Testimony of Michael Masters before the Committee on Homeland Security and Government Affairs: May 20, 2008

Most of the class can probably recall the sharp increase in worldwide commodity prices in the spring of 2008 that immediately preceded the global economic meltdown. The attached document is the testimony of Michael Masters, a hedge fund manager, before the US Senate committee on Homeland Security and Governmental Affairs in May 2008. The testimony itself is about six pages of reading, with an additional ten pages in supporting documents. This document was circulated widely within the trading community – I actually received it from one of our clearing brokers – but unfortunately was never picked up by the wider press. I personally found Masters’ argument to be both relevant and articulate and would go so far as to say it is one of the few coherent and fundamentally sound explanations of the commodity price bubble.

Masters’ primary assumption – which I agree with in full – is that the purpose of commodity futures markets is to benefit physical hedgers by providing a means of risk diversification and price discovery. His essential argument is that a single class of investors – whom he collectively refers to as Index Speculators – were responsible for the sharp increase in exchange-traded futures that pushed nearly all prices across the commodity universe to all-time, inflation-adjusted highs in a period of months. Masters contends that this class of investor operates in a distinctly different paradigm than both physical hedgers and traditional speculators and because of the amount of capital at its disposal effectively “broke” the functionality of the market.

The first few pages of the document are dedicated to explaining Masters’ position. He provides interesting and often shocking quantitative examples of the impact of Index Speculators on commodity pricing during the relevant period. Further, he explains his reasoning in layman’s terms and effectively works through concepts often presented in too opaque a manner for the general public. The balance of the testimony is dedicated to elaborating on three legislative recommendations he makes to the committee for the purpose of reigning in the impact of speculative demand on commodities markets.

http://hsgac.senate.gov/public/_files/052008Masters.pdf