Commodities: Latest Boom, Plentiful Risk

The booming commodities market has become increasingly attractive to investors, with hard assets like oil and gold perhaps offering a safe hedge against inflation, as well as the double-digit gains that have fast been disappearing from the markets for stocks, bonds and real estate.

Undeterred by the kind of volatile downdrafts that sent oil plunging 4.5 percent Wednesday, to settle at $104.48 a barrel, large funds and rich individual investors have sent a torrent of cash into this arcane market over the last year, toppling records for new money flowing in.

Mark Lennihan / AP Traders buy and sell crude oil futures contracts at the New York Mercantile Exchange Friday, Jan. 12, 2007. Oil prices rose more than $1 a barrel as traders bought up contracts after a plunge in the previous session sent crude to its lowest price in more than a year and a half. (AP Photo/Mark Lennihan)

Small investors are plunging in, too, using dozens of new retail commodity funds to participate in markets that by one measure have jumped almost 20 percent in the last six months and doubled in six years.

But this market, despite its glitter, offers risks of its own, including some dangerous weaknesses that are impairing the ability of regulators to police fraud and protect investors. Commodities are also vulnerable to the same worries affecting the rest of Wall Street, where on Wednesday the Dow Jones industrial average plunged almost 300 points, erasing more than two-thirds of Tuesday’s steep gains.

Moreover, the biggest speculators and lenders in the commodities markets are some of the same giant hedge funds, commercial banks and brokerage houses that are caught in the stormy weather of the equity, housing and credit markets.

As in those markets, an evaporation of credit could force some large investors — especially hedge funds speculating with lots of borrowed money — to sell off their holdings, creating price swings that could affect a host of marketplace prices and wipe out small investors in just a few moments of trading.

“Right now is a very scary time” for commodity market regulators, said Michael Riess, a director of the International Precious Metals Institute, a consultant to commodities investors for more than 30 years. “It’s not a question of overregulating or underregulating. It’s a question of just being swamped by volume, volatility and a dramatic shift toward speculative interests.”

Developments on Wall Street in the last few days underscored the new risks. Both Bear Stearns and its prospective new owner, JPMorgan Chase , are important clearing brokers that process and guarantee their clients’ trades in the commodities markets.

Officials at the exchanges where those trades occur had to monitor Bear Stearns’s financial situation carefully throughout last week to ensure that its cash shortage did not affect its commodity positions or those of its clients.

Walter L. Lukken, who heads the federal agency that regulates most commodity markets, said his staff had been able, so far, to cope with both the markets’ growth and the recent tremors from Wall Street.

"Even with the enormous volume coming through,” said Mr. Lukken, acting chairman of the Commodity Futures Trading Commission, “we think we have gotten a very good handle on the market. You can’t catch them all, of course, and you worry that something will get past the goalie. But we have been able to scale up the regulatory monitoring system to deal with increasing volume.”

Regulators and exchange officials take comfort from the rising commodity prices, which reduce the risk that lenders will grow nervous about their collateral and withhold new credit. Despite a broad commodities sell-off yesterday, a Commodity Research Bureau index remains almost 40 percent higher than a year earlier.

But it has been a roller coaster: commodity prices can record daily percentage changes that dwarf typical movements in stocks. Yesterday, when crude oil gave back some of its 85 percent annual gain and gold dropped almost 6 percent after an annual gain of 44.5 percent, the Standard & Poor’s 500-stock index fell 2.4 percent, leaving it down 7.4 percent over the last year. On its worst single day over the last year, it fell 3.2 percent.

So stock market investors seeking these formidable gains will find themselves on unfamiliar terrain. The heart of commodities markets is the so-called cash market, a “professionals only” setting where producers sell boatloads of iron ore, tanker ships full of oil and silos full of wheat for immediate use.

Wrapped around that core are the commodities futures markets. Here, hedgers and speculators trade various versions of a derivative called a futures contract, which calls for the delivery of a specific quantity of a commodity at a fixed price on a particular date.

CONTINUED: Obstacles to effective regulation

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