**Prepared Testimony of**

**John L. Johnston\
Before the**

**Committee on Agriculture**

**Regarding**

**The Impact of Index Investment on Energy Commodity Futures**

**U. S. House of Representatives**

**July 11, 2008**

Many years ago, when I first became a member of the NYMEX, I read a
quote by Mark Twain that described a gold mine as \"a hole in the ground
with a liar standing next to it.\" I have always remembered that wise
adage and whenever there is some question about money in the commodity
markets I tend to keep an eye out for the hole and the liar. There is a
lot of murky information in this debate about index length and there are
billions of dollars at stake, so I am careful to remind myself that
those things which I am not allowed to see are probably hidden for a
reason. Transparency is the key to unlocking the mystery of rising
energy prices, and the sooner we can see who has what position and how
big it is, the sooner this episode will be a part of history.\
 I have been working in the commodity futures industry for 33 years and
I have been a member of the COMEX and/or NYMEX for 31 years. The
opinions I intend to offer on the challenges of the commodities markets
are not unlike the views of a sailor discussing the challenges of the
sea: there are great natural forces at work and a good deal of intuition
is needed to chart a safe course.\
\
Pundits and journalists have recently demonized \'the speculator\' as
the root cause of high oil prices.  I would like to be clear at the
outset that I do not believe speculators deserve to be blamed for the
current situation. Rather, I propose the root cause of high oil prices
is the Commodity Index Investor or the \"Passive Long\" investor.  I
believe the passive long investor, through the use of commodity index
derivatives, has unwittingly cornered the WTI light sweet crude oil
futures market. The following discussion will make a case for
understanding this blameless, yet extremely dangerous condition on
futures exchanges and in leveraged derivative markets.

The market activities of the passive long investor and the speculator
are polar opposites. The speculator has an investment strategy that
relies on responding to market conditions. He manages and assesses his
risk by evaluating changing market conditions and information. He will
be either long or short, without bias. Conversely, a passive long
investor invests a set allocation of assets as directed by a risk
committee, following a long only investment model. . It is important to
note that although the portfolio may be rebalanced, or the percentage of
total assets increased or decreased, this investment model is always
long. In the case of the passive long investor, the commodity index
investment is used to stabilize total returns to the portfolio and not
to achieve them.  Thus the position remains completely passive; the
investor is not seeking returns or managing risk and the index
length will remain in the portfolio  until the entire fund is
liquidated. The long-only commodity index position merely exists and
requires no measure of active management or maintenance other than
periodic rollovers.\
\
There are a lot of estimates as to the size of the commodity index
position held by these passive long investors. The numbers most commonly
accepted are about \$250 billion dollars, of which a weighted AIG/GSCI
energy allocation of 48% equals about 1.4 billion barrels of crude oil,
heating oil, gasoline and gas oil. If the current estimated passive long
energy position were to be sold at the rate it has taken to acquire, it
would add in the neighborhood of 1 million barrels to daily supply for
-4 years. It should be noted that during the period of liquidation, the
net effect of a loss of 1 million barrels in demand (they stop buying)
and an addition of 1 million barrels in supply (they start selling)would
mean an increase of 2 million daily barrels to the supply and demand
equation. It does not take much imagination to estimate the effect such
liquidation would have on prices. Personally, I believe the positions of
the passive long investors are much larger than estimated above. \
\
Because crude oil and crude oil products require tremendous physical
resources to transport and store, the supply/demand equation is tightly
balanced. Elasticity in the physical system is limited to storage,
shipping, and tankage. If total world consumption is 85 million
barrels per day, then the system must produce at least 85 million
barrels or the marginal excess demand will become apparent in market
prices spontaneously. Conversely, because the economics of the
infrastructure supporting physical crude oil impose limitations
on excess commercial supplies, any surfeit will become equally apparent
in the board price at the futures exchanges. This is the primary
function for which futures exchanges were created: to buffer price
volatility caused by short term gaps in the production/consumption
chain. They were never intended to provide a long term leveraged
liquidity venue for an investment community abstractly
allocating of hundreds of billions of dollars.\
\
THE PROBLEM\
\
Oil futures are not oil.\
\
The core problem is in the daily auction of futures. If you have 50
futures offered and 50 futures wanted, you have a balanced auction. If
you have 48 futures offered and 52 futures wanted and you have an
imbalance. The discovery of a price for the futures contract in question
is not found in the transaction of the 48 which are balanced; rather it
is the 4 demanded that have yet to be satisfied by a seller that set the
price. In sum, it is the marginal excess of supply or demand which
defines the benchmark price in the daily auction.\
\
NYMEX futures are not oil. They are a 17th century financial creation
whose use has been, until recently, to help a small community of
producers, consumers, trading brokers (or exchange locals) and
speculators (as defined above) manage their price risks. All futures
have historically been limited by their own supply and demand rules. If
a trader is short NYMEX futures there is no substitute: either he buys
or covers the futures contracts or the trader must deliver the physical
material. Since the passive investor [never]{.underline} liquidates his
position, the short must find another seller or the physical commodity
to make a conforming delivery. Note: the passive long investor does roll
a transitory and equal amount periodically as the futures contracts
expire but the sale is a linked part of a calendar spread. For all
intents and purposes, the passive long n[eve]{.underline}r contributes
liquidity to the futures markets.\
\
Here is the rub:  \
\
1) The passive long  position, as reported by credible sources, is
estimated to be a weighted AIG/GSCI equivalent of 1.4 billion barrels
of WTI light sweet crude heating oil, gasoline and gas oil or equal
to 1.4 million contracts of crude oil, heating oil, gasoline and gas
oil of NYMEX and/or ICE futures. \
\
2) Combined NYMEX and ICE crude oil, heating oil, gasoil, and
gasoline open interest is equal to approximately 3.5 billion barrels
or 3.5 million contracts.\
\
3) Therefore: the passive long only index position is equal to 40% of
the total combined long NYMEX and ICE open interest. Otherwise stated
40% of the open interest has effectively ceased to exist from the
liquidity pool.  \
\
4) Therefore: there are only .60 longs are available for every 1 short.

Think of it like 6 girls and 10 guys at a dance. \
 \
This imbalance is dynamic: as the market goes down the active number of
longs gets smaller (they sell) and the number of passive longs gets
larger (they buy). The relative ratio of shorts to passive longs goes
up and creates a supply void.  Traditional supply and demand
fundamentals are subordinate to this elementary math:  1 contract
wanted, .60 offered. As long as this architecture is in place
the market for paper barrels or for WTI light sweet crude on NYMEX or
ICE cannot go down. The buyer is facing a chronic deficit in the daily
auction supply of futures and the resulting outcome in terms of price is
certain.\
\
5)  What is happening in energy markets is not much different in result
than an old fashioned commodity squeeze. The \[passive\] longs own a
critical  percentage of the stock or supply of daily liquidity, but the
cast of players and the motives driving prices are as different as the
definition of each found in my opening paragraphs. It is not important
why, or if the motives are legal or moral. It only matters that the
opposing shorts must auction an exit from their losses by paying a
premium to another seller who will \[risk\] take the former\'s place.
But the passive long never sells. And the new short faces the
same structural imbalance as price spirals higher and higher ever
replacing one group of short sellers with another. The auction resets
over and over again at higher prices but the architecture does
not change,\
\
6) There has been a. 99% positive correlation between the NYMEX crude
contract and the Goldman Sachs commodity index over the the last 2
years. This means that the market prices the entire Goldman Sachs
Commodity Index at nearly at par with the NYMEX crude oil contract every
day It begs one to ask if the estimates of 48% of the index being
allocated to energy are perhaps low. \
\
7) It is ironic, but there are no criminals violating laws or
rules. And\.... there are no winners: the overall portfolio that the
commodity index was intended to defend suffers at an exponentially
greater rate with each uptick in crude prices. Higher energy prices mean
lower prices for stocks and bonds.\
 \
THE REMEDY\
\
In my opinion, the most effective way to deal with the problem is
to raise the cost of being LONG in derivative exposure to commodities on
all venues: futures, OTC, ETFs, and options. \
\
If the cost of being LONG changes, investment committees will
recognize the change and adjust their allocations. This can be done by
raising margins on LONGS, demanding and enforcing greater transparency
of OTC swap positions and reporting the same to the market.\
\
I am certain if margins and credit requirements were raised on all LONG
POSITIONS ONLY except consumer hedges, crude oil would fall immediately
and precipitously. I do not suggest inhibiting the normal daily use of
futures by bona fide hedgers who need protection from unforeseen
negative events and prices. I do suggest a deliberate clear message that
the party is over.   \
 \
Asking to raise margins on longs only may seem prejudicial, but if
margins are raised on longs and shorts equally, prices will explode. In
an up market rising margins put increasing pressure on the short.
Margins have traditionally been increased in rising markets to assure
performance rather than influence behavior, but the crude market is a
moving target and American citizens are getting hurt. I suggest the
first order of business is to inhibit buyers through tighter credit and
higher margins on longs. Investment Banks, passive investors, and
producers don\'t need to be coddled and any complaints of encroachment
on free and fair markets would be disingenuous to say the least.   There
is no such thing as a \"free market\". Any intervention is designed to
produce a specific result, whether it is the FED lowering the funds rate
or the BOJ buying yen in the open market.  \
\
In my opinion, the slightest hint that the Congress might be moving to
deleverage energy derivatives would have a chilling effect on prices.\
\
Finally, so much information is hidden it is impossible to be accurate
unless changes are made to allow greater transparency.  I would ask
the banks who have been a part of the debate to stop making a case for
right or wrong. I don\'t think anyone has a perfect answer but
stubbornly insisting that only one side of the debate is correct is not
the beginning of a solution. It seems reasonable that institutions who
have relied on the American people for solvency in recent months might
be willing to oblige the government in its efforts to understand and
deal with the effects of rising energy prices rather than arguing the
truth lies only with them.  I would also suggest the congress and its
committees contact passive investors directly and inform them that
it\'s possible some of their investment objectives might be doing
serious damage to the nation and its citizens. I think an effort like
that might be well received.  Maybe we just need a time out to get a
better look at things. Handicapping margins on LONGS and I mean a hard
sharp increase on all long positions (including Wall Street trading
desks, day traders, and producers)will create that pause and oil prices
will go down and stay down for quite a while.\
\
Allow me to thank you for the opportunity to discuss these issues and
offer my opinions.

**[Current CV]{.underline}**

**John L. Johnston\
546 Van Buren Rd.\
Morristown, New Jersey 07960**

Born June 9, 1949\
\
Education:\
 Pasadena Polytechnic, American College of Paris, University of Arizona\
\
Employment:\
\
2006- present Independent trader, IB and Precious metals and energy
consultant\
\
2005- 2006 Sr. Vp commodity sales ICAP North America\
\
1996-2005 Sr Vp Energy and Metals sales Refco \
\
1994- 1996 Independent floor trader\
\
1987- 1996 Ex Vp Institutional Brokerage Corp\
\
1981- 1987 Rudolf Wolff Inc.\
\
1980- 1981 Drexel Burnham lambert\
\
1975- 1980 Continental grain co.\
\
Married 1987. 3 children