Source: Investment News Briefs Wednesday, July 15, 2009

Why has the price of oil risen so much in the past few months? Is it a supply and demand issue as some believe; or is it because of an out-of-control futures market driven by the proliferation of commodity index funds and rampant speculation, as everyone tries to get in on the rise in commodity prices? This is a very complex issue, with a lot of emotion attached to it.

This week I try to give you an understanding of why oil prices have risen and whether they are likely to stay at such lofty heights or maybe even fall! And we look at a very odd statistic: where are all the tankers? There are some very unusual things happening in the oil patch. If you are currently exposed to the energy or commodity markets, or are thinking about it, I believe you will find this letter of interest. At the end of the letter, I also tell you how you can personally see that help gets to the victims of Cyclone Nargis in Myanmar. It is a desperately needy situation. There is a lot to cover, so we will get to the essay right after this quick note.

I have talked for the past few months about why I feel we may be in for a tough investment environment and a Muddle Through Economy. I think in this type of market cycle it is important to increase your portfolio allocation weighting to noncorrelating investment strategies. I work with Steve Blumenthal and his team at CMG to help investors find managers who can take smaller minimums and who have such alternative strategies. We are creating a platform of managers that you can access for your personal portfolio. I recently completed a special write-up on Eric Leake of Anchor Capital, an investment advisor I am particularly impressed with. For the last 12-1/2 months, he is up 16.77%, in comparison to the S&P 500 index that is down -2.08% (net of fees from April 30, 2007 through May 15, 2008). Equally impressive is that he has generated this return while being uncorrelated to the S&P, and with lower volatility than the market.

You can get this report and others I have written by going to https://cmgfunds.net/public/mauldin_questionnaire.asp and filling out the form. If you are a manager and would like to be considered for the platform, drop a note to PJ Grzywacz at pjg@cmgfunds.net. And if you are an investment advisor and would like to see the managers that are on our platform and determine whether they might fit into your client portfolios, we do have a program to work directly with you.

And as always, if you have a net worth of over $2 million, I strongly suggest you go to www.accreditedinvestor.ws and register there. My partners in the US (Altegris Investments), London (Absolute Return Partners) and South Africa (Plexus) are experts in alternative investment strategies, including hedge funds and commodity funds. We have a very strong selection of funds in a wide variety of styles to help you diversify your portfolio. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now, let’s jump into the oil patch.

Those Nasty Index Speculators

Are institutional investors in the form of large commodity index funds the reason behind the current rise not just in oil prices but in the prices of seemingly all commodities? Michael Masters, a long-short hedge fund manager, in testimony before the Congressional Committee on Homeland Security and Governmental Affairs, said:

“You have asked the question ‘Are Institutional Investors contributing to food and energy price inflation?’ And my unequivocal answer is ‘YES.’ In this testimony I will explain that Institutional Investors are one of, if not the primary, factors affecting commodities prices today. Clearly, there are many factors that contribute to price determination in the commodities markets; I am here to expose a fast-growing yet virtually unnoticed factor, and one that presents a problem that can be expediently corrected through legislative policy action.”

You can read the entire testimony at http://www.mcadforums.com/forums/files/michael_masters_written_testimony.pdf, but let’s hear the basics of his argument:

“What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

“These parties, who I call Index Speculators, allocate a portion of their portfolios to “investments” in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as “Index” Speculators because of their investing strategy: they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices – the Standard & Poors – Goldman Sachs Commodity Index and the Dow Jones – AIG Commodity Index.”

These index funds are composed of a number of commodities. While oil is the biggest component of the various funds, they also have exposure to grains, base metals, precious metals, and livestock. When you buy one of these funds you are buying a basket of commodities.

Why would an investor want exposure to a long-only index of commodities? Perhaps for portfolio diversification, as commodities are uncorrelated with the rest of the portfolio, or as a way to play the growing demand for commodities of all sorts from emerging markets, as a hedge against inflation, and so on. Mainline investment consultants began to suggest a few years ago to their clients that they get into the commodity market on a buy and hold basis, just like they do with stocks and bonds.

And they have done so in a very large way. As the chart below shows, at the end of 2003 there was $13 billion in commodity index funds. By March of this year, that amount had grown 20 times, to $260 billion. Masters also shows that this corresponds with the stratospheric rise in commodity prices. In many commodity futures markets, index speculators are now the single largest participant.

The culprits: write-downs linked to failed home-equity loans, subprime mortgages and leveraged buyouts that cost the bank upwards of $5 billion.

Net revenue fell 52%, while investment-banking fees fell 30% and debt-underwriting fees declined 58%.

Its investment-banking division posted a net loss of $87 million in the first quarter, down from its record $1.5 billion net income a year earlier. Retail finance services posted a net loss of $227 million, down from an $859 million gain in 2007.

In other words, it wasn’t a good quarter.

“Our earnings this quarter were down significantly as market conditions and the credit environment remained challenging. The Investment Bank had markdowns related to leveraged lending and mortgages and increased loan loss reserves. Retail Financial Services again increased loan loss reserves related to home equity and subprime mortgages, as performance in these portfolios continued to deteriorate,” Jamie Dimon, Chairman and Chief Executive Officer, said in a statement.

Somehow, one stockholder sees that as good news.

“In this environment, being able to post earnings as they did is I think all-in good news,” Charles Bobrinskoy, vice chairman of Ariel Capital Management LLC in Chicago, which owned more than 611,000 JPMorgan shares as of Dec. 31, told Bloomberg.

If that wasn’t bad news to him, Dimon was clear about the near term outlook.

“Our expectation is for the economic environment to continue to be weak and for the capital markets to remain under stress,” he said. “These factors have affected, and are likely to continue to negatively impact, our firm’s credit losses, overall business volumes and earnings – possibly through the remainder of the year, or longer.”

To prepare for it, JPMorgan added $2.5 billion to credit reserves, including $1.1 billion related to home equity loans.

It also has its merger with The Bear Stears Cos., Inc. (BSC), a deal Dimon said “provides a unique opportunity to enhance our ability to serve clients by adding new capabilities in prime brokerage and clearing and by improving strength in equities, mortgage trading, commodities and asset management.”

Trouble for the Titans

On Tuesday, Washington Mutual Inc. (WM) reported a $1.14 billion loss due to a growing number of customers that have fallen behind in their mortgage payments. A week earlier, the Seattle-based lender announced it raised $7 billion in capital, while slashing its dividend and cutting 3,000 jobs. Ironically, the capital raise was a last-ditch effort to stave off a takeover bid from JPMorgan.

U.S. Bancorp (USB) announced Tuesday that first-quarter earnings fell 4% as a result of losses connected to the mortgage market.

Bear Stearns said Monday that profit fell 79% in its fiscal first quarter, Reuters reported.

Also on Monday, General Electric Co. (GE) shocked the market when it announced a 6% drop in net income for the first quarter of 2008.

“Our primary shortfall was a decline in financial services earnings,” GE Chairman and CEO Jeff Immelt said.

And though Wells Fargo & Co. (WFC) beat analysts’ estimates in its first-quarter earnings release today (Wednesday), net income dropped 11% to $2 billion, the company said in a statement.

National City Corp. (NCC) will report its earnings tomorrow (Thursday).