Are Speculators the Problem?

Last Friday, the New York Times reported that the increase in commodity prices and the resulting increase in prices ordinary consumers pay has attracted the attention of regulators and politicians. The specific target are speculators who are suspected of having driven up futures prices. The article goes on to repeat the arguments made by the advocates of futures trading–that speculators are necessary to make the futures market work and that there is a big difference between a speculator and someone who manipulates the market.

I thought that it might be good to explain how the futures market works, something the article fails to do.

For starters, there are two kinds of players in the futures market, hedgers who try to protect themselves against price risks and speculators who are trying to make a buck. Mind you, the dividing line is not hard and fast. Hedgers may also be speculators and speculators may also be hedgers, it all depends on the intentions. But let’s keep this simple.

When one participates in the futures market, one enters into an agreement to either buy (“going long”) or sell (“going short”) a commodity at a specific point in the future. The contracts are standardized  (10 tons for cocoa) and the delivery dates are set as well. As with all trading, the object is to buy low and sell high.

Incredible Chocolate has been quite successful and they expect big orders for the holiday season in December. So in March they order a bunch of cocoa (say 10 tons) to be delivered to their factory in September. The price is $2,000/ton for a total of $20,000. There is a lot to be said for such a “forward” contract. Incredible Chocolate Company knows that it will have the beans when it needs them and it has locked in a price, so it can plan and price is holiday production accordingly. There is, however, also a disadvantage. What if the price of cocoa declines between March and September. Then the company will have paid too much.

This is where the futures market comes into play. To protect against that risk of price decline, Incredible Chocoalte decides to “go short” on one futures contract for September, that is, it agrees to sell one contract (10 tons) of cocoa for a price of $2,000/ton (Remember, I’m trying to keep this simple).

Come September, the price has indeed gone down. Now Incredible Chocolate does not really want to sell cocoa, to they “go long,” i.e., enter into an agreement to buy on contract (10 tons) at the lower price (say $1,800/ton). Since the company now has two equal positions (buy and sell one contract) they have settled their obligations, that is they don’t have to either deliver or take delivery of the cocoa specified in the contract. However, they made $2,000 in the process. Remember, in March they agreed to sell one contract at $2,000/ton and in September they agreed to buy one contract for $1,800/ton. The difference is $200/ton or $2,000 for the entire contract. They bought low and sold high. The only difference is that the sold before they bought and that sleight of hand is possible in the futures market.

But what happens if the price goes up to, say, $2,200. Then Incredible would have been in the unenviable position of having to buy cocoa beans at $2,200/ton and then sell it at $2,000/ton, for an overall loss of $2,000. That seems like a bad deal. But remember, Incredible locked in a price of $2,000/ton for the beans that will actually be delivered to its factory. So the company saved $2,000 through its forward contract which offsets the $2,000 loss in the futures market. If all of this sounds strange, keep in mind that the futures market is almost completely divorced from the underlying commodities.

Now on to the speculators. If all players in the futures market were hedgers, we are told, then the market would face problems. For each contract sold, there must be an equivalent contract bought. True, the clearing house of the exchange settles all of these opposing positions, but the offsets still have to be there. Speculators provide liquidity, that is their actions in the futures market are driven by different motives, and they may hold positions for a much shorter time. By entering into lots of different contracts more frequently, they offset the hedgers who tend to “go short” more often than “long.”

But the real question is how much speculation is necessary? According the the article, some $230 billion have been invested in commodities by investment funds in 2008 alone, up “from barely measurable levels seven years ago.” Commodity markets are much smaller than other markets. The entire cocoa market, for example, is about $10 billion in size. It is not difficult to imagine that a pile of money flowing into such a market can have significant impact on prices, especially if they are all “going long” because they expect prices to rise.

It’s just like that famous headline of the Onion: “Market rises 10% on rumors that the market will rise 10%.”

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