Speculators Keep the Market Liquid

This commentary is from the U.S. Global natural resources team

The Commodities Futures Trading Commission (CFTC) wrapped up its hearings on whether to install position limits on futures trading this week, and like other hot topics being tossed around Capitol Hill, misinformation seems to be running rampant.

One myth is that speculators only bet on prices going higher. The chart below shows both long and short futures positions for all commodities. While it’s definitely not a one-to-one ratio, the chart shows that investing in futures is a two-way street, with investors lining up on both sides.

Another myth is the overall size of the speculative market. According to a recent TIME article, less than three percent of the world’s oil consumption over the next year is under futures contract.

Several U.S. lawmakers have claimed that speculative investors in London are using lax laws to control oil prices. However, data published by the CFTC and the Financial Times disproves that theory.

As of last week, more than 18 percent of oil speculators were trading in New York while only 9.6 percent resided in London. The FT points out that “spread” positions popular with hedge funds are also skewed towards the Big Apple.

Even the “speculator” label sounds sinister when all that is happening is that a bet is being made that a certain investment will either rise or fall in the future. That sounds pretty similar to any other type of investment.

Speculators are important because they provide liquidity for commodity producers, while allowing them to hedge their price risk. Imposing caps on the sizes of these futures positions could significantly limit their ability to hedge commodity risk.

Jeffrey Sprecher, CEO and Chairman of the Intercontinental Exchange, said in his testimony this week that “setting hard position limits across all months could drain market liquidity, impede price discovery and drive market participants off of exchanges.”

Without this liquidity, producers would find it difficult to hedge against commodity price risk, and projects that require more up-front capital, like Canadian oil sands, would be threatened. This would ultimately lead to lower production and higher long-term prices.

This issue is a good example of keeping long-term goals in mind. Imposing position caps on futures positions will only produce minimal short-term benefits while much larger unintended consequences could follow.

Disclosure: None of U.S. Global Investors family of funds held any of the securities mentioned in this article as of 6/30/09.

Comments

[BrotherMaynard:]

if nobody is there to buy a commodity, it should fall in price. just like if there is nobody there to buy a house (aka mortgage), it should fall in price.

yet, if a speculator is there to buy and keep the commodity from falling in price (i.e. stuff onto a ship and float it off the GOM), have the true fundamentals of supply and demand been born out?

this "liquidity at any and all cost" mentality is nuts.

Aug 17 02:31 PM

[Prudent Man...:]

Political collectivists despise individualists who take risks that they don't have the courage to take. The power-grabbers know they can't earn a living they have to make false promises to the naive who believe there is a free lunch.

Hopefully some day will realize that the Mixed Capitalism/Socialism Market is dictatorial and statist and antithetical the The Free Enterprise
System. Were those who discovered and drilled for oil a hundred years ago speculators or bureaucrats/politicians?

Aug 17 03:16 PM

[BullnBear:]

The words “Capitol Hill” and “misinformation” were typed up in your first paragraph and that’s really all I need to know…no really….

I have posted/commented on this subject and have read several stories here on SA about what a bad idea it is to get the political arena involved in the energy debate. Politicians don’t care about things such as this, only about the election cycle.

I really believe that if the life passion of anyone is to promote change and good then they would go into the area that most troubles them and bring about change and they would do all of this in relative obscurity and not in front of a camera or a reporter every chance that they get.

Might a time have existed when politics was meant to bring about the greatest amount of good for the greatest number of people? I believe that answer is yes but that time doesn’t exist anymore in my opinion.

Aug 17 10:48 PM

[drbob101:]

This is the first article I have read that illuminates the fact that most "speculators", whatever and whoever that is, play the market both ways. I am a speculator as I trade CL as a private trader each and every day and have made a lot more money on the short side since last summer than the long side.

If the market is going up there are more long speculators than short speculators and if the market goes down there are more short speculators than long speculators...period. The fact of the matter is that there are more speculators than there are actual producers and users trading the market and unless they limit the trading of this commodity to industry usage alone, the speculators will determine which way it goes and yes, they do work it both ways

Aug 18 08:38 AM

[Elliott:]

This article laments misinformation yet it spins history to paint speculation in a positive light.

Everyone knows what really happened in 2007-08. Hedge funds, pension funds, ETFs, etc. poured billions of dollars into energy futures. Trend followers jumped in. As long as the price went up a few dollars every month with the rollover, the trend kept going.

The problem is that the financial speculators never take delivery of physical product. Futures markets work best when most of the participants actually produce or buy the product at the wholesale level. That's when supply and demand are truly in balance.

When oil ramped up to $150/bbl under a normal supply-and-demand regime you would think there would be a shortage of oil. The opposite was true -- inventories were very high. That's because the financial demand for futures got way ahead of the physical demand for oil. Position limits on financial speculators (but not industry hedgers) are a good thing and will help keep futures markets undistorted.

Aug 18 10:53 AM

[Jack Walker:]

Frank,

Should more effort be make to distinguish between speculators and investors in the commodity markets?

We understand the important liquidity function provided by speculators, but using the term “Investor” in the commodity markets is an oxymoron since the short-term commodity price discovery function is incongruous with long- term investing.

Commodity markets were established for short-term price discovery not for long-term capital investment. Is there any wonder why futures contracts have a limited life span?

When long- term pension fund and endowment assets are allocated to commodity markets it shifts the demand curve upward to the right and if supply is constrained then the new equilibrium price point is higher than would be determined solely by the producers and uses of the commodity. The resulting distorted price signals send the wrong messages to both producers and users as they make enormous long-term capital allocation decisions.

Are we shifting the higher price level to society as a whole for the benefit of a smaller group of pension fund beneficiaries?

Perhaps the discussion goes beyond just setting position limits to examining the acceptable role of the market participants.

Should we be more concerned about matching long-term investment objectives with long-term capital requirements based on accurate fundamental data?

Jack

Aug 18 01:04 PM