Why the War on Commodity ETFs?

After enjoying a spectacular growth surge earlier this year, commodity ETF managers now find themselves under attack from the U.S. Commodity Futures Trading Commission (CFTC).

The US Commodity Funds’ United States Natural Gas Fund (UNG) had to stop accepting new investment after investors poured nearly $4 billion into the fund between March and July causing the ETF to run out of shares.  Two exchange traded funds run by Deutsche Bank’s DB Commodity Services (DBCS), the PowerShares DB Commodity Index Tracking Fund (DBC) and the PowerShares DB Agriculture Fund (DBA), have grown to $3.3 billion and $2.2 billion respectively.

The ascent of commodity ETFs benefit average investors who now have a low cost and efficient way to hedge against inflation (see Tactical Inflation Hedging for more).  Yet, the regulator appointed to oversee the U.S. commodity futures markets has declared war on commodity ETFs.

Gary Gensler, former Goldman Sachs partner and a key player behind Sarbanes-Oxley legislation, launched the opening salvo as part of his “swearing-in” remarks in May 2009:

“I intend to pay particular attention to using current authorities and obtaining much needed new ones, including aggregate position limit authority, to protect farmers, merchants, consumers, and small businesses from the burdens of excessive speculation.”

Since May, Chairman Gensler has held hearings on setting position limits in the energy markets, hampered the ability of a key ETF manager to participate in US markets (see CFTC Puts New Limits on Two Commodity ETFs), requested public comment on regulating a new carbon credit security and has even made a play at regulating the London-based ICE Futures Europe market.  New actions and pronouncements are coming fast and furious – there were four press releases yesterday alone.

The result of this flurry of regulatory actions has been chaos.

The chief investment officer of UNG has decided to stop taking new money, even after receiving approval from the SEC to increase his fund’s share count. (see Natural Gas ETF Manager Looks for New Approach).  As a result, the tracking error for UNG has swung wildly as investors try to figure out what is going to happen next (see US Natural Gas Fund Loses Track).  According to an SEC filing, DB Commodity Services has until October 31 to get its positions in line with the lower limits.  (in the filing, DBCS states that it will continue to honor timely orders submitted with respect to both creation and redemption baskets.)

All of this comes at a time when natural gas prices are at a seven year low and investors and advisors are reshaping their portfolios in anticipation of inflation caused by the new adminstration’s fiscal and monetary stimulus actions.

Why is the CFTC acting so broadly and so swiftly against financial innovations that have benefitted investors?

In our research to answer this question, one firm’s name seemed to appear more often than others –Goldman Sachs.

Is Goldman Sachs somehow behind the CFTC’s campaign against ETF investors?  At face value, no.

As part of the July hearings, managing directors of Goldman Sachs and JP Morgan Chase were both hauled in front of the commissioners to testify. (See Goldman and JPMorgan Defend Commodity Firewalls).

However, we would like to see more answers to questions raised by the sudden crackdown on the markets.

Before diving into the details, a disclaimer.  We are not conspiracy theorists and we didn’t jump on the Goldman Sachs bashing parade that went by earlier this year.  In fact, Chairman Gensler’s book, The Great Mutual Fund Trap, was one of the inspirations for founding ETF MarketPro.

With that out of the way, here are the questions that reporters that cover this industry for a living should be asking:

1. Who is Gary Gensler?

According to the CFTC’s official biography, Chairman Gensler worked for 18 years at Goldman Sachs where he was selected as a partner and in his last role was Co-head of Finance.   He left Goldman to work for Treasury Secretaries Rubin and Summers in the Clinton administration.  Specifically, Gensler was the Under Secretary of Domestic Finance (1999-2001) and Assistant Secretary of Financial Markets (1997-1999).  After his Treasury stint, he went to work for Senator Paul Sarbanes, serving as a senior advisor to the chairman of the U.S. Senate Banking Committee on the Sarbanes-Oxley Act.

According to a story filed by Marketwatch reporter Ronald Orol,

“Gensler was considered a key architect of the Commodity Futures Modernization Act, approved in 2000. The CFMA is considered by critics as a key contributor to the financial crisis because it lacked regulation of derivatives such as problematic credit default swaps. In 2008, Gensler worked on the Obama-Biden transition team.”

We think the primary question raised by Chairman Gensler’s background is whether it is healthy for US markets to continue to leave open the revolving door between Goldman and Treasury.

2. Why do J. Aron and Goldman Sachs continue to have unlimited access to CBOT positions?

This weeks’ revocation of the no-action letter that effectively places lower position limits on DBCS is in line with what Chairman Gensler said he would do.  However, no mention was made of another no-action letter for the large Goldman Sachs commodities unit, J. Aron.  According to Marketwatch reporter Moming Zhou, in 1991, J. Aron was granted unlimited authority to establish long positions on the CBOT as a hedge for swap contracts.  Marketwatch obtained and made available a copy of the letter.

3. Was Goldman losing market share to US Commodity Funds and DBCS?

US Commodity Funds and DBCS raked in billions of dollars of assets earlier this year as investors embraced commodity ETFs.  Was this money coming in from the sidelines and other assets, or was it coming from Goldman clients?  According to another MarketWatch report, Goldman is actually one of the largest owners of UNG.

4. Does Goldman’s London operation stand to gain if futures trading moves away from the exchanges?

Last fall, Fortune’s Telis Demos interviewed Goldman’s new commodities chief Isabelle Ealet.  Demos notes that Goldman’s Lodon-based commodities desk generates $3.4 billion in revenue and is a cash cow for the firm.  However, Goldman’s commodities revenues peaked in 2006 and the firm has been losing share to competitors since then.  Ealet was brought in with orders to get more aggressive.  Our guess would be that originating and trading OTC swap agreements is a much more profitable business than trying to make money on a hyper-competitive exchange.

5. Is the commodities business big enough to warrant the use of political capital?

Fox Business reporter Ken Sweet‘s article Goldman Sachs Beats Expectations As Competition Struggles notes that the firm set an all time record for revenue in Q2 and results overwhelmingly beat expectations.  The largest contributor of profit – the Fixed Income, Currency and Commodities business which earned a record $6.8 billion in the quarter.  Ironically, in commenting on Q2 results, Goldman’s CFO observed ‚ÄúThere is certainly less competition out there”.

While the regulators have ETF managers in scramble mode, Goldman is prepping for a huge run up in commodity prices.  According to Bloomberg, a recent Goldman research report notes that:

“A commodity shortage is likely next year as output of metals and agricultural products potentially rises too slowly to match revived demand”


Michael Vermillion is the president of Far Hills Media LLC, the publisher of ETF MarketPro.  He can be reached via the contact page at ETF MarketPro.