Saturday’s Wall Street Journal carried a story (subscription required) on the potential for proposed new CFTC rules to restrict issuance of shares of commodity ETFs. The withdrawal of earlier grants of rule exemptions has already led certain ETFs to suspend new share issuance. As the Journal story notes, this has driven UNG, the natural gas ETF, to trade to a 16% premium to net asset value.
There is clearly an increased focus at the CFTC in protecting market integrity through he imposition of position limits, rules which restrict the amount of interest in a market for any non-commercial entity. To date, most of the truly effective ways of implementing this (e.g., extending the restrictions to the OTC swap market and international regulatory coordination) are still on the drawing board. However, if the CFTC does move forward in this direction there will be significant investment implications.
While the Wall Street Journal focused on the loss of investment opportunities, this is not necessarily so. From a trading perspective, demand for a commodity ETF whose new issuance has become restricted might offer existing shareholders the opportunity for valuation expansion similar to what has already happened with UNG. But such premiums are fickle and fleeting. Investors with long memories may recall the spectacular valuation expansion of the closed-end Germany fund whose market price soared to double its net asset value in early 1990 in the wake of the fall of the Berlin Wall. Then, as likely now, such premiums are unsustainable as lookalike products flood the market with new supply, or investors assess the risks created by such premiums. For ETFs this is particularly problematic, since one of the key selling points of this structure is the elimination of discount/premium valuation worries.
The most likely long-term outcome of any robust CFTC position limits will be a reevaluation of the entire commodity-as-asset-class story at both the retail and institutional levels. As noted in an earlier post, this has always been a suspect concept, more a creation of Wall Street’s salesmanship than reality. Those same product pushers are likely to rediscover that which has always been true — certain commodity related equities offer similar or superior portfolio characteristics to the underlying commodities.
In this regulatory scenario, we may well witness a surge of interest in commodity related equities, assuming of course that the bullish case for commodity prices (primarily emerging market demand and weak dollar) remains intact. Morgan Stanley already created an index of 20 commodity related equities: AA, ABX, ADM, APA, APC, BHI, BHP, CAG, DVN, FCX, GG, HES, IP, MRO, NEM, POT, SLB, TSN, WY, X. Such names may benefit not only from generic interest in commodity related equities, but from specific products, yet-to-be-created, that are linked to this or similar indices.
Interest in energy-linked stocks both on individual merit and as part of packaged index vehicles may well lead the way. Contrary to the claims of the marketers of futures-linked product, energy stock indices correlate well to energy prices, provided you use the right index, such as the Dow Jones U.S. Oil Equipment, Services & Distribution Index. Another index that correlates well to energy prices, the Dow Jones U.S. Oil & Gas Producers Index already has an ETF (the i-Share, ticker IEO).
Strict CFTC limits will indeed close off some avenues for investors. Those funds have been sitting in markets ill-designed for such purposes (see the dangers of this here). However, this will also open the door for inflows into appropriate vehicles in the equity markets, which were designed for just such investments. Investors who can look beyond any new restrictions will recognize some new opportunities.
Disclaimer: neither the author nor his clients have any direct positions in the securities mentioned in this piece. Both may or may not indirectly hold these securities through third-party managers.