Tuesday, September 18, 2012

$50Bn of Commodity Investment at Risk?


A tax lawyer I know sent me a link to an article about a tax ruling. I’m thinking “Boring”, who cares about that? Then I read the article. A few lines jumped out:


Commodity prices could come under severe pressure if the U.S. Internal Revenue Service (IRS) decides to revoke previous rulings.


Without the tax exemption, mutual funds would have to restructure or liquidate their holdings.


The resulting liquidation would put tremendous pressure on commodity prices and reverse much of the build up of speculative money in commodity markets over the past decade.


An enormous industry has built up on a very thin legal foundation, and now it’s starting to sway dangerously in the wind.


I’m no tax lawyer, so I recommend that readers draw their own conclusions about this screwy story. Link. My take:


Mutual Funds (MFs) are restricted as to their investments in commodities by a law that was established in 1936 and revised in 1954. The rules are straightforward. No mutual fund registered in the USA is allowed to own more that 10% of total assets in commodities. (There are negative tax consequences to the MFs if they exceed the limit.)


The law hurt the MFs, so they sought a way around the laws. One after another the MFs requested an exception from the Internal Revenue Service (IRS). The rulings allowed the clever MFs to set up commodity investments using derivatives. To meet the guidelines for the special tax treatment, the funds set up “sham” companies in the Cayman Islands. From the article:


These offshore shell corporations, established by mutual funds, are in every case wholly owned Cayman Island corporations. They are shells. There are no physical offices, no employees of their own, no independent operations. The mutual fund’s U.S. employees run their commodities portfolios from their U.S. offices.


After 2006, the IRS issued a total of 72 Private Letter Rulings to MFs that gave the go-ahead for the MFs to investment 100% in commodities via derivatives and offshore shell companies. The IRS stopped issuing these PLRs in 2011. As of today, there are 28 requests for similar PLRs. The IRS has left these in an inbox for over a year now.


Behind this standstill at the IRS is the guiding hand of Administration. What are its objectives?


Many Democrats, including Obama, have pointed at the “evil speculators” who push up commodity prices. Any regulatory/tax changes that discouraged the speculation would, therefore, be a “positive” outcome.


Individuals who invest in commodities via mutual funds do pay taxes on any of the gains that are realized. But those gains are often deferred for years; therefore the timing of the tax receipts is also deferred. This is a disadvantageous position for a government that is running trillion dollar annual deficits.


Some thoughts on this:


-This is nuts! $50Bn of small investor money is tied up in commodity derivatives booked with offshore corporate shells to skirt existing regulations and to avoid current US taxes? And its happening with “side deals”?


-Something has to give. 72 mutual funds have permission to avoid the law (the PLRs). These entities have a “green light”, but no one else is allowed to play in this lucrative sandbox? There can’t be a carve-out for a select few. Either this is legal (confirmed by Congress), or it’s not.


-A very powerful Senator, Carl Levin, (D-Mi) is behind the effort to eliminate the mutual fund exemption (reverse the existing PLRS) for commodity investment. His words on the topic; clearly he is no fan:


“The controlled foreign corporations are corporate fictions, offshore shams, paper exercises whose sole purpose is to make an end run around the legal restrictions on commodity investments by mutual funds.”



-Nothing will happen on this until well after the election. If there are no changes at the White House, and the composition of Congress remains about the same, then this issue will come up in Q1 2013.


-If Congress did vote on this, and they concluded (as per Senator Levin) that MFs should not be allowed to avoid current law via PLRs, then it could result in a fairly large hiccup in the commodity markets. A significant portion of the $50Bn now invested by MFs would have to be unwound.


-On the other hand, Congress could go in the other direction and confirm what the IRS has said in the PLRs. It could amend existing law to resolve the uncertainty. This would also create a hiccup as new money moved into the playground.


-The outcome of this has hiccup potential, but the lasting consequences would be minimal (either way). In the end, global supply and demand sets prices for commodities, not tax and regulatory issues in the US.


-If you were looking for an example of just how screwed up the system is, this might be it. We rely on 80-year old laws (that have been patched with private deals for a select few) to govern the way individuals invest. The cobbled-up system is broken; hiccups will be the result.



  1. Conscience of a Conservative says:

    This is nefarious. Not the Cayman Islands part but the structured notes part. Structure notes by their very existence seem to be built around the concept of encouraging investments in things funds are not permitted to own or don’t wish to commit the required margin to get that exposure. There seems to be a structured note for everything these days, yet if someone wants exposure to Copper or real estate or the difference between LIBOR and Corn Futures there are ways to do that using existing instruments assuming the funds charter places no such limit. As result of these structure notes, we find accounts taking on more leverage than they should or investing in assets they really weren’t supposed to be. Case in point, the big banks common target retail investors with structured notes yet fail to disclose to those accounts what the investment really is. Are they investing in a commodity or lending money to the issuer?
    I’d like to see this loop-hole closed

    • Conscience of a Conservative says:

      Bruce, I think you are missing something. When commodities are sold this way by Wall Street instead of the normal way through the futures or physical markets it’s often because the buyer is mis-pricing the exposure and Wall Street loves that. These notes are customized and the price not observed as directly as for example a Comex or NYSE contract.

  2. This piece was a jolt. Does the SEC consider Sprotts gold trust a mutual fund?

  3. Ben needs the QE money in the stock market to achieve a 30pe bubble (ie circa 2000). Cannot allow for leakage into commodity market causing inflation so large that even they would feel stupid trying to convince the masses it is contained at 2%. They will use all means possible (margin hikes, new rules, confiscation, etc) to create uncertainty forcing commodity speculators to capitulate and join the party in the stock market.

  4. Old laws are not necessarily bad. You have to ask yourself why the restriction in the first place? Probably because MFs were to be mainstream and to stay out of a area of more volitility.
    Of course, with monetary policy of recent decades being what it is, all markets have been thrown into aggrevated volitility [Wall Street makes much more trade money when there is volitility a brokerage manager told me about 4 years ago, and said to expect increased volitility going forward].
    But the fast money knows that it money is in the commodity cycle, and they are not content with equities gains from companies in that business. How else do they make 4%/yr fees on the MF industry holdings of trillions of dollars – even if it is at the customers’ expense in a 5% vs. 10% or 11% equities growth market as Warren Buffet has suggested is a reasonable expectation for this next decade – which leaves the customers an average 1%. OOPS! Customers can get 1% from a CD.

    • This was exactly my first thought: what’s wrong with 80-year old laws? The whole process of ‘modernizing’ financial law is to attempt to circumvent existing laws or to pile speculation on top of speculation, in other words, the attempt to turn nothing into something through excessive leverage or trickery – which is what the old laws were put in place for: to protect the financial system. As one example, ten years after the Glass-Steagall Act was repealed because it was ‘antiquated’ we had a near financial collapse and are on the brink of another one now.

  5. This is silly — no wonder that a corrupt member of Congress is behind it.

    Lets stipulate that evil speculators and the boogey man are driving up commodity prices — we all know its the criminals Bernanke and Draghi driving up prices, but lets play along with the stupidity of Congress for a minute.

    The world consumes at least 85 million barrels of oil per day. The current price is about $95/bbl (for WTI), $112/bbl (for Brent) and much lower than $95 for the more sour/heavy blends. Lets call it $100/bbl on average to make the math easy.

    That works out to $8.5 billion *PER DAY* worth of oil consumed, which means about $3.1 TRILLION per year.

    Compare this $3.1 trillion to the $50 billion total that Congressional dumb-ass Levin claims is lurking in shell companies. Even if his bullshit had any truth to it, $50 billion is a rounding error.

    This is just another example of Congressional criminals trying to divert attention away from their own failings. While the stupid voters wallow in filth and ObamaCare (that Crook Levin supported), Congress has their own private gym and vastly superior medical care, both paid for by taxpayers. And Congressional crooks don’t even have to pay taxes on the benefits they steal from us.

    Want to fix the deficit? FOLLOW THE MONEY. TAX CONGRESS and LOBBYIST

  6. The article is all good but the missing point here is markets are based on time and when time is up the trend will change. In the case of commodities it has been one huge bull market since 1999 with your normal pull backs. Still time has not run its course i.e. still more room on the upside.

  7. Armchair mutual fundees? Just buy and trade the individual stocks yourselves…nyway, YIELD-sseking is a dead-end. Speculate! and punish the government.

  8. It’s obvious that this issue does require addressing by Congress, since there is no logic to limiting this rule to some that are already doing so. It should be either all or none.

    My personal opinion: The idea of mutual funds is to NOT invest directly in commodities, so they should all be barred from doing so.

  9. Hi!, Patrons Of Bruce Krasting Et Al:

    Folks this is an easy one for the richer speculators among us; just buy the commodities of their choice in debth by paying total cash down and take control of the market without involving any margin plus afterwards name your price or starve that market segment until the “cave in” by potential buyers & maybe these speculators will achieve a private forum of bidding back and forth amongst potential buyers just like taking your novelty paintings to Christy’s for achieving a winning bid heh?! As the old saying goes: there’s always more than one way to skin a cat!! Good deal for the major catagory speculators that there’s no cloud on the title of their goods by any MF’s & so what?

    RUSS SMITH, CALIFORNIA (One Of The Broke States)

  10. If “we the people” are too stupid to evaluate the risks of speculating in commodities, its a sure thing that Congress will mess it up even worse — after all, “we the stupid” elected them

  11. Could someone please post a link to the original article?

    It sounds like they are discussing Subchapter M of the tax code which limits “investment income” from commodities to 10 percent of a registered investment company’s total income.

  12. Liars and thieves make the rules and laws….vote them ALL out…anyone that has been in office more then two years has too go…even the good ones and they are but a few…BOTH PARTIES are responsible for the trouble that is here and the really bad problems that are approaching…THROW THE BUMS OUT THIS NOVEMBER…please

  13. This is interesting, but as others have noted, it’s a “rounding error” in the Grand Scheme Of Things. The REAL Elephant In The Room is the imminent edict forcing 401k and IRA money out of whatever it’s in now and into Treasury Bonds, Treasury Bonds thoughtfully printed and provided by Ben “Bubbles” Bernanke. Or, if they notice enough people asleep all at once, just straight plain outright confiscation of 401k’s and IRA’s, much as Roosevelt took the gold in the 30’s with the stroke of a pen on an Executive Order. In fact, that might just be the first E.O. of a re-elected B.O. After all, we really didn’t build those 401k’s or IRA’s, did we ?

  14. Maybe I didn’t build my IRA.

    But I DID take it out several years back and put it all in physical held silver……because the handwriting on the wall was clear to me that they intended to print away the value, or outright steal it.

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  16. @james “Ben needs the QE money in the stock market to achieve a (ho)pe bubble (ie circa 2000).”
    Yes, the un-elected Master of the Universe is trying to blow bubbles again (that he thinks he can control, or at least lay the blame for off on somebody else! ;^) and keep the ones he’s already blown from popping (that’s called deflation, isn’t it? ;^)

    You know what they say, “You can fool some of the people all of the time, and all of the people some of the time, but you can’ fool all of the people all of the time! (unless…you have unlimited funds! But wait, Ben does have unlimited funds, doesn’t he? ;^)

    “If you tell a lie big enough and keep repeating it, people will eventually come to believe it. The lie can be maintained only for such time as the State can shield the people from the political, economic and/or military consequences of the lie. It thus becomes vitally important for the State to use all of its powers to repress dissent, for the truth is the mortal enemy of the lie, and thus by extension, the truth is the greatest enemy of the State.” ~ Joseph Goebbels, Hitler’s Propaganda Minister

  17. @ Russ Smith “…and take control of the market without involving any margin plus afterwards name your price or starve that market segment until the “cave in” by potential buyers & maybe these speculators will achieve a private forum of bidding back and forth amongst potential buyers…”

    Great idea, Russ! Drive up the price of food for those little old ladies on Social Security! Of course, you’re not the first one to want to corner the market in commodities. As I recall the Hunt brothers got that same idea in the 1970’s, wasn’t it? And it worked great, for a while…

  18. @Kreditanstalt “…YIELD-sseking is a dead-end. Speculate! and punish the government.”

    Wow! Is it that easy? I thought the market moved against you, sometimes, but what do I know, I’m not a pro.

    I kind of wondered why, if it was so easy to make money speculating, Bruce seemed to find it hard?

    “…I was involved with a Macro hedge fund later. That worked out all right, but it is not an easy road. There was one tough week and I thought, “Maybe I should do something else for a year or two….”

    Looks like he could have just speculated and punished the government, doesn’t it? ;^)