Testimony before the CFTC 

July 28, 2009 

Todd E. Petzel, Ph.D. 

Chief Investment Officer 

Offit Capital Advisors, New York 
Testimony before the CFTC

July 28, 2009

Todd E. Petzel, Ph.D.

Chief Investment Officer

Offit Capital Advisors, New York

Mr. Chairman and Commissioners, my name is Todd Petzel and I am the Chief Investment Officer of Offit

Capital Advisors, a New York City based Registered Investment Advisor.   Our business is to advise on

investment portfolios to private families and not‐for‐profit entities.  Our client base numbers 43, and the

assets under advisement exceed $4 billion dollars.  The portfolios are diversified across all asset classes

and are truly global.   Our clients are not major investors in futures markets, but rely on the efficient

workings of securities and commodity markets worldwide.

Despite my current lack of direct involvement in futures markets, I have long been a student of and a

practitioner in the futures markets.  My academic research in the markets dates back over thirty years.  

From 1982 to 1988, I was Chief Economist of the Coffee, Sugar & Cocoa Exchange, where my duties

included monitoring positions for market surveillance purposes.  From 1988 through 1995, I was with

the Chicago Mercantile Exchange, mostly in the role of Chief Economist.  During my more than 13 year

exchange tenure, I worked closely with the CFTC and its staff on market surveillance and position limit

issues.  In 1996 I moved into the money management and advising business, serving as Chief Investment

Officer of Commonfund, Azimuth Trust, and Offit Capital Advisors in the time since.  In 1996 I was first

elected a public director to both the National Futures Association (NFA) and the Futures Industry

Association (FIA).  I have been reelected regularly to both posts since, but I want to emphasize that my

testimony here today represents my own views and should not be attributed to either organization or

its members.

While the focus of the panel today is on the energy markets, the issues are much broader, and the topics

are not new.  In 1981 I published a paper, included as Appendix A, trying to identify if large speculators

unduly influenced wheat prices in the volatile markets of 1925, an episode that generated Congressional

hearings and helped ultimately to shape the Grain Futures Act of 1936, creating the first federal limits

on futures positions. 1 Citations from the hearings and research of that era are strikingly similar to much

of the dialogue today.

                                                           

1 Petzel, Todd E. “A New Look at Some Old Evidence: The Wheat Market Scandal of 1925,” Food Research Institute

Studies, Vol XVIII, Number 1, 1981.
The three topics I wish to address concern collection and dissemination of market information, position

limits, and the participation of traditional investors in commodity futures markets, often in the form of

commodity index products.

Collection and Dissemination of Market Information

The subject of information is relatively easy as it is undeniably essential to good market oversight.  

Exchanges and CFTC collect good information for their analysis.  Any positions above a “reportable” level

are collected with enough background information to identify the ultimate owner, which allows the

exchanges and the Commission to aggregate common accounts held at different clearing members.  

Participants in the markets implicitly agree to supply further detailed information on request.    The

record of the exchanges and the Commission in keeping such delicate information confidential has been

exemplary.   

When positions grow large enough to approach the position limits set by Federal statute or the

exchanges, the typical behavior is to request an exemption for the purposes of hedging or risk

management.    In these instances, additional information about the nature of the trade is routinely

collected to evaluate the merits of the request.  When I was actively involved in the process, the data set

was reasonably rich.

Broad summaries of the reportable positions have been created and published by the Commission for

many years.   Originally the categories included labels like “speculator” and “hedger,” which implicitly

imputed motivation.    These were later changed to “commercial” and “non‐commercial” in an honest

effort toward more objective labeling.

Recently questions have arisen about the activities of unleveraged commodities investors, who, if they

are trading directly, often establish positions in portfolios of futures contracts.  In these situations they

would be classed as “non‐commercial” traders.  More often, however, these investors establish index

positions away from the exchanges, using structures created by dealers that were not contemplated

when the reporting rules were established.  When this occurs, the dealers providing these structures to

their customers can turn to the exchange to offset the risk.  In the traditional scheme of reporting rules,

such activities fall under the “commercial” heading.

Herein lays a problem.   Investors trading directly are counted among the non‐commercial set.   But if

they do the same activity via an off‐exchange structure, and that gets hedged back to the exchange, it

gets counted as commercial activity.  The exchanges and the Commission probably have enough detail

to see through the reality, but the users of the public reports are severely disadvantaged.

Adding more classification in public reports is probably a good idea to help market participants.  It is my

experience that most commercial market participants have an excellent understanding of the current

market dynamic.  But for those who do not, and for all of the broader public participants, summaries of

market positions that are more granular in their categories would be most helpful.  The steps taken to

date by the Commission should be encouraged and applauded.

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Position Limits and Exemptions

The subject of position limits is much more complicated.  Much of the confusion over this topic stems

from some very loose language.    The terms investor, speculator and manipulator are used almost

interchangeably in some circles, doing a great disservice to the process of finding the correct regulatory

mix.  As the Commissioners are certainly aware, manipulation in a legal sense involves not only artificial

prices, but also the specific intent to create them.    This is an important fact to keep in mind, and it

would be a major step for a free society to move from a historical policy of preventing market

manipulations to using laws and regulations in an attempt to change unpopular market outcomes.   

Position limits have a very basic role.  They are set by statute or regulation to help prevent any individual

participant, or a group of participants acting in concert, from amassing a position so large that it would

disrupt the market in general, or, if held toward expiration, the convergence of the relevant spot and

futures prices.  Anyone who has performed a market surveillance function knows that position limits are

only a starting point, and great mischief can be done by people who begin with positions well inside the

limits.

I wish there was a magic formula that translated the size of a physical market to the appropriate

position limits, but there is none.  When one considers the number of links in any commodities supply

chain, one could easily see futures open interest five or six times the total size of the physical market

without including any non‐commercial participants.  Setting workable position limits combines art and

science.

When the authority for setting position limits is delegated to the exchanges, they have a very strong

incentive to get it right.  One should always remember that futures markets are completely voluntary

activities.    Commercial participants, who form the backbone of all successful futures contracts, are

particularly disturbed by markets that are prone to excessive volatility or expirations that lack

convergence.   

If the limits are set too loose, there is the possibility of disruptive behavior, which can drive commercial

participants away.    If they are set too tight, traders who possess important market information and

provide crucial liquidity are kept away.  At either extreme, the markets fail, though for different reasons.  

When one considers the phenomenal growth of commodity and non‐commodity futures contracts alike

over the past 30 years, it is hard to give the exchanges anything but strong marks in striking the right

balance.    Any particular commercial participant may not like a specific outcome, but on average the

group has voted with their feet that the markets are doing a good job.

The exchanges understand that this is not a permanent state of affairs.    Competitors for risk

management are everywhere and vigilance is ongoing.    As the exchanges have transformed from

mutualized not‐for‐profits to competitive, for‐profit organizations, there are heightened pressures to get

the position limit puzzle solved correctly.

The Commission or the Congress could step in as they did in 1936 and impose their own view.    This

would likely be an error.  With no disrespect to the staffs of either organization, it is unlikely that there is

3
either the knowledge base or the incentives to strike the right balance when establishing appropriate

limits.  Instead the pressure would be political and reflective of only the moment.  Imagine the conflicts

when tight position limits are set to combat perceived high energy prices, only to be followed by a

period of bumper crops where farmers are begging for demanders of any kind.

Exemptions to the position limits are as old as the limits themselves.    Congress understood that

commercial activity could be done in sizes greater than the limits, and allowed for hedge exemptions.  It

is important to note that exemptions to the speculative limits are not a blank check, but instead are

expanded limits that are applied for by the hedger.  This process, in my experience, allows the exchange

or the Commission to acquire supporting documents describing the size and nature of the commercial

activity being hedged.

In the 1980’s and the early 1990’s the traditional concept of hedge exemptions needed to evolve to

incorporate commercial activities using recently invented financial futures.  The parallelism between a

grain dealer and a Treasury Bond dealer was exact and needed no real modification of the model.  But

the growth of interest rate swaps off exchanges was the first major application of the hedge principle to

activities that were constructed by financial engineers.    The growth of both the interest rate swap

market and the Eurodollar futures market at the CME came about in no small way because of the early

recognition that the activity of swap dealers qualified for bona fide hedge exemptions to the position

limit rules.

The second major evolutionary step was the creation of risk management exemptions.  A few years after

stock index futures were begun in 1982, traditional stock investors recognized that they could create an

unleveraged equivalent of an S&P 500 index portfolio by combining S&P 500 futures and Treasury Bills.  

These positions were fully collateralized and marked a major step in improving the efficiency of portfolio

management.    The question naturally arose as to whether this activity would qualify for a hedge

exemption.

Obviously, this was not hedging activity in the traditional sense, nor was it leveraged speculative activity

that largely motivated the creation of position limits.  There was an acknowledgement that there were

few reasons to artificially constrain this synthetic portfolio activity.    Anyone can build a stock index

portfolio of virtually any size, so allowing equivalent activity using futures not only made sense, but

likely would add to the liquidity of and connectivity between cash and futures markets.  Rather than try

to contort the then existing hedge exemptions to this situation, the exchanges and the Commission in

the early 1990’s agreed to the concept of risk management exemptions.   

As usual, in a dynamic, evolving world, the risk management exemption concept that initially had a

narrow application to stock index futures and portfolios soon became relevant for a broader range of

activities.  It is particularly relevant today in the discussion of synthetic commodity portfolios.

Commodity investing by traditional portfolio managers will be discussed in more detail in the section

below, but for now, the important thing to consider is that many institutional and individual investors

have made significant commitments to long commodities as part of their asset allocation.    These are

not, in general, investors who have any interest in constructing CTA like positions of leveraged

4
exposures.  Instead their research has led them to conclude that their overall risk and return profile is

enhanced by the inclusion of unleveraged holdings of physical commodities including industrial and

commercial metals, foods and fibers, and energy.    The big question then becomes, what is the most

efficient way to access these markets for these investors who have no particular skill in handling physical

commodities.

Two logical avenues appeared.    It is in the public record that in the 1990’s Harvard Management

Company began an internal program of building commodity exposures in a variety of ways.    But a

cornerstone of this program was a portfolio of fully collateralized futures contracts that they rolled

forward at regular intervals.    The program was modeled along the lines of the Goldman Sachs

Commodity Index, which had been created in the early part of that decade, though Harvard developed

its own modifications to the standard index.

Few institutional investors, and probably no individuals, were as well equipped as Harvard to execute

such a plan directly.    Swap dealers, who had deep experience in creating customized, off‐exchange

solutions for their clients, quickly turned their skills to commodities.    They offered a wide array of

structures that generally provided access to a diversified array of commodity exposures in an

unleveraged product.   

These dealer‐created, synthetic portfolios of commodity exposures needed to be managed by offsetting

positions in the cash and futures markets.   While the motivation of the ultimate customer might be

different, this activity is the same in principle to a wheat or coffee dealer negotiating price‐to‐be‐fixed

contracts with a miller or roaster, and it deserved hedge exemptions from the position limits.

There is a valid question whether non‐commercial commodities buyers can use off‐exchange

transactions to circumvent position limits.  The matter is somewhat complicated by the fact that dealers

only bring their net off‐exchange transactions to the futures markets to hedge, but there may be a way

to address this.    Dealers should be able to provide documentation justifying any hedge exemption

request.    If that documentation shows any single off‐exchange position that would translate to a

violation of the position limits, that request could be denied.   In such cases the dealer would choose

either to carry an unhedged position against that customer or turn to other markets for protection.  An

example could show how this might work.

Suppose there is a stylized commodity futures contract with a position limit of 100.  A dealer offers swap

positions or structures that replicate that commodity from either the long or the short side.  20 clients

come to the dealer and each want the equivalent of 10 contracts long.  The dealer writes the contracts

and then hedges the position in the futures market.    Since the 200 contract total exceeds the 100

contract limit, a hedge exemption would be applied for.  Since each of the customers is well below the

individual limit, this dealer hedge exemption should be granted.

Now suppose another client comes to the dealer and wants to take a 200 contract position on the short

side.  The dealer could create a structure for this client, taking the chance that the 20 clients on the long

side together would act as an internal hedge.  This would be a calculated risk from an execution stand

point.  If most of the long clients decided to cover their positions, the remaining net exposure would be

5
larger than the position limit at the exchange.  If the dealer tried to justify a hedge exemption with the

short position of the single customer, it would be flagged as inappropriate and denied.  The dealer could

turn to the physical markets to hedge in this instance, which is always an option for those skilled in that

activity.

I purposely used a completely abstract example above to avoid any value judgments in the discussion.  It

doesn’t matter what the commodity is or whether the limits are “too small.”    The point is that once

limits are established, there should be a mechanism for dealers to create the synthetic equivalent of

futures positions for customers who choose not to trade directly.  And that activity should be completely

supported by the hedge exemption process as long as it is not being used to circumvent the position

limit rules.   

Today, we do not know if this is anything more than a theoretical issue.  As the Commission gets more of

the detailed data from market participants discussed above, they will be able to determine if this is a

real problem at all and how big it is.   

While the proper size and effectiveness of position limits can be debated at great length, what cannot

be disputed is the necessity of dealer hedge exemptions associated with any activity that is consistent

and allowed by the established position limits.  The negative impact of disallowing such exemptions on

the effectiveness of our futures markets cannot be overstated.

Traditional Investors in Commodity Futures Markets

Much has been made about the impact of traditional investors who in the last several years have

increasingly added unleveraged synthetic or direct positions in commodities to their portfolios.    The

language has been particularly unhelpful, as some commentators use the terms investor, speculator and

manipulator with almost no distinction.  I would like today to try to clarify what I believe are the most

relevant points in the discussion.

And clarification is needed because as the debate has heated up, advocates on both sides have been

increasingly shrill in their assertions.  In these comments I hope to be able to strike a balance, as I have

no index products to sell and I have no reason to keep legitimate investors from pursuing any particular

opportunity.

There is a camp that asserts that commodity index investors are only liquidity providers and that they

have no impact on the price of the underlying commodities.  These assertions strain our intuition about

how markets work, and they come in the following three varieties:

• Commodity index owners are always buying and then selling, never taking delivery. Therefore it

is not “real demand.”    The act of selling the soon to expire futures contract when the more

deferred contract is purchased is a neutral act.

• Commodity index owners rebalance these exposures to maintain target portfolio weights, just

as they do their bond and stock exposures.    Rebalancing involves selling after markets

appreciate and buying after declines, so commodity index owners add stability to the market.

6
• Commodity index buyers clearly had no impact on their markets as evidenced by the fact that

prices for commodities that had futures and those that did not both went up in 2007 and early

2008.  If index buyers had an impact the futures based commodities would have gone up while

those without futures would have not.

Each of these points is made with great conviction, backed with data where selectively appropriate, and

each contains a grain of truth.  But the broader assertions are false for the following reasons:

• Any neutrality of “rolling” futures positions is true only after the initial positions are established.  

Every time a new long‐only index futures client appears, they represent a new long position that

has to be met by a short.  Tens of billions of dollars of new money entered the index space in

2007 and early 2008, competing with other longs.   Higher prices were required to encourage

new shorts to be counterparties.    This is exactly how markets always work, and these index

buyers did not magically appear on the open interest records to assume their price neutral

rolling activity.  Additionally, the act of rolling futures contracts may be neutral with respect to

price levels, but it is not neutral with respect to the spreads.  Selling the front month and buying

the deferred tends to create and widen the carry in any market.    Many market participants

believe commodity index buyers have had a meaningful impact on both price levels and spreads.  

This is not a new phenomenon.  For several years I have communicated with my investors and

advisory clients describing the process.  Copies of these commentaries can be found in Appendix

B.

• The rebalancing comment is quite accurate if the number and size of commodity index

participants is static.    The problem in 2007 and 2008 was that for every investor who was

trimming an outsized commodity exposure because of price appreciation, there were probably

10 new participants who were being attracted to the space.  The net effect was still a major net

addition to the long side as prices rallied.

• The correlation argument is made only by those people who fail to understand or acknowledge

that physical commodity markets are linked in many ways.  Coal and rice are two commodities

for which futures markets have never achieved serious liquidity.  And yet, their prices rose in

2007 and 2008 without futures buyers.    Unfortunately for this assertion, many end users of

natural gas and heating oil on the energy side and wheat and corn on the food side have the

ability and incentive to shift to coal and rice when the prices of the futures commodities go up.  

In economics this is called a cross elasticity of demand.

While it is certainly true that China, India and many other parts of the developed and developing world

were rapidly expanding their demand for all commodities in 2007 and early 2008, it is also true that tens

of billions of dollars of demand was entering the market via commodity index investing.  Ascribing how

much of a price increase is attributable to each activity is probably beyond the powers of our

econometric tools.  Saying one is responsible and the other is not is roughly the equivalent of trying to

say which blade of the scissors is doing the cutting.  Most sensible people believe that both activities

had a role, which leads to the discussion of the other extreme opinion in this debate.

7
There are those who believe institutional investors like pension plans, insurance companies and

endowments should be prohibited from investing in these unleveraged, futures‐based products, not

because they are manipulating the market, but simply because they are “too big.”  The theory goes that

in the short run, the supplies of any physical commodity are relatively constrained and that when large

sums of money appear on the long side, the result is unnecessary price volatility.    Like the extreme

arguments on the opposite side of the debate, there is some intuition that has appeal, but the ultimate

argument is equally flawed.

The basic error comes from the assumption that such investors will either invest in futures based

products or they will do nothing at all.    While the futures based instruments are perhaps the most

convenient and cost effective, there are many other ways to gain exposure.  Notable just last week was

a news report that prominent fund investor David Einhorn had converted his sizable holdings in a gold

based ETF into actual holdings of physical gold.  While this is not a specific example of an index investor,

it suggests what will happen if investors are prohibited from those products.  Many of the same dealers

who today provide futures based structures will simple create private facilities for holding inventories of

commodities, which they could unitize and assign to the investors.  Sophisticated investors like Harvard

Management Company would decide whether the service was worth the fees, and might elect to

manage the inventories directly.  In either case, the institutional investor will secure access to physical

commodities, which as we all know, will translate right back to the futures market through the arbitrage

process.

An intermediate proposal would be to simply ban the activities of those investors who are deemed “too

big” for the markets.    Presumably at the top of the list would be state and national pension plans

measured in the tens of billions of dollars.    But under what rules does one draw the line?    Is a $50

million endowment all right?  Can we allow small state pension plans access to efficient tools, but keep

California and New York out?  The issue of equity is an important one, and discriminating across classes

or sizes of investors is a very bad idea.  Add that to the fact that any such scheme won’t work for the

reasons cited above, and this discussion should be given no attention.

Careful thinkers do ask the question, “Don’t these large flows of money matter?” and the answer is, of

course, yes.  They matter in the same ways that flows into tech stocks and emerging market equities in

the 1990’s mattered, and the path of prices as a result is not always pretty.  But those price signals are

not noise, and they do illicit a response from people who can modify their own supply and demand.  

There are people who believe they know better than the market what is a fair value, but I am not one of

them.  Having twice had first hand experience in the 1970’s with gasoline rationing created entirely by

programs designed by people who presumed they knew more than the markets, I am more humble.   

Seasoned observers of commodity markets know that as non‐commercial participants enter a market,

the opposite side is usually taken by a short‐term liquidity provider, but the ultimate counterparty is

likely to be a commercial.  In the case of commodity index buyers, evidence suggests that the sellers are

not typically other investors or leveraged speculators.    Instead, they are owners of the physical

commodity who are willing to sell into the futures market and either deliver at expiration or roll their

hedge forward if the spread allows them to profit from continued storage.  This activity is effectively

8
creating “synthetic” long positions in the commodity for the index investor, matched against real

inventories held by the shorts.  We have seen high spot prices along with large inventories and strong

positive carry relationships as a result of the expanded index activity over the last few years.

While some have complained about the immediate resulting price moves, over a longer horizon two

things will likely occur.  First, the build up of inventories beyond historical norms will have a moderating

effect on supply disruptions.  Given our stocks of natural gas, propane, crude oil and heating oil today,

we are in much better position to withstand the impact of a misplaced hurricane than we were just a

few years ago.    The second effect is a natural decline in the attractiveness of the commodity index

strategy.   The large inventories and the prevailing positive carry in the market create a “negative roll

yield” for the investor.  This is not a random event, but a direct result of the size of the commodity index

activity.  For several years, I have advised clients who are seeking commodity exposure that there are

less expensive ways to acquire that portfolio exposure.  The motivation for these recommendations is

not the goal of a better operating futures market, but maximized returns for the client.  Examples of

these views are found in the commentaries included in Appendix B.  As more people become aware of

these features, the allure of commodity index investing may wane without any outside intervention.

Finally, it needs to be emphasized that if synthetic vehicles to acquire long commodity exposure are

limited or made prohibitively expensive, investors will find other ways to achieve their ends.  If we think

such investors are disruptive to the futures markets, imagine how much more disruption would result

from institutional investors taking over grain elevators or oil bunkers.  Attempts to keep these investors

out of the market will only succeed in moving them into storage activities where they have little skill and

no advantage.  It is much better to let them be met by professionals in the handling of the commodities,

and keep them on the exchange, adding to both liquidity and transparency.

I have great empathy for consumers and producers of commodities who operate in a world of many

uncertainties.  Both buyers and sellers frequently encounter bad price outcomes and there is a natural

temptation from some to approach Washington to reshape the market mix to a more favorable

outcome.   I would caution the Commission, however, that if limits are imposed on long, unleveraged

futures participants in an attempt to keep energy prices low for important groups of consumers, there

will be a day on the horizon when those limits are completely derided by farmers facing large crops and

artificially constrained demand.

Summary

I greatly appreciate the opportunity to share my views with the Commission on this important topic.  

These markets are complicated and dynamic, and the enormity of the oversight task is large.  Any time

there has been extreme volatility in any important market there has been a historical temptation to look

for culprits and victims, and perhaps try to shape the outcomes differently.  Unless there is a permanent

problem and no other solution, this temptation should be resisted.     

Exchanges will seek to preserve non‐manipulated markets.  Commercials users of the markets can adjust

their trading and hedging activities to profit from non‐commercial speculators and investors.  That latter

group, if they are not acting in concert to create an artificial price, should fend for themselves.  These

9
investors are not manipulators and will find a way to get the exposures they want for their portfolios.  

The Commission and Congress, through their actions, can encourage well functioning, transparent

markets or they can force these participants into higher cost, much less transparent opportunities.  The

issues being debated here are not new, but each generation has to reaffirm their commitment to letting

market forces interact for the long‐term benefit of all participants.

In my opinion the exchanges have done an outstanding job in letting market forces work, balancing the

need for control with the absolute requirement of encouraging liquidity and free price discovery.  The

growth of these markets over the past 40 years has been nothing but phenomenal, but that growth has

not been an accident.  Efforts to expand transparency will enhance the markets.  The judicious use of

position limits and appropriate exemptions to these limits will continue the tradition of fair, non‐

manipulated markets that are largely the envy of the world.  I encourage the Commission to make the

continuation of that legacy their highest priority.

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APPENDIX A 

A New Look at Some Old Evidence 
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
© 1981 by The Board of Trustees of the Leland Stanford Junior University
APPENDIX B 

Commentaries from 

May 2005, September 2006, and 

September 2008 

Todd E. Petzel, Ph.D. 
Carry Me Home

Investment Commentary

by Todd E. Petzel 

Chief Investment Officer 

Azimuth Trust 

May 1, 2005 

Summary Points 

• Last month's commentary ended with a comment about the impact of commodity funds on the likely 

shape of the price of crude oil futures. Some readers asked for a further explanation of why that is 

relevant to investors. 

• "Roll yield" is an important component to historical commodity fund returns. It is, however, heavily 

dependent on the configuration of futures prices, which might not be favorable at all points in time. 

• Unlike many dimensions to investing, roll yield is fairly easy to anticipate in the short run, making 

the economics of commodity fund investing open to some easy analysis. 

• As more and more investors add commodity funds to their portfolios, the head wind created by 

negative roll yield will make it increasingly difficult to produce a profit. 

Last month's discussion was on the state of the energy markets and how a heated (perhaps overheated) 

view of world supply and demand has caused many investors to consider adding a commodity index 

investment to their portfolios. We described the state of the oil futures markets being in a "carry" as a market 

signal that inventories were relatively high and offered Department of Energy data to support that. Still, over 

the past month prices continue to be at or near historical highs and more investors are heeding the siren's 

call to join the band wagon. 

The vehicle most often used by investors in commodities is a fund that rarely actually owns the physical 

product, but instead establishes long positions synthetically through the use of futures or other derivatives. 

At the end of last month's commentary I suggested that the environment for these funds might be entering 

into a troubled phase simply because of the number of people using them. This prompted a few inquiries 

into why this might be the case. 

Most of us are quite comfortable with the way our stock and bond funds work. In general, we give the 

manager a dollar and he or she buys a dollar's worth of securities. These securities are placed in custody for 

a very nominal fee and we benefit to the extent that price appreciation plus dividends or interest exceed the 

costs of "storing" the securities plus the management fees. We hardly ever think about the cost of storing 

stocks because it is so very low. 

Commodities are different. Almost without exception, physical commodities are a pain in the neck to store 

properly. They can be bulky and difficult to transport. Grains and products like cocoa and sugar change in 

quality through time. In the extreme, some commodities are actually alive (cattle and hogs). All in all, most 

people who are interested in speculating in commodities do so using futures contracts because those 

instruments allow them to participate in price changes (up or down) without having to actually deal with the 

physical products if they choose not to. 

Investors in commodity funds might think they have something akin to their stock and bond funds, but the 

difference is striking and it is all about storage. Very few, if any, commodity fund managers have any 

experience in the complicated business of physical commodity management. So what they do is construct 

unlevered synthetic buckets of commodities using a combination of treasury bills and long commodities 

futures contracts. Let's look at a simple example. 

An investor wants to be long crude oil as part of their portfolio. Each NYMEX crude oil futures contract calls 

for delivery of 1,000 barrels of West Texas Intermediate crude oil. With the current front month contract 

trading at $58 a barrel, each contract is worth $58,000. For simplicity, let's assume the investor wants to 

invest $580,000, or 10 contracts worth of oil. 

The typical commodity fund will first take the $580,000 and buy t-bills, or some other very secure interest 

bearing collateral. It will then go out and purchase 10 of the front month futures contract, which is the 

position that most closely corresponds to the spot price of oil. Note that when this trade is done, the end 
result is almost the same as if the investor had bought $580,000 worth of oil and hired some storage facility 

to hold the goods for him or her. 

The key word, though, is almost. The commodity fund investor doesn't have to pay storage or insurance and 

the fund investor doesn't give up the interest on $580,000 by actually buying the product. This synthetic 

futures business sounds like a pretty good deal, but as you might suspect it's not as easy as it might seem. 

Let's break the source of the fund's returns down. 

There are three components. The first is the interest earned on the collateral. It is your money and you are 

entitled to the interest. Small retail investors sometimes give this up to their brokers, but any commodity fund 

worth its salt captures this for the investor. The second component of the return is the price change of the 

commodity. If when you sell, the futures price is, say, $63.80, you will have a $5.80 per barrel, or 10%, profit. 

Of course, if you sell at $52.20, there will be a $5.80 per barrel, or 10% loss. Note that since you have 

committed the full value of the contracts as collateral, there is no leverage effect on the return. If the price 

moves a dollar, you make or lose a dollar. 

Life would be pretty simple if that was all there was to it, but commodity fund investors tend to want to be 

long commodities for longer than a few weeks. When the front month contract approaches delivery, to stay 

long one has to sell the current contract and buy the next one in the string. Let's go back to the simple 

example. The only thing to keep in mind is that futures prices can always be expected to converge to the 

spot price as they move toward delivery. 

Suppose the spot price is $58 and the market is inverted because inventories are relatively low. This means 

the first futures price might be at $57 and the next contract at $56. You go long the front contract as 

described above. Now suppose a few weeks pass and nothing happens to the spot price. The futures 

contract you own moves toward the spot price as delivery approaches, and we can assume the spread 

between the futures stays at a dollar. You sell your maturing futures near the $58 spot price and buy the 

next future for around $57. Note that in an inverted market you make money from what is called "the roll 

yield" even if commodity prices remain unchanged. 

This leads us to see how the total return of a commodity fund is comprised of interest returns on collateral, 

price appreciation of the commodity and roll yield. In a bull market that is inverted, this is like the trifecta of 

investing: you earn interest, a positive roll yield and any price appreciation. But it doesn't always work that 

way. 

As discussed last month, in physical commodity markets that have ample inventories, the futures markets 

are usually in a carry relationship. That is, the deferred contracts are more expensive than spot. In our 

simple example, the spot price might be $58, while the first and second futures contracts are $59 and $60. 

Going long the front futures contract and holding it a month in the example now produces a loss of $1 per 

barrel as the futures market converges to spot. And as long as the market is in a carry, this loss will happen 

continuously over the life of the investment. This is known as "negative roll yield" and it can be significant. 

As an example of how significant this effect can be, consider the expiration of the May 2005 NYMEX crude 

contract that happened the third week of April. At its widest point on April 13 of this year the spread between 

the May and June contracts reached $1.91 per barrel, when the May contract was trading at $50.22. On a 

pure percentage basis, that is around 3.8%, or over 40% annualized! The person buying June and selling 

May to roll the position forward is trying to walk into a proverbial hurricane. 

Who benefits from this? The owner of physical oil who has hedged it by selling futures is the real winner. As 

delivery draws near and the commodity index long holder gets more anxious about avoiding physical oil, the 

short tries to suppress a grin. "Sure. I'll keep the stuff. But at a price." And then they finally cover their short 

and roll the position into the next contract, set up to replay the scenario as often as they can. The worst thing 

that can happen to them is that the longs actually want to take delivery and the game stops. There is 

essentially no risk to this trade. Assuming it costs around $.60 per barrel to physically store the oil, such a 

strategy returns a net $1.31 per barrel ($1.91 - $.60 in the example) or 2.6% for the month on the 

committed capital. While this example is taken from the most extreme point of this past month's cycle, even 

narrower spreads yield incredible returns for what is essentially a risk free trade. This is, in my opinion, the 

best trade in the world right now, and unfortunately, you can't take advantage of it without a real presence in 

the oil business. 

Are there ways to speculate on this? Absolutely. You can open a commodities account and watch the 

spreads. You can sell the front month and buy a deferred contract when you anticipate the spread to widen 

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out as the commodity index players roll forward their long positions. If you are nimble, this is a good 

contrarian trade. However, if you wake up one day with news that another Middle East hotspot has blown 

up, the nice carry market that you were counting on will likely be reversed in a wink, and you will become the 

weak party coming to the table to cover. The true short hedgers do not face this risk because they can 

always deliver. 

This leads us back to where we began last month. What is the state of the energy market and where is it 

likely to go? There is no way of knowing exactly what amount of buying is coming from real demanders and 

how much is coming from commodity index investors. Anecdotal evidence is suggesting that a great deal of 

money is coming into the funds, but if those investors are correct they will still be quite small relative to real 

demanders around the globe. It appears, however, that the index people may have gotten a little ahead of 

real demand, and if that is the case the state of carry in the front oil markets may be with us for some time to 

come. 

Sponsors of commodity indexes at this point should be crying, "Wait. It's not just about oil." This is true. 

Toward one extreme, you have the Goldman Sachs Commodity Index (GSCI) that is more than 70% energy 

related. Other index providers have looked at that and said that was too much and have more balanced 

indexes across energy, metals, crops and livestock. But the carry question still needs to be asked. In midApril, a quick examination of the 24 commodities in the GSCI showed only 5 (live cattle, Kansas City wheat, 

copper, nickel and lead), representing less than 9% of the index weight, in an inverted state. It seems the 

headwind is blowing at more than just oil, and one should look carefully at this factor in any index being 

considered. 

It is a curious state of the world, these days. Every day we are confronted with logical arguments about how 

we are running out of our natural resources, and yet the inventory markets are saying something completely 

different. It reminds me a bit of the early days of TIPs trading when real yields being offered were over 4% 

for risk free instruments. There were lots of stories why that supposedly made sense at the time, but 

ultimately the imbalances were addressed, and real yields fell. 

How this shakes out remains to be seen. The only point to these past comments is that investors need to 

think through the situation and decide carefully whether the environment is truly supportive of a commodity 

investment, or whether running with the consensus in this instance is setting up such hurdles to success that 

disappointment is a much more likely outcome. 

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Will this be the Winter of our Discontent? 

Investment Commentary by Todd E. Petzel 

Managing Director and Chief Investment Officer 

September 1, 2006 

Summary Points 

• 2006 has seen well publicized increases in energy and metal prices. The impression is of 

significant commodity price inflation. 

• Because of the popularity of commodity indexes, these increases in spot prices have not 

translated into gains for index investors. 

• There are not only investment issues with passive commodity investing, there are broader 

social implications. 

• Investors wanting to exploit commodity themes have many opportunities beyond passive 

commodity indexes. 

Scan the following percentage price changes. Each price change is calculated between December 30, 2005 

and August 28, 2006, capturing pretty much 2006's experience to date. All the prices are for the "spot" 

commodity, or what you would pay to take immediate delivery. 

Commodity % Change 

Aluminum 10.5% 

Copper 66.6% 

Crude Oil 15.5% 

Gasoline 17.1% 

Gold 18.7% 

Silver 36.6% 

There is little new in this chart. We hear about it every day in the newspapers and on CNBC. By now we all 

know we are in a raging commodity bull market. One can't help but look at the above chart and infer that 

once again commodities are stomping stocks and bonds. But appearances can be deceiving. 

As of August 28, the total return Goldman Sachs Commodity Index had earned .07% for 2006. That's 

according to Goldman Sachs' web site. Since the six commodities above represent 62% of the GSCI, one 

can reasonably ask what else was going on to produce the paltry index returns. 

One contributor is other spot prices that were falling. Natural gas, soybeans and sugar all fell over the 

period, but their declines are far from large enough to offset the price increases above. 

A cynic might suggest fees are the culprit. While it is true that the commodities index business has been 

extremely lucrative for Goldman Sachs, AIG, Pimco and many others, the fees are tiny in terms of basis 

points of return. 

The real reason was described in my May, 2005 investment commentary, Carry Me Home. You may access 

the full text from our web site, but that commentary's last summary bullet point says it all: 

• As more and more investors add commodity funds to their portfolios, the head wind created 

by negative roll yield will make it increasingly difficult to produce a profit. 

If the concept of a roll yield is unfamiliar to you, I encourage you to go back and look at the April and May, 

2005 commentaries. The basic theme is that commodity index investors typically do not own the physical 

commodities directly. They create synthetic portfolios with fully collateralized futures contracts, which must 

be rolled over from month to month. Since the contracts being sold and bought during the roll rarely have the 
same price, the synthetic commodity investor is subject to risk that can either add to or reduce total return. 

This risk is not a random factor. If there are large inventories of a product around, the spot price will be less 

than the deferred futures price to compensate those who actually incur the costs of storage. The synthetic 

investor in these circumstances is typically selling low and buying high, which we call a negative roll yield. I 

argued over a year ago that this could produce a significant head wind to the commodity investor. It appears 

this has been the major story so far in 2006. It may be the main story for a long while. 

Passive investors in commodities have produced such a demand for every commodity index component that 

they have produced huge distortions in the physical flow of these goods. We are living in a world of higher 

than average inventory levels and the perception of scarcity. The energy markets are perhaps the clearest 

examples of this phenomenon. 

The Department of Energy publishes weekly reports on the supplies of petroleum products and natural gas. 

Each market is highly seasonal, so comparing gasoline or natural gas stocks in September to those six 

months ago is almost meaningless. One needs to look at where we stand versus a year ago and against 

longer term averages. The reports covering the third week in August are typical for the recent months. 

Supplies of crude oil in the United States at the end of September stood 2% higher than they were a year 

ago and now are about 10% above the previous 5-year average. This figure includes almost no contribution 

from the largely symbolic Strategic Oil Reserve. Non-gasoline distillates are also above their five year 

ranges. Natural gas stocks are 10% higher than the year ago pre-Katrina's levels and 13% above the 5-year 

average. Only gasoline stocks aren't plentiful by historical standards, but supplies are still 10% higher than 

they were a year ago. 

With all these energy products around, how do we explain the high prices? It must be demand. The popular 

story is that global growth is running well ahead of our capacity to supply energy and hence higher prices 

are necessary to allocate the scarce resource across an increasingly competitive world. These growth 

projections may be spot on, but the shortage story doesn't ring true with the current market even after the 

hurricane disruptions. There is something else going on behind the headlines. 

Welcome to commodity investing. You may have seen ads for seminars or investment products touting the 

benefits of owning baskets of commodities. In the new global economy there simply won't be enough of 

anything to go around, so you should make sure your portfolio doesn't miss this next big theme. To back up 

the promise, the sellers look at the last few years' returns. In the last five years U.S. equities have earned 

almost nothing and bonds, thanks to the Fed, have earned little more. Commodities? Depending on the 

index you follow, the average return has exceeded 20% a year. 2006's disappointment will only lower the 

three and five year returns a little. 

The investment pitch to add "real" resources to one's portfolio is more than just a returns story. Commodities 

offer some protection against inflation and they tend to move somewhat independently of stocks and bonds. 

To the experts this spells diversification, the holy grail of portfolio construction. But in the end, it is the eyepopping returns that continue to grab people's attention. 

Many individuals and institutions have responded. From essentially zero 12 years ago when Goldman Sachs 

introduced their own commodity index and trading vehicles, the industry has grown to become a significant 

part of the investment landscape. Giants like PIMCO, AIG, Deutsche Bank and others have all introduced 

products. While specific figures are hard to come by, industry analysts estimate that more than $65 billion 

are currently invested in products tied to commodity baskets. This is, of course, a tiny number when 

compared to stock and bond markets, but it appears to be growing by several billion dollars a year. It also 

represents real buying power when it comes to the size of the underlying commodity markets. 

Buyers of commodity index products are just like buyers of stock index mutual funds. Few follow the 

underlying components, and there is usually little analysis assessing which areas are cheap and which are 

dear. If you buy a stock index, you get all the stocks in the weights established by the index provider. The 

same is true for commodity indexes, and these days the biggest weights are on energy related commodities 

like crude oil, natural gas, and gasoline. 

Who are the buyers? Nearly everyone. Foundations, endowments and pension funds are all actively 

pursuing the strategy or are considering it. These are institutions that have no immediate need for food, 

industrial metals or fuel. They simply want to own a block of resources because their value might be rising in 

a way different from their stocks and bonds. Trustees are simply trying to do what is best for their 

2
institutions. Since the early innovators have been richly rewarded over the past few years, there are many 

others wanting to follow their lead. 

Interestingly, these buyers may be the least economical actors in the play. As energy prices have increased, 

suppliers around the world are scrambling to deliver more product. Real demanders are also responding as 

evidenced by an apparent drop in gasoline purchases as prices have broken $3. Econ 101 teaches us that 

the longer we live with high prices, suppliers will increasingly come to market and demanders will figure out 

how better to economize. For the commodity index demander, however, the more prices go up, the greater 

the appeal. 

Commodities are highly cyclical, and to produce massively larger supplies of energy requires investments of 

hundreds of billions of dollars and many years. That is what happened in the 1970's and by the following 

decade we had a world of excess supply, cheap energy and virtually no new investment in energy 

infrastructure. Proponents of the commodity investment story argue that there is a lot of time left in the 

upside of the current cycle. 

Others argue that this looks like a bubble, similar to tech stocks in the late ‘90's and more recently, housing. 

There seem to be no real s hortages, yet the fear of future problems and a momentum mentality have driven 

prices up and up. 

If this is an overheated market, it is fundamentally different than the tech stock bubble. As equities prices 

were bid up in the 1990's, most real people weren't hurt. Some worthy entrepreneurs in traditional industries 

may have had trouble raising capital as the venture capital world was infatuated with tech wizards, but most 

people were either on the sidelines watching or were helped modestly by the updraft in the economy. 

Today there are many people, perhaps millions, who will be making hard choices this winter. For every 

person forgoing a ski trip to Aspen because the heating bill in their McMansion has doubled, there are 

hundreds of middle and lower class Americans who will be squeezed in much more critical areas. We may 

read of people freezing to death or dying in fires from improvised heaters as they fail to cope with the world 

of high energy costs. 

In the 1980's a small movement began that stressed socially responsible investing. Typically, institutions 

shunned certain stocks and bonds from companies pursuing agendas inconsistent with their own values and 

goals. South African firms during Apartheid, tobacco and arms manufacturers, and many others found 

themselves on restricted lists. Students have long carried the banner in this area and have encouraged their 

institutions to either formally follow a socially responsible investment program or simply avoid the most 

egregious investments. 

Commodities may appear to be above morals, but perhaps they are not. What is socially responsible about 

some of the wealthiest institutions in the country figuratively stocking their larders and fuel tanks with 

products they neither need nor want while the rest of the population suffers real deprivation? The fact that 

you can buy a basket of commodities doesn't mean you should. 

Unfortunately, one of the main problems with these institutions is their staying power. Unlike the Eddie 

Murphy and Dan Ackroyd characters in the 1981 movie Trading Places, these investors use no leverage and 

are not easily swayed from their position. They may have tiptoed into the market when oil was in the $40 

neighborhood. They are now looking at their results compared to their traditional stock and bond portfolios. 

Instead of cutting back demand as prices rise, they may be thinking of adding to their positions. It will take a 

huge drop in commodity prices to force them out of the market. 

Perhaps we need an old fashioned public awareness campaign. We used to chastise hoarders during war 

times, but that kind of moral suasion now seems passé. We've already had the president urge us to drive 

less. The exhortation to turn down thermostats can't be far behind. Americans, by and large, are trying to do 

their part. 

You don't need $70 oil or $10 natural gas to make new energy investments or conservation programs 

attractive. And much higher prices are not going to bring new supplies to market immediately. It will take 

time and money to fully respond to the world's growth, but historically this has always happened. Malthus 

predicted over 200 years ago that the planet would periodically out consume its resources, leading to 

economic crisis and worse. Others have followed in his path with great regularity and just as inaccurate a 

vision. 

3
Still enchanted with the scarcity story? Consumers in India and China and many other increasingly wealthy 

nations have growing real demands for energy and scores of other commodities. If this is an investment 

theme you want to pursue, there are many ways to pursue it. It is a rare day I don't speak with equity 

investors who believe they have found fundamental values in traditional and alternative energy companies. 

There are also private equity and long/short strategies that hold much more promise today than simple 

commodity index investing. 

We will get through this cycle. Supply will eventually adjust, as will demand. Technologies will continue to 

evolve to save scarce resources. But that is an economist's perspective. That the long run will take care of 

itself is of small comfort to people w ho have to get through this winter. A modern day Marie Antoinette might 

suggest wintering in the Caribbean. Trustees of institutions that are adding to commodity demand right now 

s hould first ask themselves if they are doing a smart thing. Then they may want to ask if they also doing the 

right thing. 

4
Commodities Update 

Web Commentary 

Todd E. Petzel 

Chief Investment Officer 

Offit Capital Advisors 

September 1, 2008 

Summary Points 

• For commodities, the start of the second half of 2008 could not have been 

in greater contrast to the beginning of the year with prices for precious 

metals, industrial metals, energy and agricultural products all falling by 

significant margins. 

• Slowing global economies, demand destruction and a stronger dollar all 

contributed to the declines, but there were other forces at work as well. 

• It appears too that the popular long commodities trade that built 

momentum through the first half of the year was sharply reduced 

beginning in July. 

• The main lesson from the last six weeks is that commodity price 

movements will always be governed by specific supply and demand factors 

in the long run, but short-term volatility can be dominated by unexpected, 

highly correlated trades. 

At the end of June, many not-for-profit investors looked at their fiscal year-end 

investment performance and saw massive disappointment in their equity book. It did not 

matter whether one was in large or small cap, growth or value, or domestic or 

international stocks. Equity investments of all types were challenged in the previous 12 

months. For some investors, however, there was a major bright spot on their account 

summary: long commodities. Returns differed according to one’s specific approach, but 

it was not unusual to have earned 40% for the trailing twelve months. 

Then July arrived. Almost in a blink of an eye, commodities across the board turned 

south, and over the next six weeks gave back in some instances more than half of the 

previous year’s return. Commodities crossing all sectors participated in the decline: 

gold, down 15%; copper, down 14%; crude oil, down 19%; corn, down 26%. 

Naturally, such an abrupt market turn evoked all kinds of commentary. Some have 

argued that the secular bull market in commodities is over. Slowing economies around 

the world will see at least declines in the rate of growth of consumption, if not absolute 

declines in demand. Others have also noted real demand destruction as prices rapidly 

accelerated. While there is likely merit in such arguments, the size of the price move 

does not seem completely consistent with the change in the fundamentals. 
September 1, 2008 Offit Capital Advisors 

Commodities Update 2 

In the first half of the year commodities rallied despite slowing global economies. The 

increase in prices was propelled by a long-term expectation of demand growth as well as 

investors and speculators coming increasingly into the long side of the trade. These 

traders likely played a big role in the recent reversal as well. One of the truly remarkable 

facts about the six weeks starting July 1 is that virtually all traded commodities fell over 

the period. This high level of correlation is an anomaly. It is unlikely that the supply and 

demand picture for scores of unrelated products should all move in the same direction 

independently. The more likely common factor was the unwinding of part of the 

commodity trade. 

It appears that the most successful investors in the first half of 2008 had one or more 

types of the long commodity trade in place. There were those who traded commodity 

futures directly, or through index based products. There were also many who might not 

have the authority or inclination to trade futures, but got their commodity exposure 

through commodity themed equities including ETFs. No matter which path one took, 

there were profits to be had. 

What changed on July 1? It was not the state of the world economy. The most likely 

event was that investors looked at their allocations at quarter end and saw much higher 

commodity exposure than targeted. Not only were commodities higher, but equities 

were lower, driving commodity’s share up. As investors tried to sell some commodity 

exposure to get back within target ranges, there were few fundamental buyers at 

historically high prices. Commodity prices had to tumble significantly to clear the market. 

Such moves also had follow-on effects. Trend-following traders were primarily long 

going into July. When commodity prices began to reverse, these traders not only 

covered their long positions, but might have switched to the short side, adding to the 

downward price pressure. 

Some argue that two forces have combined to create these price drops: demand 

destruction, and dollar strength. Recall that most internationally traded goods are 

denominated in dollars. When the dollar strengthens, prices of these commodities 

decline to reflect the stronger purchasing power of each dollar. However, in the first half 

of the third calendar quarter the value of the dollar increased only 6.5%, hardly enough 

to push commodities as much as they fell. 

Then there is demand destruction. One recent news story trumpeted the fact that 

Americans drove 54 billion fewer miles over the past 8 months versus the comparable 

period a year earlier. This sounds like a big number. However, there are 250 million 

registered vehicles in the United States. That means the roughly 7 billion miles saved 

each month, translates to 28 fewer miles driven per vehicle per month. That may be an 

important start toward greater conservation, but hardly massive demand destruction. 

The specific lesson here comes from our August commentary, ”Lessons Learned from a 

Volatile Year”. Investors need to be careful about potentially crowded trades. 

Fundamentals do not have to change materially for such trades to reverse suddenly and 

produce high volatility. A corollary to this is that correlations across independent 

markets can rise suddenly as well, diminishing the benefits of diversification. 
September 1, 2008 Offit Capital Advisors 

Commodities Update 3 

One can argue that the commodity “super-cycle” is still in place because of global 

development and demand growth outpacing supply. The start of the third calendar 

quarter was perhaps just a dramatic correction from the still present bull market. The 

next several months will give greater clarity about the long-term direction of the market. 

But whether you are a bull or bear, the last several weeks have been a text book 

example of how commodities can trade. High volatility and correlation are not always 

the investor’s friend. 

This report is for informational purposes only and is not an offer, solicitation or 

recommendation that any particular investor should purchase or sell any particular 

security or pursue a particular investment strategy. Any data here are obtained from 

what are considered reliable sources; however, its accuracy, completeness, or reliability 

cannot be guaranteed.