Speculators and Onion Prices  

The FT has an interesting article on the politics of commodity price movements - The usual suspects: Are financial investors driving up the cost of commodities?.

Prices were outrageously volatile. While traders attributed the sharp market movements to supply and demand, most politicians in Washington were sure that speculation was the culprit. The US public became incensed.

The year was 1958, the commodity in question onions. Congress held long and sometimes tumultuous hearings in which Everette Harris, then president of the Chicago Mercantile Exchange, tried to convince lawmakers that the futures market for onions was not the cause of the volatility. “We merely furnish the hall for trading . . . we are like a thermometer, which registers temperatures,” Mr Harris told a hearing. “You would not want to pass a law against thermometers just because we had a short spell of zero weather.” But such arguments were ignored and in August of that year the Onion Futures Act was passed, banning futures trading in the commodity.

Fast-forward 50 years and it seems that little has changed. The recent surge in commodity prices has sparked an intense and politically charged debate on whether financial investments – to some, plain speculation – are affecting the markets. Pension funds and other big institutions today hold about $250bn in commodities, mostly invested through indices such as the S&P GSCI, a widely accepted industry benchmark. This compares with just $10bn in 2000, although part of the increase represents the rise in prices rather than fresh flows of money. ...

The US regulator says there is little evidence to link price rises to institutional investors. It has maintained its stance that fundamental supply-and-demand factors combined with a depreciating US dollar – which is used to price and trade commodities – are mainly behind the recent market movements.

There is, moreover, a significant difference between speculation and manipulation or illegal activity. In response to a question at one of the hearings last month, Mr Lukken of the CFTC, said: “Speculators . . . provide a healthy mix of participants in the market to ensure there is a buyer for every seller and a seller for every buyer. That has been the case for the 150 years that these markets have been around.”

He added: “We are taking steps to ensure that markets are not being overrun by speculative interests. But, to date, we have not seen evidence of that . . . [Speculators] are not all on the long side of the market, betting it will go up. So it is difficult to say there is a smoking gun there but we continue to look.” ...

The Onion Futures Act is a perfect case study. When economists studied the market, they discovered that volatility and prices were higher in the period after the ban than they were before. Frédéric Lasserre, head of commodities research at Société Générale in Paris – who has studied the onion example – says today’s context is very similar. “The politicians are leading the debate pressured by the people,” Mr Lasserre says.

The onions market is not the only example. India last year banned financial trading in most agricultural commodities but prices continued to rise. “[Banning financial trading] is irrelevant,” says a senior Indian official. “When a commodity is scarce, its price rises, whether it is traded on an exchange or not.”

That is exactly the argument of those who say that high prices merely reflect robust demand growth – boosted by the industrialisation of populous emerging economies such as China, India and Brazil or new policies such as biofuels – against sluggish supply increases following years of underinvestment.

Moreover, record commodity prices are being seen across the board, not just in raw materials with developed futures markets but also in those without significant speculative investments such as iron ore and rice, up 96.5 per cent and 120 per cent respectively this year. Research by Lehman Brothers shows that prices for metals that are not traded in exchanges, such as chromium, molybdenum or steel, have risen faster than prices for metals traded in exchanges, such as copper or aluminium. In addition, some of the commodities markets in which pension funds hold the largest share of outstanding contracts, such as hogs, have seen price drops.

Equally important is that price rises across the commodity spectrum are not in line. This shows that different markets are responding to their own supply-and-demand fundamentals rather than to financial investors’ money flows, analysts say. The base metals market is a good example: while aluminium and copper prices have risen by about 30 per cent since January, nickel, zinc and lead have fallen between 20 and 40 per cent. Tin, the only metal in which pension funds had little exposure, has jumped almost 40 per cent.

In another sign that supply and demand is the main driver, inventories for most commodities – including crude oil – have fallen since January. Many analysts echo Mr Lukken in pointing out that financial investors in commodities are no longer betting only that prices would rise, as at the beginning of the boom in 2000-2001. Today, many funds are betting on lower prices. ...

Today, the Onion Futures Act remains in effect. But that has not stopped the price of onions from shooting up an eye-watering 420 per cent since 2000. ...

Bart Stupak, a Michigan Democrat who has introduced legislation, said in May that “excessive speculation” had “inflated oil prices to the point that they are no longer tied to underlying supply and demand” – a claim most economists would struggle to agree with.

Some of the stakeholders in the debate are not helping. A coalition of airline and travel industry associations wrote to Harry Reid, the Senate majority leader, and Nancy Pelosi, the House Speaker, last month claiming that speculators traded 22 barrels of “paper oil” – futures contracts – for every physical barrel of oil consumed. However, Francisco Blanch, commodity strategist at Merrill Lynch, says: “Speculators do not add physical demand or take away physical supply from the market. They do not take away any barrel of oil or bushel of corn from the economy and the only way they can affect spot prices is if they reduce the quantity available for final consumers.”

Of course, while this little fable is a reassuring tale about the reliability of the markets, it ignores the fact that the price of onions is driven by the price of oil (fuel, fertiliser and pesticides), so it is quite possible that all of the onion price increase seen has been oil related.

The real question here (to me) is how much weight speculators have vs "genuine" market participants (buyers or sellers of physical oil) and what direction their trades have moved the market. I don't believe that the spot price for oil is set entirely independently of the futures market, regardless of what some commodity strategists may say.

I suspect this story will trundle on for some time to come...