The Commodity Speculation Bubble

I'm taking on speculation in commodity markets over at NexGen:

bubble.jpgThe trouble is financial speculators. The world's growing middle class is buying more food and oil and investing in large institutional commodity markets. In other words, traders are betting on rising prices.

So don't look to ANWR and offshore drilling as the solution to high oil prices. Look to the traders who do not pass price fall benefits to the consumer. The trend has not gone unnoticed in the US and the Senate is now considering legislation aimed at cutting the cost of petrol and heating oil by ending excessive speculation in oil futures driving up prices.

The spike in commodity prices is giving us a taste of the future. We must develop alternative energy technologies now because despite a reprieve, be assured prices will climb back up again. Read my full post here.


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This is a very, very complicated subject. You cannot just say "it is because of speculators, so we should end speculation". Futures markets are very important to many industries.

Take for example the airline industry. If they had to price tickets to the change in oil prices, they would go out of business. They need to sell all the tickets before the flight goes off (many several weeks out), but then they have to pay for the gas on the day of the flight. If gas goes up, they lose money on the flight. If gas goes down, they cannot efficiently compete with other carriers.

So, what do they do? They buy up a lot of gas options at a time, so they can lock in a price. They do not always use all this product or take delivery. Maybe they decide to eliminate the service to certain cities, and so they need less oil; then they sell off the oil. But by having the option to take delivery at a fixed price, they at least know how to price the tickets.

Similarly, a lot of people in the food futures markets are post-processors. The people who buy oranges to make orange juice. The people who buy potatoes to make potato chips.

The future market is going to exist. The question is whether it will be legal or black market. I have seen zero proposals to curb excess speculation that do not seriously hamper legitimate uses of the future market.

If you want to talk economics, then we should talk about getting the government to raise interest rates. This is what is leading to commodities speculation. Interest rates right now are below inflation even using current metrics (which are heavily distorted for political reasons), and if you use the 1980s measurements of inflation, your money is losing 10% a year even if it sits in a money market. Wealthy investors are not as stupid about inflation as your average NY Times reporter; they are going to commodities because it is the only way to not lose capital right now.

But no investor who is not buying these for business purposes (e.g. the airlines) really wants to invest in commodities. These things fluctuate much more than stocks and they are a very easy way to go bankrupt. So all you have to do is insure that there are other investments that give an adequate risk-to-return ratio. But as long as the government keeps lying about inflation in determining its interest rates this is never going to happen.

I'm a bit skeptical that speculation can sustain long-term price differentials without some way to either hoard the commodity or limit its production. The spot market always clears, and any sustained dip can quickly burst the hopes of speculators who are holding long positions.

The Hunt brothers cornered silver. For a while. No doubt, the hoarding of physical gold as a hedge or investment accounts for a large part of its price.

But except for the Saudis possibly holding it in the ground, no one is hoarding oil.

The Hunt brothers cornered silver. For a while. No doubt, the hoarding of physical gold as a hedge or investment accounts for a large part of its price.

Read any economics blog. The gold bugs are a major force on the internet. So a good part of that is speculation. Indeed, I read that the cost to pull gold out of the ground is like a third of the current spot price. That is why you have so many old gold mines scrambling to get back into production.

As for oil, there is a physical limit on the amount of oil produced per day, largely determined by technology. Purchasing futures is a form of hoarding, just not in the way that you normally think.

But you are right, speculation cannot last for long. As commodities are all speculation (instead of growth potential like a business), this always makes them a very, very risky investment. But everything else right now is a money loser (either because the return is lower than inflation or the risk is too high), so it is attracting a lot of capital.