ABSORBING NOT ADDING LIQUIDITY
The problem is not the overall amount of money that investors have poured into commodity markets, but its concentration at certain points along the futures curve, and the fact investors have tended to behave as a herd, all trying to go long at the same time. As a result, the influx of investment money has tended to absorb rather than provide liquidity to the rest of the market.
In theory, rising commodity prices should have encouraged commodity producers to sell production forward, ensuring the market remained balanced. In practice, it simply encouraged producers to discontinue hedging programs and accept spot prices, in expectation prices would rise even further.
So as oil prices climbed relentlessly, buying interest from investors was met by less selling interest from producers, and less willingness from dealers to take a short position against the trend. Liquidity declined, prices became discontinuous and the market began to “gap” higher.
Even after prices have fallen, the concentration of investor positions in certain parts of the curve is still causing distortions. The need to roll the Oil Fund’s contracts and those of commodity indices forward each month (selling existing holdings in the nearby month and buying contracts for the next one) is keeping the market locked in a deep contango.
Contracts which the Oil Fund and the indices need to sell are locked at a permanent discount to the ones they need to buy, as the rest of the market preys on forced sellers. In the process it is inflicting substantial roll losses on index and fund investors even though oil prices have been steady over the last three months.