Are Speculators Really That Bad for Commodities Markets?

Commodity index investors (ie, speculators) sold $39 billion worth of crude oil futures between the July market peaks and September 2nd, a time that saw a rapid sell-off in crude oil prices (see Independent.ie

article).

The analysis was once again done by Michael Masters, president of Masters Capital Management, who recently blamed speculators for driving up prices. The drop also comes at a time when the IEA is forecasting lower demand, and pension and hedge funds are unwinding commodity positions. Each of these events has put pressure on prices.

In the end, such debate may be academic as to whether we call those who are selling speculators (be it hedge funds, pension funds, index funds, or individual traders). Given the exposure we all have to pensions and index funds (even us retail money mortals), we all might be classified as speculators, notwithstanding the evil mustache-twisting monopoly banker image.

Of course, all this talk says nothing as to whether speculators are even inherently bad for the markets as a whole (see US News & World Report blog). After all, who is going to take the other side of the position when a company is looking to hedge its risk? If the market is rising or falling, will there always be the perfect number of textbook farmers and bakers on the other side of the wheat contract? Probably not.

How many companies will show higher profits, or at least less loss, due to placing proper hedges? Raising margins to decrease leverage and unhealthy exposure is one thing, but making it more difficult for the market to even function is another. If we eliminate all trades and traders that don't actually plan to buy or sell the commodity, liquidity will decrease. If this does happen, individuals may find themselves living in a much riskier world, even if the price of crude seems a little less volatile day-to-day.

Disclosure: None

Comments

[Donald Johnson:]

The Masters report is authoritative, well written and honest. It shows the tremendous impact index speculators have had and are having on the markets and how they're distorting the markets. The CFTC report is written to defend the index speculators, exchanges and their members.

2008 Sep 12 10:05 AM

[Ferdinand E...:]

Without speculators there would be inadequate liquidity in the e.g. futures market, and so producers and consumers of physical commodities (e.g. oil) could not optimally hedge risk if they wanted to hedge it with futures.. Period. But Mr Masters deserves our congradulations. He has shown that the role of ignorance in this old world of ours is expanding all the time.

2008 Sep 12 10:14 AM

[Mr Bigfoot:]

My question is the reverse. "Is speculation really that good." Do we need that many speculating for specialty groups for profit gain only. Should we trust a company with such a bad track record as Vitol to hold 11 percent in the NYMEX Oil commodities market. Remember the Vitol "Oil for food" scandal in 2007 and the "Contaminated oil scandal" in 1993 in which Vitol sold over 280,000 barrels of dirty oil sold to Pakistan? I guess we can call this one the "Vitol Swaps Scandal" How come no one is talking about compensation for the public? That’s right. We all got ripped off at the pumps and we want our money back. Vitol, Goldman Sachs, Morgan Stanley and the rest of the scoundrals have an obligation to make it right again and the CFTC should be disbanded and punishment administered to the ones that covered up this massive mistake.

2008 Sep 12 11:25 AM

[searcher:]

There would be no hedge without the speculator; period. Other abuses so often cited are not inherent in the function of the speculator. In fact, those cited above are generally irrelevant to the 'issue' of those evil speculators. They are nothing but 'bloody flags' from wounds inflicted by abuses that are addressed by laws of long standing. Lack of needed enforcement is not the fault of the party taking the other side of the hedge.

2008 Sep 12 01:09 PM

[farmer448:]

Is there a role for speculators in the commodities markets?

Yes, their purpose is to provide liquidity. This allows prices to reflect longer term supply and demand imbalances and for lots of suppliers to adjust their production to the longer term pricing or for consumers to look for alternative materials or adjust their pricing of product.

Is there a role for regulation?

Yes, the problem is how to keep the market in a reasonable balance between suppliers and consumers of commodities. The supply side is “Cornering the Market” like the Hunts did with silver. In this case the enough of the supply of silver was controlled by the Hunts so they could set futures prices. The second is due to “herd mentality” of speculators. Here due to, loose/fast money, speculators start chasing a commodity price irregardless of the underlying demand of the price. The regulator, like an umpire, needs to be in place to make sure neither side is favored in the futures market and that the supplier or consumer does not have an overwhelming advantage.

Now supposedly the CFTC is supposed to be the umpire of the game. The problem is they are in the spectators box saying regulation is the responsibility of the “Great and all Powerful Invisible Hand”.

Yes, massive excesses will correct. But when this has happened in history the economic dislocation is incredible. Have the regulators learned nothing from history? Regulation is supposed to dampen excesses before the “Invisible Hand” corrects catastrophically.

Personally give me practical leadership over ideological leadership any day. I have enough drama in my life without our leaders dumping more on me.

2008 Sep 12 01:23 PM

[JasonC:]

Trend following speculators are bad for markets because they lead to high serial correlation but always get the actual eventual equilibrium price wrong. Modest amounts of it can be helpful as it speeds price adjustments to new information, but that is not what happened in oil or any of the other cases public policy is rightly concerned about. Instead massive trend following leads to systematically incorrect prices for long periods of time, very far from their eventual equilibrium level.

Besides handing massive losses to some of the speculators involved (and gains to some, of course), these positive feedback deviations from equilibrium cause *real* misallocations of resources and of capital. Which makes all of us worse off in the aggregate.

It is basic control theory that large positive feedbacks destabilize systems, while modest and leading negative ones stabilize them. A financial system geared to profitiing as much as possible by creating large positive feedbacks through herding behaviors, it parasitical on the real economy.

The underlying cause is the ease with which reckless speculators get access to credit for leverage and to other people's money to manage. In reality their creditors are bearing most of the risk, but contract terms obscure this whenever the lending side naively believes the borrowing side can and will actually pay if their great whopping hail mary bets go south.

The solution is for banks and other financiers to cease lending to speculators. All they are going to do is gun risk at the creditors' expense anyway. As for naked shorters, they should simply go to jail and have all their assets seized. As for deadbeats playing heads I win tails you lose, all their collateral should be seized yesterday and to a warm place with their whining.

The only commercial decent people in this entire mess are the bankers currently being shafted, so naturally the entire press and public is screaming for their blood. It is disgusting, you should all be ashamed of yourselves.

2008 Sep 12 01:27 PM

[ValueInvestor:]

I love how people are always ready to blast speculators in the commodities market but don't consider people in the stock market to be speculators. What gives?

2008 Sep 12 01:51 PM

[john s. gordon:]

as usual CFTC is out to lunch. the whole policy of bush/cheney has been to eliminate regulation so that the crooks can rip off the consumers. time for a new administration (& i don't mean mccain/palin) who will clean up the mess.
> jack

2008 Sep 12 02:20 PM

[titans:]

this is a bunch of hog-wash the markets are stuffing down our throats.the energy sector is taking a beating because the BIG BOYS are taking their HUGE profits from this 5 year bull run in anything related to energy stocks:mining,solar oil,coal steel,agri. and even the poor uranium sector which was already beaten down getting beaten while knocked-out already.I guess these hedge funds own EVERY stock in all those sectors i mentioned;hum ??????? Even a mining company from Kazakhstan called Kazakhmys has gone from $1950 A SHARE TO $810 A SHARE YESTERDAY....I GUESS SOME HEDGE FUND HAD THIS COMPANY ON THEIR BOOKS AS WELL which is traded on the london stock exchange; HUM ??????????? All the BIG BOYS got together ACCROSS THE GLOBE AND DECIDED TO TAKE DOWN "ALL" THE STOCKS IN THE SECTORS I MENTIONED EARLIER (ENERGY RELATED).Enough of this B.S. about hedge funds.I TRACK 100'S OF THESE COMPANIES THAT ARE GETTING HAMMERRED.YOU CAN'T TELL ME EVERY SINGLE ONE OF THESE COMPANIES ARE ALL BEING "UNWOUND" ; HUM ????? IT'S ALL ABOUT THE BIG BOYS TAKING YOUR HARD EARNED MONEY & LEAVING YOU HOLDING THE BAG.NOW THE 1,000,000 DOLLAR QUESTION IS WHEN WILL THE "BIG BOYS" GET BACK INTO THESE STOCKS TO BE THE FIRST ONES IN (AGAIN) SO ALL US SUCKERS CAN FOLLOW THEIR LEAD TO MAKE THEM MORE MONEY.....THEY HAVE THIS GAME DOWN REAL GOOOOOD !!!!!

2008 Sep 12 04:45 PM

[Managing Ed...:]

The profits made by oil's "big boys," titans, can be modeled by the crack spread, an explanation of which can be found in Hard Assets Investors article "Time For Crack Spreads?" at www.hardassetsinvestor....

As for the speculator blame game, Congress seems hell-bent against so-called "Index Speculators." The conclusions reached by the prime witness against index funds seem sweeping and ill-founded.
A refutation can be found in the HAI article "Congress Blames Index Speculators" at www.hardassetsinvestor....

2008 Sep 13 10:36 AM