Commodity Hoarding
One argument that you hear often from those who say that excessive commodity speculation is not a problem is that, if it was unduly affecting prices, there would be hoarding of physical stocks of those commodities. Paul Krugman recently used this argument to say that excessive commodity speculation is not a problem.
But Krugman misses a few key points:
1) Demand for food and energy is highly inelastic, meaning that even with large price changes, production and consumption may not be affected
2) Oil and natural gas can be stored above ground where it can be seen and measured, or it can be stored underground by not pumping it out of the ground
3) There is evidence of food hoarding, but much of that hoarding is unable to be measured
4) Even without physical hoarding, commodity futures prices directly affect spot (physical) prices. If futures prices rise, the physical prices also rise.
Inelastic demand
In his blog Accidental Hunt Brothers, Adam White offers two responses to those pointing to a lack of hoarding. One is that because of their trading strategy of going long (betting that prices will rise) for long periods of time, ”index speculators have their upward impact on commodities futures prices when they first put on the trade. We think that they have additional impact when they roll their positions but we don’t have any data to back that up the way we do with the initial impact.”
The second explanation is worth reading in its entirety, but basically says that because demand for food and energy are highly inelastic, “the price can rise dramatically before you get any reduction in consumption. Likewise it can rise dramatically before you get any increase in production. It takes time to grow food, drill oil, etc. So price increases might result in little or no inventory change in the short to medium term.”
Commodity hoarding
Another argument White makes is that “oil and natural gas inventories are stored above ground and below ground. The above ground is to take care of ebbs and flows in ultra short term supply and demand (the U.S. has like 15 – 20 days of consumption in commercial storage at any one time). Below ground is where it accumulates if the demand is not there. Why would an oil producer pump more oil or gas than he has orders for?”
And there is indeed evidence of hoarding in agricultural commodities as seen in the two videos here. Glencore, Goldman Sachs, JP Morgan and other big commodity traders are all increasing their storage capabilities showing that they will be storing increasing amounts of commodities in the future.
While huge warehouses of rice from 2008 shown in the shocking second video may be visible and measurable, what Krugman and others forget is the multitude of other places that food commodities can be hoarded. Each and every family could, logically, increase its store of food as they hear again and again that food prices are rising. Bakeries and mills do the same thing. All of these other points of commodity hoarding are immeasurable, so we are really unable to know for sure how much is being accumulated. But it is logical that food is being hoarded all over the world.
Future prices do affect spot (physical) prices
Finally, futures prices directly affect spot prices in two ways regardless of inventory levels. First, many physical purchases of food and energy commodities around the world are done through long-term contracts that use futures prices as their benchmark. For example, a refinery might offer “100,000 barrels of light sweet crude to be delivered on the first of each month for the next 6 months at the WTI price ((West Texas Intermediate, or light sweet crude oil) + 0.3% per barrel”. A producer might come back with “WTI + 0.4% per barrel) etc. Same for grain, e.g. “100,000 bushels of hard wheat to be delivered on the first of each month for the next 6 months at the CME (Chicago Mercantile Exchange) price +0.3% per bushel”.
4 questions
1. Every futures market trade has two sides. The long side, those whod think the price is going up and the short side, those who think the price is coming down. How do these dynamics work together in the moving futures price?
2. You note that the futures market influences the spot price, but provide no concrete examples or formulas of how they are connected. Is it spot plus a percentage of the differential between the current spot and the near or long term futures price? What exactly is the mechanism and what exactly is the size of the influence of the futures market?
3. You only address the side of the business cycle where the price is going up. Is there a corresponding decrease in current spot prices if the sum of the futures markets say the price is coming down in the near term?
4. You totally fail to address the fact that this administration has engaged in a weak monetary policy which by definition is inflationary. As the US dollar weakens, the cost of oil increases as oil is traded in US dollars. If an oil producer now has to charge 10% more in US dollars to make the same rate of return, guess what, they will!
4. Even if your analysis is correct, what is morally wrong with speculating on futures markets?
Hi Brad,
Good questions. Thanks for writing. The link between futures and spot prices is key. Traditionally, these two prices converge on the date of delivery. With the excessive amount of speculation of the past few years, there are many times when those prices do not converge which makes the commodity markets basically useless for businesses that deal in physical commodities. In response to your specific questions:
1. Right, every trade has two sides. The question is, at what price are those two sides settling on? If you sell your house and have one buyer, you will sell at a certain price, but if you have five potential buyers, you will obviously get a higher price. It’s a little similar with commodities. When you have hundreds of billions of dollars flooding the markets, almost exclusively betting the price will go up (commodity indexes, ETFs, ETNs – the instruments that pension funds and endowments use), they will obviously drive the price up.
2. For grains, futures prices are a primary determinant of spot prices in US markets, and a significant determinant of spot prices globally. In the US, this is because of three facts:
First, a lot of physical grain is pre-priced using basis contracts and other similar mechanisms, all of which price the grain at a differential from the futures price. e.g. in March the farmer agrees to sell grain in June at the July CBOT futures price -40 cents. The price he eventually receives will therefore be 40 cents below the July futures price, whatever it may be at that time.
Second, when grain is bought and sold via physical auctions at the elevator, the bids and offers are closely benchmarked to the futures price. e.g. if near month CBOT wheat is trading at $10, bids and offers will start at around the $10 mark. If the futures contract moves up to $20, bids and offers will adjust accordingly and start at around the $20 mark.
Internationally, the relationship is slightly more complex, but it is similar. Remember that the U.S. is the largest exporter of wheat in the world. The price at which producers are willing to export is influenced by the price they can receive domestically. The domestic price is largely determined by the futures price, as explained above. Therefore, so is the export price.
Third, Platts, the company that daily determines and publishes the spot price for many commodities uses the futures prices to determine the spot price. From Platts’ explanation their methodology to determine the spot price: “… in those markets where commodities trade at differentials to futures, the prevailing futures’ value as assessed by Platts at 3:15 pm ET will be used in the assessment process. These physical markets typically may trade as differentials/exchange for physical (EFPs) to futures contracts and, therefore, both the futures value and the spot differentials are considered in the physical assessment process…”
3. Yes, in the second half of 2008, large investors sold their commodity holdings to cover losses elsewhere and because with the recession, demand was expected to decrease. Commodity prices plunged as they pulled their money out. See more here.
4. If you go to accidentalhuntbrothers.com and click on the “Click here to download reports” button, it will load two pieces. The first is an excellent, in depth explanation of commodity markets and what has happened because of deregulation (I highly recommend it). The second is much shorter and shows how, certainly in 2008 (and I would argue today as well), rising commodity prices were not related to the falling dollar. The numbers just don’t add up.
5. I don’t believe that investors are evil people trying to make money off of people going hungry, but because of the deregulation of the commodities markets, that is exactly what is happening. Money from our pension funds and university endowments are flooding commodity markets and driving world food prices crazy – a tendency to drive them upward, but more importantly making prices much more volatile. And the people that feel those effects most strongly are the poorest people in the world who spend large portions of their budgets on food and tend to buy less processed food.
There is no need for this type of speculation. There are literally millions of investment options. If you see our last letter to CALSTRS, you will see that these indexes and ETFs are dog investments. Even as commodity prices have risen, returns on these instruments have been weak and even negative. In that letter we recommend that if an investor wants to take advantage of rising commodity prices, they should buy agricultural equities, that have much better returns than futures, and I would consider equities to be a much more legitimate investment for a pension fund. Commodities create no dividends or production. “Investing” in commodity futures is simply placing a bet that the price will rise – it provides no money for investment or production – it is merely a bet, and a bet that makes the entire planet pay more for food and energy. It must stop.
Thanks again for your questions,
Dave
thanks for the thoughtful response, however, I have a further question.
lite sweet crude closed at $112.21 today. The futures market monthly quotes are higher than that for the next 12 months, peaking at $113.13 (0.8% increase to current spot price) in Oct 2011 and declining from there. Beginning in May of 2012, the price is lower at $112.01 and declines steadily over the next 44 months to $105.21 (6.2% decrease to current spot price) in Dec of 2015. Why the short term slight increase and the long term decrease?
My theory is that the current market is pricing in a premium over the next several months but that the side of the futures market that drives the whole thing, the demand side, isn’t willing to sustain the increased price indefinately, thus the decrease over time. It is those who want to purchase the future contract as a hedge against future higher costs that matter here. For these speculators, the lower the price of oil the higher their profit so there is the net futures market over the mid term, 4 years or so, is actually trading at below current market rates. This all makes perfect sense when you understand that the folks in the drivers seat hold all of the cards. If the prices are too high, they simply will take their chances and buy the oil at spot in 6 months rather than hedging their investment now. Analysis of the market at other points in time produces very similar numbers in terms of percentages futures price to spot.
I fail to see how the slight increase, max of 0.8%, over the next 12 months is a significant influencer of price let alone the primary driver.
Speculation theory driving up food prices is really cute and all, but consider something much more important: 5 billion bushels of corn are being converted to ethanol this year just in the US. That is enough individual daily calories requirement to feed almost 1 Billion people every day for one year, or an extra 500 calories per day per person for 4 Billion people every day of the year, every year. Every gallon of ethanol produced requires nearly one gallon of petroleum. Absurd. Flood the food market with an extra 5 billion bushels of corn and watch food prices plummet. Watch, no politician will give up a farmer’s or ethanol producer’s vote. Instead, the government will attempt to manipulate food prices causing further increase in prices.