Enter the Dragon- first published March 29, 2005

March 2005 Article:

Kudlow’s Guest Commentary:

Enter the Dragon – New Dynamics in the Oil Market

By Tom Nugent and Warren Mosler

Traditionally, the hedgers and speculators have ruled the commodity
markets. But now a new behemoth has stepped in- the institutional ‘long
only,’ ‘real money,’ fund manager, who has incorporated indirect ownership
of raw commodities as an ‘asset class.’ Yes, there are very large commercial
hedgers, and there are very large hedge funds who are speculators, but this
new entrant with $ trillions of assets under management is changing the

In a recent Dow Jones Newswires article by Spencer Jakab, entitled
“US Pension Funds Dip Toe into Commodities, Roil Waters” the author
presents his research into the prospective impact of direct investor
involvement in commodities:

“…the advent of new funds that have allowed pension trustees to buy
a basket of commodities without dabbling in futures themselves, has
unleashed a torrent of money — an estimated $50 billion of flows into
indextracking funds in the last two years alone, with estimates of
another $50 billion on the way in 2005.”

What makes these funds qualitatively different is that they buy and,
for all practical purposes, never sell. In fact, most of them continue to net
buy an asset class as a percent of their total assets, which means as their
financial assets grow over time they buy and hold more and more
commodities. And this is exactly what the crude oil markets are telling us.
Even as inventories continue to grow well beyond commercial demand, the
price continues to rise, as pension funds continue to buy and hoard
inventory. And, if allowed to continue, this building inventory will grow
indefinitely and NEVER be used! Yes, price is still a matter of ‘supply and
demand,’ but in this case the demand is to hoard- continuously buy and
store, and NEVER sell.

At the macro level, our own pension funds are buying crude oil to put
away forever, by bidding up the price and depriving us FOREVER from using
the crude oil they purchase. This is truly a bizarre set of circumstances
at the macro level, while it makes perfect sense at the micro level. It is a
classic and colossal case of failure of institutional structure to serve a viable
public purpose.

To make matters worse, this monster has staggering geopolitical
consequences that are currently being played out. Hopefully essays on this
developing story will trigger more of the same that will enlighten our
leadership to these new forces in motion. But be prepared for things to get
much worse before they get better.

*Thomas E. Nugent is executive vice president and chief investment officer of
PlanMember Advisors, Inc. and chief investment officer for Victoria Capital
Management, Inc.

*Warren Mosler is a principal of Valance Co. and associate fellow at the Cambridge
Centre for Economic and Public Policy in the United Kingdom.

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