How Bad Will the Commodity Market Sell-Off Hit Leveraged Players?

Gold-bug conspiracy theorists claim that the US treasury and the Fed implemented a "grand plan" to force a massive de-leveraging in the commodity sector in order to boost the US dollar and take the pressure from the "short financials/long commodities" trade on US financials. As a result, selling by leveraged hedge funds selling billions of USD of commodity positions to meet redemption demands have ostensibly pushed down crude oil prices from $147.90/bbl to $93.89/bbl (36.5%) and gold down from $1,033.90/ounce to $739.80/ounce (28.4%) since July.

A more likely reason is a crack-down by the CFTC (Commodities Future Trading Commission) who on Sept. 12, 2008 said it was imposing "enhanced control" on dealing by Wall Street banks by forcing them to publish data on their positions. Heretofore, swap dealers (of which the Wall Street banks are major players) had received exemptions from "speculative position" limits, making swaps on commodity indices another backwater of unregulated and undisclosed trading.

Under a swap contract, the user secures a maximum price and agrees to pay the financial institution a fixed price. The user gets payments based on market prices. According to a CFTC in June, the net notational value of commodity index investments was $200 billion, while total futures and options contracts for 33 US exchange-traded commodities in major commodity indices was $945 billion. Individual investors/traders can also control $75,000 worth of gold for an initial margin of $3,500 (21X leverage), while a $85,000 position in crude oil can be gotten for an initial margin of $4,050 (21X leverage).

Given the sharp sell-off in commodity markets and the fact that a favorite trade for hedge funds had been a long commodities/short financials, one wonders how much unrealized losses there are out there for those caught wrong-footed by the sharp falls in major commodities. Relative the substantially smaller size of trading in commodity markets, this is probably a big deal.

Moreover, these losses could well come on top of MBS valuation losses, only adding more toxic fuel to the credit squeeze tsunami raging through mainly the US financial sector.