Proof positive derivative speculation drives commodity prices higher -- for now

The weight of money moves markets, be it speculation or whatever other moniker you want to put on it. This was one point John Mauldin made as pointed out in a recent Guambat post, but the more general notion has also been ranted about for months or years on these "pages".

The anecdotal evidence of this dynamic is featured in a Bloomberg report today:

Goldman, Morgan Stanley Profits Conceal Reliance on Commodities By Christine Harper

Goldman Sachs Group Inc. and Morgan Stanley are making money the old-fashioned way: Buying and selling commodities.

Goldman and Morgan Stanley are expected by analysts to report the best second-quarter earnings of the world's biggest securities firms this week, having limited their losses from the collapsing credit market. They also lead Wall Street in commodities trading, where crude oil futures doubled in the past year and the price of products from gold to corn soared to record highs.

Surging prices are attracting investors, as well as companies hedging their positions by buying derivatives. That's played to the strength of Goldman and Morgan Stanley, which dominate the market for commodity derivatives. The two New York-based companies accounted for about half of the $15 billion of revenue that the world's 10 largest investment banks generated from commodities last year, said Ethan Ravage, a financial-services industry consultant in San Francisco.

"There's just a lot of money chasing these markets," said Peter Fusaro, chairman of New York-based Global Change Associates, which advises hedge funds on energy investments. The number of energy-related hedge funds his company lists has more than tripled to 634 in less than four years.

Global trading in commodity derivatives on exchanges rose 52 percent to 489 million contracts in the first quarter from a year earlier, according to data compiled by the Bank for International Settlements. Energy and agricultural products led the climb. In the over-the-counter market, the value of outstanding commodity- derivative contracts jumped 26 percent to $9 trillion in December 2007 from a year earlier, the most recent BIS data show.

The commodities business is also risky. Amaranth Advisors LLC collapsed in September 2006 after trader Brian Hunter's natural gas positions lost about $6.6 billion in one month, the biggest loss ever by a hedge fund.

Commodities revenue can swing wildly. Morgan Stanley said in December that its fourth-quarter commodities revenue decreased 84 percent, without providing an actual figure.

The firm's traders were "badly positioned in electricity, natural gas and oils," Chief Financial Officer Colm Kelleher told analysts on a conference call. "It was poor trading; it is as simple as that."

At New York-based Merrill Lynch, the third-biggest U.S. securities firm after Goldman and Morgan Stanley, President Gregory Fleming said the commodities boom could turn out to mirror the rise and fall of technology stocks in the late 1990s and structured-credit products between 2002 and 2007.

"I'm hearing a lot of talk about supply and demand in commodities is not necessarily what we should be looking at," Fleming said in an interview on May 29. "Boy I've heard that twice before in less than a decade in two different markets."