**Testimony of Blythe Masters**

**Managing Director, Head of Global Commodities, JPMorgan Chase & Co.
and**

**Chairman, Securities Industry and Financial Markets Association**

**Before the Subcommittee of Energy of the Senate Committee on Energy
and Natural Resources**

**September 16, 2008**

**Introduction**

Mr. Chairman and members of the Committee, I am Blythe Masters,
appearing on behalf of JPMorgan and SIFMA, of which I am the present
chairman. I am responsible for JP Morgan's Global Commodities business.
By background, I am a trained economist, with a BA in economics from
Trinity College, Cambridge in the UK. I appreciate the opportunity to
present our views on the role of speculative investment in energy
markets.

**JPMorgan Does Not Benefit from Higher Energy Prices**

Before addressing specifically the conclusions in some of the recent
analyses, I would like to describe what JPMorgan's Commodities' business
does, and what JPMorgan as an institution does, to show what effect
higher energy prices have on our businesses.

JPMorgan's Global Commodities business provides risk management
services, develops investor products and makes markets in energy
products around the world. The business is focused on serving corporate
clients (including producers and consumers of commodities) as well as
investor clients. We stand as intermediaries between our clients and the
markets, and we act as risk managers.

Rising energy prices have a significant effect on our clients and
therefore on our business. As prices rise, not only do producers tend to
hedge less, taking advantage of the favorable price trend, but consumers
and investors also tend to postpone transacting, not wanting to lock in
high prices. The effect is that overall business volumes decrease and
risk increases, which hurts our business. Our Commodities business has
no incentive to see energy prices rise and in fact benefits much more in
a lower-priced environment.

Moreover, JPMorgan Chase overall does not benefit from higher energy
prices. Our Retail Financial Services business serves millions of
individual customers in the United States, with branches in seventeen
states. Our Card Services business has more than 155 million cards in
circulation, the vast majority in the United States. Our Commercial
Banking business serves 30,000 clients nationally, including
corporations, municipalities, financial institutions and not-for-profit
entities with annual revenue generally ranging from \$10 million to \$2
billion. JPMorgan Chase is core to the US economy, and rising energy
prices result in a weaker economy - consumers struggling to pay for
gasoline or energy to heat their homes, businesses having to cut back on
investment, defaults rising. As Jamie Dimon, our Chairman and CEO, has
stated, "The weaker the economy gets, the greater the impact could be
across all our lines of business." Higher energy prices hurt our
customers, weaken the economy and therefore hurt us.

One of the truly regrettable consequences of the focus on energy
speculation has been to detract from what we believe is a critical issue
facing the United States: the development of a long-term energy policy.
It is because JPMorgan benefits from a strong US economy that we
strongly support the development of a comprehensive US energy policy,
one that would reduce our dependence on foreign energy and promote the
development of alternative energy in an environmentally responsible
manner. We support the efforts of the CFTC to weed out and prevent
market manipulation, but we fundamentally believe that high energy
prices are a result of supply and demand, not excessive speculation. I
will now turn to our analysis of the role of speculation in energy
markets.

# 

# [The impact of speculators on commodity markets]{.smallcaps} 

What we are addressing here today is the impact of investment flows on
energy prices, and oil prices in particular. But this debate is not
exclusively an oil issue. The same arguments are being discussed in all
the primary commodity markets from corn to copper. These commodities
form the backbone of the world's industrial and economic system and have
a disproportionate impact on the finances of low income groups and
developing nations, understanding the root cause of such price rises is
extremely important.

From the prime vantage point that JPMorgan Chase has across a broad
spectrum of commodity markets, we can see the arguments from many
different perspectives. And we can see that the arguments are often very
inconsistent.

**The growth of index fund investment and its impact on commodity
prices**

Media and political analysis has often focused on the category of
investment flows from passive investors, in particular, those
investments generally categorized as index funds. They have been widely
blamed for rising prices because they have typically been seen as
long-term buyers of commodities, rather than being on both buy- and
sell-sides of the market as hedge funds and other speculators tend to
be.

No one disputes the rapid growth of investment flows into commodity
futures -- we estimate that the money under management in these
commodity indices has increased from \$10-15 bn in 2003 to \$146 bn at
the end of 2007 and \$200 bn at the end of June 2008. But we have to be
very careful in asserting that because commodity prices have risen over
the same period one has caused the other. There is a strong correlation
between the consumption of Tylenol and the frequency of headaches but
that does not imply causality.

You do not have to scratch too deeply behind these assertions to
question the validity of the arguments.

Firstly, if you invest \$1mln dollars in a commodity index fund in 2003
of course you would see the value of your investment increase by exactly
the same amount as the index it was invested in. Commonsense would tell
you that before leaping to a conclusion, you need to see what the net
money flows are after you strip out the capital gain associated with
these trades. When you do that you find no meaningful relationship
between the flows of money coming in and the change in the oil price.

**Index Flows Change vs. SP-GSCI Index Change**

![](media/image1.wmf){width="3.11875in" height="1.7555555555555555in"}

Secondly, index funds tend to hold a basket of commodities, so if
investment money is moving one commodity, it should be moving all
commodities at the same time. It does not. While there has been a
general trend for commodity prices to rise, within that you see
distinctly different trends between commodity sub-groups.

These two factors together argue strongly that spot commodity prices in
general are not being driven by fund flows, but fundamentals.

**Main Commodities Price Evolution (Indexed to 100 --- Dec. 31, 2002)**

![](media/image2.wmf){width="3.122916666666667in"
height="1.6034722222222222in"}

**Correlation Table**

**(Jan. 2003 -- Aug. 2008, monthly data)**

![](media/image3.wmf){width="3.24375in" height="1.6041666666666667in"}

**Corn**![](media/image4.wmf){width="2.995833333333333in"
height="1.7277777777777779in"}

**Wheat**

![](media/image5.wmf){width="2.8743055555555554in"
height="1.6708333333333334in"}

The linkage between physical and futures markets is also important to
understand. Some recent analysis confuses a trading link between the two
with a pricing link.

Futures markets have a much more important economic role than simply
allowing the hedging and transfer of risk over different time periods.
The standardization of commodities traded on futures exchanges offers
price transparency that cannot be achieved with the multitude of grades
and delivery locations of the spot commodity market. But the
concentration of trading in the futures contracts provides a reference
point which spot traders use as a benchmark. They then price their spot
commodity as either a premium or a discount to the futures price. That
links the spot and futures market from a quotation perspective, but that
does not mean that one determines the other.

We had a very clear example of this in the oil market in 2006, when
storage tanks in the US Midwest, the pricing point of WTI, were full up
due to a combination of increased Canadian pipeline flows, refinery
shutdowns and the lack of any infrastructure to ship surplus oil out of
the region. As a result, WTI traded at massive discounts to
international crudes such as Brent, and US Benchmarks such as Mars and
Light Louisianna Sweet crude. This is a classic example of how spot
markets have to clear, regardless of what is happening to the futures
market -- and how spot markets lead futures and not visa versa.

This is important. High school economics students will be able to tell
you that if fund flows into commodity markets artificially push spot
prices above this equilibrium clearing level, you will distort the
market. That distortion will be manifested in a build in stocks. Where
was that stockbuild in the oil market between July 2007 and July 2008
when prices rose from \$70 to nearly \$150/barrel? Where was it when
London Metal Exchange stocks were at near zero levels when copper,
nickel and zinc prices hit record highs? Where was it when we had the
recent surge in wheat and rice prices, or coal come to that?

Some observers point out that this argument does not hold if traders are
secretly holding stocks. But have you seen the size of a VLCC -- you
can't hide one in your back garden. You can't hide an oil storage tank
or offloading facility either. Yes, in oil we know that several
countries have been building strategic reserves, and don't report the
buying, nor do many non-OECD countries report stock levels. But that is
not an issue for the markets -- if they see more physical buying and
supplies tightening, the price rises. This is not fund flows lifting
prices, it is not fund flows replicating the Hunt Brothers squeezing the
silver market. It is however a strong argument for more data
transparency -- which we would fully support.

High prices are there for a reason -- to choke off demand. If the oil
market is working efficiently and effectively you will never see
shortages. You will see consumers being priced out of the market, but
shortages will only occur if there is a sudden supply shock - not a
structural shift.

But what if these investment flows are lifting forward prices? What does
that mean?

What it does not mean is that the man at the pump is paying more for his
oil -- that is determined by the spot market. Higher forward prices
should mean more investment: producers can lock in high prices, and can
guarantee a cash flow. They send a strong signal to consumers to invest
in energy efficient technology, or to look for substitutes.

In the oil and metals industry it may take 5-10 years for an investment
to come to fruition - try hedging that risk in a futures market that
only had significant liquidity six months forward - as we had in oil a
decade ago. Now we have futures markets liquid three to five years
forward. Financial intermediaries such as JPMorgan make markets going
out a decade or more.

These fund flows have provided a huge economic service to the US and to
the world economic system. But are these fund flows distorting the
futures markets -- again, the answer is no. Look at the latest
medium-term analyses - they show that despite these record high prices,
and record investments, we will still see crude oil supplies getting
very tight again in five years time. These high prices are clearly
justified.

Look outside of the commodities and you get more evidence that index
fund flows are not driving commodity prices. Look at commodities that
are difficult for speculators to access: coal, rice, rubber, minor
metals, uranium. All of these commodities have seen sharp price rises at
some point over the past five years -- yet they do not appear in the
main commodity indexes.

There is a much simpler explanation for a generally rising trend in oil
prices: strong economic growth in highly populous countries -- China and
India in particular.

GDP per capita in these countries has risen above the threshold level
(usually seen around \$1000-\$2000/capita) where the population shifts
from a subsistence level to consumer status. As their income expands,
naturally they want to have access to the same goods as we enjoy in the
developed world - housing, running water, better and more food (more
meat) electricity, cars, washing machines and so on. Such a rapid
expansion requires significant increases in primary commodity
consumption.

**Real GDP**

![](media/image6.wmf){width="3.245833333333333in"
height="1.726388888888889in"}

**GDP Per Capita**

![](media/image7.wmf){width="3.3694444444444445in"
height="1.7451388888888888in"}

But supply growth has been poor. The increase in China's oil demand
since 2003 has required the discovery of new oil supplies roughly the
equivalent of Iraq, or Libya or Angola. However, this growth in demand
has come at exactly the same time as the world has struggled to add new
production capacity. According to the International Energy Agency's
Medium Term Oil Market Report in July 2008, non-OPEC crude oil supplies
have been static or in decline since 2004.

Most of the additional growth has been provided by either OPEC, biofuels
or Natural Gas Liquids -- the latter of which can not be readily
transformed into the much-in-demand transportation fuels.

**Quite simply, if you do not have the supply, you have to ration
demand - and in the free market we do this with price. And as the
government sets the price in many developing countries, it is the
developed countries that have to cut back. And the higher your income,
the higher the price needed to curb demand.**

Oil is also getting more expensive to get out of the ground. No one
would debate that. Yet some analysts point to Hotelling's Rule to imply
that oil prices are being inflated by fund flows. No academic would
invoke this if they understood the oil market, no oil market analyst us
this if they understood the academic debate. Hotelling implies that that
even if oil is running out, the price of oil should rise by no more than
the rate of interest. But he was very clear that this rule only held
true if production costs remain constant. In fact, the escalation of
production costs has been unprecedented and therefore his assessment has
no relevance in today's world. . There has been a massive increase in
marginal costs since 2003.

Recent finds in Brazil are five kilometres deep and require penetration
through a vast salt crust.  These finds may be huge, but getting this
oil out of the ground will not come cheaply and there will be
significant infrastructure and technological hurdles to overcome.  It is
not speculation or fear of peak oil which is leading to higher prices,
but the reality of getting oil out of the ground.

We don't think *fear* of peak oil is pushing prices higher, but prices
are reflecting the higher cost of getting oil out of the ground in more
and more challenging locations.

This does not however mean that oil prices stick like glue to the
marginal cost -- currently \$70 to \$100/barrel at current costs.
Marginal cost provides a rough estimate of where oil prices should
gravitate over time. But in the short run, the true marginal cost can be
determined by the price at which OPEC is willing to take off or add oil,
the price at which corn ethanol is available, or the availability of
diesel supplies to a market constrained by ever-tighter product
specifications, limited flexibility in refining capacity and surging
diesel demand.

The weaker dollar has also had an impact. Academics can debate the
precise mechanism for days, but simplistically, a commodity's price is
determined by the supply and demand for the commodity not by the
currency it is denominated in. If the dollar weakens, the value of oil
has not changed globally, so the price in dollar terms has to increase.
In fact, a recent study by the IMF showed that the impact of a weaker
dollar could actually cause a greater than a one-for-one increase in the
price of a commodity. But the impact is not just on the sales price --
costs in the oil and other commodity industries are often denominated in
dollars as well, so a weaker dollar can raise the marginal cost of
production too. But, regardless of this, oil prices have generally risen
by much more than the dollar has depreciated, highlighting that this is
only one background feature of many.

**NYMEX Crude vs. EUR-USD**

![](media/image8.wmf){width="3.9791666666666665in" height="2.25in"}

OPEC has also gained renewed importance in the market. It was slow to
raise output in 2007 when demand was increasing, and prices only started
to decline when Saudi Arabia ramped up production in July 2008. It has
been argued that higher prices are actually leading to less investment
and supply as producer countries seek to maximize their long term
revenue flow. That is a possibility, although I would argue that the
recent decision by Saudi Arabia to increase output sends a clear signal
that there is also concern about the impact demand destruction is having
on their future market prospects. But regardless of your view, that is a
symptom of high prices and political dynamics, not an impact from fund
flows.

The oil market has also had problems in the refining sector, which have
amplified the rise in the oil price. In fact, we believe that the
tightness in global diesel markets was the key factor behind the oil
price rally over the past year. It is not a simple mechanism, or one
that is easy to understand without an in-depth understanding of oil
market functioning. Many traders and analysts will be able to tell you
that diesel has been driving the market over the past few years, but few
will be able to explain the mechanism, but when you think about it in
first principle terms, it is intuitive.

Crude oil is not much use to anyone in its raw form -- a couple of power
stations around the world may use it for fuel, but that is it. Our use
for crude oil is in the refined product form -- gasoline, diesel,
petrochemicals and fuel oil. Each of these refined products is a
commodity in its own right, with a price determined by the supply and
demand for that product. If we sum the values of all of these refined
products we get the price that refiners will be willing to pay for a
barrel of crude oil. So if the price of refined products goes up, the
price of crude oil goes up too.

So if we have strong demand for diesel fuel, but not enough refinery
capacity or crude supply to meet it, diesel prices will rise, and that
will raise the value of the product slate, and so the price of crude oil
rises as well. If the supply of crude oil is too high, refiners will
make a bigger profit and will store more crude. If the supply of crude
is tight, their profits will be less, marginal producers will cut runs
-- and there will be less diesel supply.

In the past year, demand for diesel has been so strong that prices have
had to rise to record premiums to crude oil to restrain demand. In many
ways the diesel market has endured a "perfect storm."

-   Europe is consuming ever-more diesel as tax incentives encourage its
    consumers to switch to diesel cars.

-   A market failure has led to China's teapot refineries being closed
    down, leading China to seek more diesel from an already tight
    international market.

-   Widespread shortages in the retail market prompted China to order an
    increase in stock levels ahead of the Olympics.

-   Power shortages in South Africa and Chile prompted a surge in diesel
    for backup generators.

-   To cap it all, there was a natural gas pipeline accident in
    Australia which, again, caused a surge in diesel demand. Only when
    some of these pressures on the diesel market eased (unfortunately
    partly due to a spreading global economic slowdown) did oil prices
    start to decline.

**ULSD ARA Spot Price -- Nymex WTI Differential**

![](media/image9.wmf){width="3.96875in" height="2.2395833333333335in"}

Importantly, as oil prices embarked on the largest part of this surge,
commodity index investment declined. It is not just our analysis that
shows this, but also the most recent and comprehensive analysis by the
CFTC.

Similarly, when we look to other markets there has also been an easing
of pressure. Some of this has been a response to improved investment:
crop yields have increased, investment is underway in the base metals,
and international oil companies are reinvesting a greater portion of
cash flow than would be seen in any other industry.

Unfortunately, while price pressures have eased in oil (and many other
commodity markets) the unifying factor is a widening weakening of
economic conditions. But even as we weather this downturn, we must be
aware that the fundamentals that underpinned this commodity boom are
unlikely to completely go away.

We recognize that there is a need for more information, and we fully
support efforts to make these markets more transparent. But we have to
recognize that one of the main areas where we lack fundamental
information is on commodities themselves. There have been times when
estimates of the Brazilian coffee crop have fluctuated between 30 and 50
mln bags; when traders have believed there have been secret stockpiles
of metal building up around the world, only to see them "wiped out" by a
dramatic upward revision to demand. The discrepancy between crude oil
supply and petroleum product demand has exceeded 1 mb/d because we only
get reliable data 18 months late. We have no idea of the true production
capacity of many major oil producing countries in the world. There is
little surprise that pundits jump to the wrong conclusions over the
drivers of commodity prices.

Similarly, if we want to regulate markets, we need to know whether they
are functioning properly from a supply and demand perspective first.

But while we support the need for more transparency, for both financial
and fundamental data, it is imperative that we recognize the benefits
that additional liquidity from investment flows provides. Commodity
producers can now invest in the future with the financial tools that
will help them mitigate risk and lock in profitable returns. Arbitrary
changes in fund flows could reduce that new-found liquidity, resulting
in lower investment and ironically exactly the opposite effect that was
intended - higher prices in the future.