I came across an interesting quote today whilst reading my usual gamut of market commentary that made my political antennae shoot up into the air:
As we understand it, back in late July Goldman Sachs decided it was going to reduce the weighting of gasoline in its widely followed commodity index (GSCI). Participants wanting to dissect the entrails of that decision may refer to The Financial Times story dated August 29, 2006 titled "Market Insight: Index shifts follows oil decline." Suffice it to say, Goldman took the gasoline weighting in its commodity index from 7.3% to 2.5%, for pretty mysterious reasons, in a gasoline-centric economy (IMO). Goldman even went so far as to scale-in those reductions at intervals between August and November. Accordingly, the billions of institutional dollars that "mimic" (read: invest) the GSCI have had to periodically SELL those gasoline futures contracts to stay in-sync with the index's new weightings. Unsurprisingly, unleaded gasoline prices peaked on August 3rd at $2.35/gallon, basis the NYMEX November future's contract, and crashed into last week's lows of $1.46/gallon for an eight-week price decline of 38%
Let's unpack this. A goodly portion of the reason gas prices have plunged lately, and a 38% decline meets my definition of a plunge, is due to the fact that Goldman Sachs tweaked the weighting on their commodity index. So what, right? Well, all the folks out their running managed futures funds, hedge funds and other various and sundry financial types, all had to go out and change their weighting of actual holdings in gasoline because that's the benchmark their performance is measure by.
Here's another analogy. The Dow 30 is composed of 30 stocks. There are a lot of mutual funds that own "the index" as we call it. All 30 stocks. But what happens when the Dow 30 changes the stocks that make up the index like they did in 2002. They removed AT&T, Kodak and International Paper and replaced them with AIG, Pfizer and Verizon. Now, all the stocks the index dumped took a dive, right? Because all the mutual funds, hedge funds and asset managers that hold the index dumped those stocks.
It's the same with Goldman's Commodities Index. If they reduce the percentage of gasoline in the index all the folks who follow the index's weightings do the same and voila! Gas plunges.
Great timing too.
Which leads to three questions: what's the economic rationale of making gasoline a smaller portion of overall commodoties in such a gasoline centric economy?
Why now?
And finally, who made the call to do so?
Might it have anything to do with the fact that the new Treasury Secretary used to be the Chairman of Goldman Sachs?
Just asking.
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Comments: 11
How come you're a tiger when it comes
to finance. But you refuse to eat those
Democrooks? LOL
I'm so glad others are investigating this. Most consumers don't realize how unregulated trading has flourished in the U.S energy markets; based on a formula designed by Enron, benefitting from a loophole named the Enron Exemption. These crooks have made the energies future trading markets run amok, with little oversight.
It's just a theory, but I think the energy companies know what will happen to their little cabal should the Democrats take either one or both Chambers of Congress (investigations they are loathe to participate in); and decided to take action. By using cunning timing, ridiculous excuses (mild hurricane season, CA not in cafe blending season, end of summer driving....blah blah blah); and once November elections come and go, prices will shoot up, blamed on the same lame excuses as every other post election season. Just look at 2002 and 2004, gas prices took a nose dive prior tot he elections, and went right back up after ward.
Plus, there have been two nonpartisan polls illustrating that as Bush's poll number plummet, so do gas prices! The graphs are in perfect Synchronicity!
Here is an excerpt and the link to a great Business Week article, explaining the BP investigation, the unregulated trading, and the Enron Exemption. It also talks about Goldman's as far as the benefit of ownership good article.
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http://www.businessweek.com/investor/content/aug2006/pi20060830_917860.htm
"According to news reports, federal authorities are investigating whether the energy giant manipulated crude-oil and unleaded gasoline markets. BP (BP), according to the same reports, said it is cooperating with both probes.
NOT ILLEGAL. The investigations come at a time when banks and other financial institutions are rushing into the sizzling energy sector—both snapping up hard assets and pouring money into commodities markets—with the hopes of making big profits. Meanwhile, members of Congress, facing November elections and a restless electorate, are looking at whether energy companies and speculators are partly responsible for pushing up energy prices....
In Washington circles, that lack of oversight has a specific name: The Enron Exemption. It refers to a longstanding regulatory loophole that was written into law in 2000, when Enron and other big energy traders convinced congressional lawmakers to codify an exemption for over-the-counter electronic exchanges from the Commodity Futures Modernization Act, a law that was designed to bolster regulatory review of commodities trades....
OUT OF SIGHT? Since then, unregulated trading has flourished in the U.S., most notably with the growing reach of the London-based Intercontinental Exchange, or ICE, a leading operator of electronic energy exchanges that, until recently, trafficked only in European commodities.
The upshot: U.S. speculators now can avoid all federal oversight or reporting requirements by routing their trades through London's ICE instead of the highly regulated New York Mercantile Exchange. Both exchanges have had voluminous growth In recent years. "What's transparent is huge," Fusaro says. "What's not transparent is even bigger."
Want a bigger fraud? How about the CPI which used to based in part on a specific list of groceries in different parts of the country but after 2001 became "substitutable" if there were lower prices available. So, instead of specifically costing out Kraft Macaroni and Cheese, they started using store brand specials that were 1/3 the cost?
Tell you why CPI isn't annually in the 6-8% range instead of 2-3%?
This is true in the short-term, Sean-Paul, but Professor Jeremy Siegel of Wharton did a study on what happens to these stocks after they were taken out of the index. Over time, the stock added to the index underperformed and the stock taken out outperforms. Remember, Dow Jones, S&P and Russell are all trying to game their indices. That is, they want a hot index. What better way to get it then by putting in a hot stock?
I'm not sure you can read anything sinister into Goldman Sachs changing their index. They change the index every year and no one really knows what formula they use. There are other commodity indices that have significantly different weights for the same commodities. It's probably true that the change helped the decline in gasoline prices, but it probably did not account for the entire decline.
I'm not arguing about stocks here at all. And the case you cite is correct.
However, in the short term, which in market oriented terms in 0-11 months, altering the index makes a material difference, especially when this particular index is the benchmark in its field. Being the benchmark is critical.
And, of course they are all gaming their indexes. It's the Wall Street way.