy was as immense as it was predictable, involving a simply huge allocation of dollars across 25 key commodities in routine bursts. And, he added, “while the commodities markets have always had some speculators, never before had major investment institutions seriously considered the commodities futures markets as viable for larger scale investment programs.”

“But as Masters explained to FT Alphaville on Monday, the core part of his argument was always based on the notion that prices respond to order flows irrespective of whether they are speculator or hedger driven. Furthermore, he added, the inelastic nature of the oil market has always meant it can take a very long time — people’s entire careers — for imbalances to be corrected, something that understandably allows for serious mispricings to last a very long time.

“There’s a temporal difference between speculative flows and price formation, and supply and demand flows,” Masters said. “It takes a long time for supply to be added, even if the price goes from $30 to $50, it takes management a long time to believe that the price is going to stay there. It may take them a year or two to actually add supply.”

“In the past, every time crude got as high as $30, he said, the market would add production very quickly. But this only meant the price would instantly spring back to $10. This, over time, created a sequence of affairs that taught producers to ignore the $30 production pressure point, leading to a sort of self-imposed production strike until prices were high enough to really make producing more volume truly worth while. These factors, Masters said, were magnified when risk-averse passive investors decided about the same time that commodities were something they could invest in as a speculative asset.”


Read the full FT Alphaville article by Izabella Kaminska here.

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