Is the entire world being lashed by rising prices simply because of a shift in institutional portfolio allocations? Are cocoa, rice, and oil prices soaring just because the equity markets have failed to deliver juicy profits and traders have turned to commodities instead? Is such a thing possible?

Not only is it possible, according to the managing member of Masters Capital Management, Michael Masters, but it is happening right now. Mr. Masters, who describes himself as a “concerned citizen,” testified on May 20 before a Senate Committee on Homeland Security and Governmental Affairs, and his message was sobering, for many reasons.

First, he is not alone in blaming much of the recent upsurge in inflation on the unprecedented flow of funds into commodities markets. Many analysts have concluded that the prices of various food and energy products have broken loose of their traditional fundamental underpinnings. Several oil analysts, for instance, say the supply and demand figures do not support $130 crude.

Second, the speculation in commodities prices presents a real-life opportunity to see how the overhaul of financial industry regulations proposed by the treasury secretary, Henry Paulson, might pan out. Mr. Paulson wants to set up an “overseer” of the economy who would be able to spot and rein in dangerous market excesses. As we have noted in the past, much of Mr. Paulson’s regulatory revamp springs from the work of economists at the Bank for International Settlements. They have concluded that cycles are a natural feature of free markets, and that popping bubbles before they get out of hand is a desirable role for financial authorities. They warn, however, that to intervene in markets is not easy, as it would be opposed by embedded interests.

The question is, does the government have the stomach to step in and break the upward spiral in commodities markets?

Mr. Masters makes the case that an enormous flow of new money from institutional investors such as pension funds, endowments, and sovereign wealth funds has been pouring into commodities futures markets. He says that collectively, these “index speculators” now account for a larger share of outstanding commodities futures contracts than any other market participant. This group behaves differently than other commodities traders, in that they are only buyers, not sellers. Because they are new to this market and building new positions, they purchase only those 25 commodities that make up the principal indices. The assets invested by this group have increased to $260 billion as of the end of March from $13 billion at the end of 2003. During that period, the prices of the 25 commodities increased by 183%.

Mr. Masters demonstrates the impact of this new-money flow by pointing out that while Chinese demand for petroleum has grown to 2.8 billion barrels from 1.88 billion barrels during the past five years, the demand from index speculators has increased by 848 million barrels — almost as much.

He is not the only one targeting speculation in the pits. Mike Rothman at International Strategy & Investment cites recent BIS statistics on over-the-counter derivatives exposure to make the same point. The end of December figure rose to $8.4 trillion from $7.14 trillion at the end of June. Making certain assumptions, Mr. Rothman concludes that this figure equates to anywhere between 58 billion and 82 billion barrels of crude oil, or an eye-popping 18.5 to 26 times the current total open interest of Nymex crude futures and options. Mr. Rothman says that “many questions have been asked about potential counterparty risks related to OTC instruments”; I would think so.

Another data point is this: While everyone is squalling about the American ethanol program bidding up corn prices, Mr. Masters points out that index speculators have stockpiled enough corn futures to fuel the entire U.S. ethanol industry at full capacity for a year.

While significant new buyers can have an impact on any market, they can be especially disruptive when the marketplace is relatively small. As Mr. Masters points out, “in 2004, the total value of futures contracts outstanding for all 25 index commodities amounted to only about $180 billion,” compared to worldwide equity markets of $44 trillion.

Moreover, index speculators have had untoward influence, as most are allocating a certain portion of their portfolios to commodities for the first time. They are therefore indifferent to price. This sets them apart from traditional traders in this space.

The final important point is that futures prices often determine the prices actually charged for goods. In other words, this is not a theoretical issue. As prices have surged for corn, wheat, and oil futures, the markets for these products have moved apace.

Let us assume that Mr. Masters (and others) are correct, and that this giant wave of new money coming into the futures markets is causing inflation to rise. What is to be done? Over a long period, these investments will sour, because prices will ultimately fall. Eventually, soaring prices of most commodities will elicit rising supply and will crimp demand. However, that process in the case of oil and many other goods could take years.

In the meantime, the damage to the world’s economy could be severe. Already, skyrocketing prices have caused food riots, job losses, and other hardships.

Last week, the Nymex raised margin requirements on certain oil contracts. This is a starting point, but is unlikely to be enough. What else can be done?

Mr. Masters outlines various measures that could temper the frothy commodities play. First, he proposes that Congress prohibit pension funds from replicating commodities index strategies because they are at heart unsuitable for ERISA accounts. He also suggests that Congress close certain regulatory loopholes that the Commodities Futures Trading Commission has opened. Specifically, the CFTC has exempted traders from position limits when they enter into swaps transactions. This also means that these speculators are then classified as “commercial” interests, which is obviously a distortion of reality. This, too, should be fixed.

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