News and commentary

Oil Surge: Is Key S&P Commodity Index the Cause or Effect?

By Richard Suttmeier
Updated: Thursday, July 03 2008 12:07:PM

Oil Surge: Is Key S&P Commodity Index the Cause or Effect?
Posted Jul 03, 2008 12:34pm EDT by Aaron Task in Investing, Commodities
Related: GLD, OIL, USO, DUG, MHP, OIH, XOM
Crude prices hit $146 per barrel early Thursday, a surge many attributed to the ECB's rate hike, which initially put further downward pressure on the dollar. (The dollar has since bounced and oil retreated as the ECB suggested this rate hike may be its last.)
Amid the seemingly endless debate over the "real" cause of crude's ascent, Richard Suttmeier, chief market strategist of RightSide.com offers yet another explanation: The influence of the S&P GSCI Index.
The index, which S&P acquired from Goldman Sachs in early 2007, is used by many institutional investors, most notably pension funds, as a benchmark for commodities.
S&P estimates $100 billion to $110 billion is currently benchmarked to the index, up from $80-$85 billion at the end of 2007.
Suttmeier's point is that because the index is so heavily weighted in energy -- 78.1% with more than half of that total NYMEX crude -- the increased pension money going into commodities is driving energy prices higher, thus driving up its weighting in the index, prompting more buying by index funds (lather, rinse, repeat).
Technically, the funds are buying swaps contracts that mimic the index vs. the index itself, but Suttmeier's main point is that the index is overweighted in energy and rebalancing it would go a long way to bringing crude prices down, as occurred when Goldman cut energy weightings in 2006 and 2007.
Not surprisingly, the folks at S&P refute this view, saying the GSCI (like the S&P 500) measures the market but doesn't influence how it performs.
"Isn't there supply/demand involved?" Michael McGlone, S&P's Director of Commodity Indexing asks rhetorically. "The main thing about investors is they're just following [the market]. The tail can't wag the dog."
McGlone refuted the idea that S&P could/should "rebalance" the energy component in the index since it is based on world production. The GSCI is "a simple rules-based index with little human intervention," he says. "Changing the methodology is very unlikely. That it's been tracking the actual price [of energy] well doesn't mean we should change it -- it wouldn't make logical sense."
Finally, McGlone makes the point that the "index itself cannot and never does buy or hold any physical commodity," drawing a distinction between the GSCI and other indexes such as the Gold Shares SPDR (GLD) that do buy/sell the physical commodity. "They will create supply/demand -- this is a purely hypothetical index, there's no actual physical delivery."