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The New Chemistry of Speculation

   1   

Contracts in Metals, Food Show Difficulty in Placing Shackles on Market Bets

    By

IANTHE JEANNE DUGAN

   

As Washington attempts to crack down on speculation in food, fuel and metals, Wall Street is rolling out new ways to bring in money.

 

In May,

Credit Suisse Group
and Deutsche Bank
AG began offering investments in iron ore, a key component of steel. Iron ore is

   

mined copiously — about one billion tons a year — but isn’t traded on a futures exchange. So it has been virtually impossible for

 

speculators to bet on price movements

  

The investment banks were inundated with interest in the iron-ore deals, which function like futures contracts. In just two months,

   

investors and hedgers took on more than $500 million of notional exposure — about 2.7 million metric tons — making this one of the

   

biggest commodities markets to spring up almost overnight.

   

The new markets show how hard it will be for legislators to curb commodities speculation. Such trading is spreading to an array of

   

other goods, from jet fuel to chicken, that have been off-limits to investors because they aren’t traded on futures markets. They also

   

are offered for commodities already bought and sold on global exchanges, including crude oil, corn and coffee.

   

Through

   

Goldman Sachs Group
Inc., clients can invest in palm oil and other biofuel components. Deutsche Bank is trading

   

ruthenium, an obscure metal used in fountain pens. Along with other firms, Deutsche is expanding into rhodium, used in catalytic

   

converters.

   

Deals are being teed up in lithium and “rare earth” metals, including components of electric and hybrid cars. One Credit Suisse list

   

reads like a science textbook: alumina, cobalt, molybdenum, ferrochrome and vanadium.

 

“The model is virtually limitless,” said Kamal Naqvi, a 36-year-old, London-based Credit Suisse executive who helped create the new

   

platform after joining the bank last year. In July alone, Credit Suisse was asked to put together similar contracts by producers of

   

wood chips, chicken and potash fertilizer.

   

Some lawmakers have been alarmed by the surge in investments by big institutions such as pension funds and university

   

endowments, which allocate money to commodities tied to indexes that track futures exchanges. Big institutions have about $260

 

billion invested in commodities, up from $13 billion five years ago, hedge-fund manager Michael Masters told Congress earlier this

   

summer.

   

These “index speculators,” he testified, were driving up prices of oil and other natural resources. Several senators agreed,

   

responding with bills that would limit what investors can channel into commodities they don’t intend to own.

   

Many economists and investors balk at the bills, attributing high commodities prices to demand from emerging economies and

   

production squeezes. Often, they hold out iron ore as evidence: Even though it wasn’t traded on a futures exchange, its price surged

   

in the last year. The price Chinese steelmakers pay to Australian mines, for example, has nearly doubled.

   

“It is not that the flow of money has no impact,” said Mr. Naqvi, the Credit Suisse executive. “But this flow…is a distant second to the

   

impact of market expectations on physical supply and demand fundamentals.”

   

If passed, the legislation could complicate contracts linked to exchanges. The bills, investors and bankers said, are inadvertently

   

helping nurture these nascent, over-the-counter markets. That worries some critics.

   

In June, Mr. Masters urged Congress to investigate the iron-ore contracts and similar deals, claiming they could help investors buy

   

natural resources, sit on them until their price rises and then sell them. “This is Wall Street innovation run amok,” he said in an

   

interview.

   

“He misunderstood our product,” said Mr. Naqvi. “There is no requirement to take physical delivery at any point, so there is no

   

encouragement to physically hoard.”

   

Credit Suisse’s contracts are offered by a London unit that is an alliance with Glencore International AG, a Swiss commodities

   

company. The alliance has about 75 people in London, New York, Hong Kong, Switzerland and Sydney.

   

Though clients can obtain physical assets through Glencore, Credit Suisse isn’t directly involved in any physical transactions, other

   

than its precious-metals business in Zurich. The alliance helps Credit Suisse collect information about commodities and pass it onto

   

clients in exchange for more trading business.

   

These instruments have profound implications for the way money flows into commodities. Historically, if someone sought to profit

   

from iron ore, they could buy shares in a producer or a mine, but not the underlying assets.

   

“Iron ore is probably the largest commodity market in the world that hasn’t had financial trading around it,” said Raymond Key, the

   

global head of metals trading for Deutsche Bank in London

   

Under the contracts, known as “cash-settled swaps,” the client — a hedge fund, pension fund or steelmaker — agrees to pay a fixed

   

price for iron ore in the future. Now, it stands at about $180 per metric ton. The bank lines up a seller that wants to lock in a price.

   

Credit Suisse’s minimum transaction is 5,000 metric tons. No physical delivery is taken. Instead, every month, there is a net payment

   

in cash of the difference between the set price and a floating price pegged to an index of the spot price that steelmakers pay for iron

   

ore that is delivered immediately.

   

Since Credit Suisse rolled out the program in May, its clients have taken on more than $300 million in notional exposure to 1.7 million

   

metric tons of iron ore. Deutsche Bank has traded about one million metric tons.

   

Among iron-ore suppliers working on the deals with Credit Suisse is mining company

   

BHP Billiton
Ltd. “We support any mechanism

   

that leads to more transparency in the market,” a BHP spokeswoman said in an email.

 

QUESTIONS

 2:     

1. In May, Credit Suisse and Deutsche Bank began offering investments in what commodity?

   

2. Are lawmakers justified in their concerns that speculation is driving up commodity prices?

   

3. What happens during the monthly settlements on the iron ore contracts created by Credit Suisse and Deutsche Bank?

   

4. Do the monthly settlements make the contacts more attractive to speculators or to iron ore producers and users who

   

want to hedge? Explain