Speculation in the Commodity Markets Good or Bad?

In recent months, I have come to the conclusion that speculation in the commodity markets (i.e. Futures, Options, and other instruments) is no longer a good thing. In the past it was used to lock in prices by being a hedge against inflation. These days, people are using it to prey on people fears to get rich.

The oil market is one good example. In recent months the speculators have been a major part of the rise in oil prices by bidding up the price. I have seen reports where analyst have said that speculation is pricing oil as much as $30 to $40 over where it should be. Just in the last couple of days, though, the price has dropped dramatically when these same “investors” dumped their positions. This speculation, in my opinion, is one reason why gas prices have been fluctuating wildly.

The same thing is starting to happen in food prices. With the talk of alternative fuels driving up prices of certain grain prices, people are panicking about food prices. You never hear about the research and use of non-food materials for the alternative fuels.

Has speculation turned into something immoral?

Are you suggesting you plan to divest yourself of all investments in the stock and commodities markets? Because the purchase of stocks, hedge funds, index funds and other such instruments also involves an element of speculation. I don’t think I’m ready to follow you down that path and start burying my money in a mayonaise jar out back. (Not to mention my husband works in the investment industry and our family’s livelihood depends on it.)

They are neither good or bad. They are simply investment tools that are as old as mankind. People can use them in a bad way, such as using them for excessive greed, or in a good way, such as a prudent hedge against unforseen circumstances. They are a part of what makes capitalism run. Roanoker

No. I am looking at the over-speculation that is associated with commodities only via the futures and options market.

I know a little more about these markets than the average person due to having a minor in Finance and writing my minor thesis on the futures. I have never invested in the commodity markets via either options or futures.

Maybe that is it. They have become a tool of evil by those who use them.

So in your theory when crude is delivered the owner has 1) the crude, and 2) money paid to him from the “dropped” contracts. So that would discount the gas price but only by a little amount.

If the contracts are not dropped the speculator sells the crude at current prices for a loss or gain neither changes the price of gas.

Only when the contract is held by a refiner with retail stores can cheaper gas be delivered by the futures contract being under market value.

At any and all times one can mark-up gas yet it may not sell

The only affect on the pump is if futures contracts are going higher many people in the trade would rather error to marking over the market (losing sales) which if done in mass can temporarily increase prices. Then inventories increase and prices drop

Revisiting: Is Speculation in the Commodity Markets Immoral?

Awhile back I asked the question whether speculation in the commodity markets is immoral. Since then I have kept tabs on the commodity markets and am convinced more than ever that the commodity market have indeed become immortal.

Oil and food prices are rising on the mere hint of trouble (real or imagined) in those markets and there are hyped reports daily of further rises further fueling the rise. Just a few years ago, a threat of a hurricane or inclement weather would not of caused a ripple in oil and fuel prices. Now they cause wild swings to the upside of the market. The only persons this wild speculation benefits is the speculators. Everyone else loses.

One bright note, I expect that, like the housing market, the commodity markets may be in for a crash.

Is it your opinion that speculators increase demand or decrease supply?

In my opinion, they do nothing about supply or demand. They use to speculate based on estimates but now, they seem to have one goal, drive prices up as much as possible to get as much money as they can.

It is my opinion that this is the result of the greed of the 90’s. Speculateors today are nothing but pump and dump artists. They drive the price in the way they want it and then dump their options and futures positions on the unsuspecting.

BTW: No, I have not been and have never been caught in a pump and dump. I have a minor in finance concentrating on the financial markets. I did a investment paper in college on the futures markets when the were still relatively small.

supply and demand drive price. Low demand and high supply drop price, low supply and high demand increase price, so again which do speculators do increase demand or decrease supply?

Speculation is neutral.

Neither good nor bad.

The commodities markets do have some rules. Excessive leverage may be bad.

If you have a factory and if you use raw materials, you are subject to the whims of the market place for your materials and the pricing may fluctuate.

If your raw materials prices fluctuate wildly, then you will have a problem pricing your output product and your customers will complain.

If you lose money (meaning that your costs are greater than your selling price), then you will go out of business.

To get some semblance of order in your raw materials pricing, some companies engage in speculation … buying materials at discounted prices well in advance of actual need, for example.

It seems to help them smooth out the fluctuations in their raw materials commodity prices.

To some extent everyone speculates in futures prices.

If you work and if you earn a salary, you may decide to put some money in the bank … to save it; to defer spending at the present time … in the belief that the money will be more useful to you in the future.

If you believe that your money in excess of present needs will not be worth as much in the future, you may speculate by spending all of your money now. You may spend your money by visiting BuildABear and buying teddy bears. Or you may spend your money by visiting Fidelity and buying mutual funds.

Or you may spend your money by buying gold.

Or you may spend your money by buying a truck.

Problems may arise when a person or a small group of persons attempt to borrow money to buy up all of the available supply of a commodity, whether it is silver or tickets to the Yankee games, with the idea of reselling the stuff later at a higher price.

If the end customer declines to buy any of their hoarded stuff, then the speculators end up with nothing or less than nothing … because they have to pay back the money that they borrowed. Which is why lenders need to perform “due diligence” analyses of the folks they are lending money to.

Some folks like to lend money to speculators (… such as so-called “hedge funds”) … but that is very risky and not for the faint of heart.

If the end customers find alternative supplies (they buy tourmaline instead of silver or they use digital photography instead of film photography or they watch the Yankee game on satellite TV) then the speculators and their financial backers may end up losing money.

Speculation may be a good thing in that they generally even out fluctuations in the market place and serve as intermediaries when the end user isn’t able to satisfactorily negotiate with the initial provider.

So, a speculator may purchase 200 Boeing passenger and freight jet planes from Boeing at good prices. The speculator then offers those planes at attractive lease rates to a large number of airlines all over the world. Everybody wins. The passengers get cheaper air fares. Boeing gets a long and smooth production run. The airlines get an assured supply of planes and they know that if the economy gets bad, they can easily turn the planes back to the speculator, who will then offer them to other airlines.

Many producers utilize the futures market. As Al said, it’s useful in that the producer can use it to ensure itself a supply of some product it has to have in its processes, and it can protect itself against price uncertainty.

It works on the other side as well. If a farmer, for example, believes he is likely to produce “X” bushels of corn, he might sell into the futures market to “lock in” a price with which he feels comfortable.

The producer or user might “win” or “lose” in doing this, but it’s a calculated risk, presumably based on a knowledge of just how far things are likely to swing and the degree to which he can absorb those swings in the economics of his business.

Entirely different are those who produce nothing, yet buy and sell and do nothing more. That’s a “knowledgeable” form of gambling that is neither good nor bad if one can afford taking the risk. That’s “speculation”. It’s a bit like card playing by a player who really understands his game. Luck is involved,but it’s not entirely luck.

Another variant of an entirely different sort, is the “speculator” who isn’t really a speculator, but a “manipulator”; one who has sufficient economic power, either alone or in combination with others, to buy or sell in such quantities that his activity itself can make the prices go up or down. Such manipulators can, and do, buy to create an artificially high price, then suddenly “dump” what they have bought, and sometimes more than they have bought, in order to artificially depress the price of the commodity and/or to make the fall happen faster than it other would have. It also can work in reverse; depress, buy, elevate then sell.

But supply and demand aren’t really quite effective in preventing manipulation, because ultimate users can’t just stop their processes. A poultry producer can’t just “do without grain” because the price is, in its judgment “too high”, because it has a lot of poultry “in the pipeline” that have to be fed regardless of the price. Auto manufacturers aren’t going to just let a year go by without producing automobiles because, e.g., they think the price of steel is “too high”. People also have to eat and they have to travel. On the production side, the farmer with a crop in the field isn’t going to just plow it under if the price plummets because he has already invested in the crop and will produce it anyway, even at a loss because his loss will be greater if he doesn’t. So, within very wide margins, supply and demand don’t really regulate speculator activity in the short run. Over time, it would, but even then, only to a degree. People would still buy oil at $300 because they would have a limited ability to do without it. It’s not even gambling, except in the sense that a card player who can determine the cards in the deck as well as the order of dealing is “gambling”.

I believe much of the problem we are now seeing with wild gyrations in the prices of all sorts of things; commodities, financial instruments, stocks, currencies is due to manipulators. Now and then, the actions of manipulators get exposed or they simply disclose themselves because they’re proud of themselves for making a lot of money doing it. George Soros comes immediately to mind (Ribozyme will doubtless scan for Soros’ name and come into this thread to defend him.) Soros himself said the following about his “breaking” the British pound.

“When I sold sterling short in 1992, the Bank of England was on the other side of my transactions, and I was in effect taking money out of the pockets of British taxpayers. But if I had tried to take social consequences into account, it would have thrown off my risk-reward calculation, and my profits would have been reduced.”

He claims that if he had not done so, someone else would have. Maybe so, maybe not. Soros as an individual aside, (and he’s not the topic) this sort of thing seems to be getting increasingly pervasive as individuals or institutions of enormous and increasing wealth, doubtless helped by electronic means that allow widespread, largely anonymous activity in a global network, execute sudden, and massive intervention into markets. Anyone who remembers the conspiracy of oil sheiks and Bunker Hunt in the silver market years ago could hardly doubt the phenomenon.

There are those who believe the current high prices of oil and food and the low price of the dollar are, to a significant degree, both due to speculation.

I’m not sure what the answer is to this, if there is an answer. Governments seem particularly inept when it comes to intervening in markets to achieve social objectives, or even when it comes to knowing when manipulation is happening.

Hate to follow myself, but I might add the following.

Unfortunately, people tend not to recognize that speculative or manipulative activity are what they are, and take poltical positions based on erroneous assumptions. Those positions can have unfortunate consequences.

At present, for example, there are all kinds of political “solutions” being proposed, e.g., for the high price of gasoline. Some political candidates, for instance, advocate reducing gasoline taxes, to be paid for by “windfall” taxes on oil producers. While this might have a certain appearance of social symmetry, it does nothing, since it is also within the power of many oil producers (particularly foreign ones) to avoid the effect and simply add the new tax burden to the price of the product, whereupon the consumer pays it anyway. It could simply result in shifting tax revenues overseas, in effect.
Speculators can then simply factor such shifts into their calculations or manipulations, making them even more opaque.
Political “solutions” of that sort totally ignore the role speculation and manipulation have in the whole thing. The whole corn/ethanol program seems a boondoggle whose effect seems merely to shift costs and revenues around and enhance speculative opportunities, rather than actually achieve the ostensible goal, which was the reduction of dependency on foreign oil. “Easy answers” are almost always wrong.

Car companies can use futures markets to buy steel and other materials. Or to provide some price stability for their raw materials.

Of course, one of the major car companies bought huge amounts of platinum and paladium for making catalytic converters. But then some genius figured out how to make those catalytic converters using much less of the precious metals.

So instead of holding their stock piles and using them up gradually, the car company dumped their stock piles on the market and cleared out their warehouse … and took a big loss on the deal.


And then shortly thereafter, there was big demand and the price went way up. If they had just held for a while, they could have made some real money. OR, they could have saved some real money by having their in-house hedge.

Instead, first, they bought high and sold low. And then they bought very high.

That’s not the way it’s supposed to go.

Let me offer a brief, non-technical explanation of how commodity and futures markets work.

John and Jim have a problem. John is a wheat farmer. It costs him money to plant his crop, and he has no idea of what wheat will sell for at harvest time. He could lose a lot of money if the price is too low.

Jim on the other hand is a baker. He wants to expand his business. Of course, he needs wheat. If he borrows money to fund his expansion and the price of wheat goes up too high, he could go bankrupt.

Now imagine John and Jim get together even before John plants his crop. Jim has figured that if wheat doesn’t go above $40 a bushel (I’m picking this number out of the air), he can make a profit. John, the farmer, has figured that if wheat doesn’t go below $40 a bushel, he can make a profit.

So they sign a contract – even before the wheat is planted. John agrees to sell his wheat to Jim at $40 a bushel. And Jim agrees to buy it at that price. The money is not paid over at that time – payment will come when the wheat is delivered.

How is this different from any other agreement to buy and sell? It isn’t – a thing (including a bushel of wheat) is worth what a willing buyer will offer and a willing buyer will accept. Of course the actual market value at harvest time may well be different. If it is higher that $40 a bushel, John will get less than if he had waited. And if it is lower, Jim will pay more than he would if he had waited. They both know that – and agree that setting an assured price is worth it.

The problem is, John is busy farming, Jim is busy baking. They haven’t got time to run around looking for buyers and sellers all the time. They need a market place where these “futures” are bought and sold.

Now come Mary and Jane. Mary says to herself, “I know in my heart that wheat will sell for $50 a bushel at harvest time. So if I can get someone to agree to sell me a million bushels at $40 a bushel right now, at harvest time I can borrow the money – using the signed agreement as collateral – and turn around and sell the wheat for a cool $10 million profit.” So Mary goes to the market, looking for someone who will sell her a futures option on a million bushels of wheat at $40.

Jane says to herself, “I know in my heart that wheat will sell for $30 a bushel at harvest time. So if I can get someone to buy a option on a million bushels from me at $40 a bushel right now, at harvest time I can borrow the money – using the signed agreement as collateral – and turn around and sell the wheat for a cool $10 million profit.”

So Mary buys an option from Jane, a million bushels at $40 a bushel. Since very little money changes hands now, whichever one of them is right stands to make a whopping profit. And whichever one of them is wrong stands to take a whopping loss. We call Mary and Jane “speculators.”

This is the characteristic of the commodities or futures market – it is a zero-sum game. For every profit, there is a corresponding loss – dollar for dollar.

Now, if this is true, how can speculators drive prices? They can’t – if they could, it wouldn’t be a zero-sum market!! If the price of wheat goes down, Mary cannot drive it up. If the price of wheat goes up, Jane cannot drive it down.

Only supply and demand can influence the market – and speculators cannot control either of those factors.

Storms. Computer trouble. Will respond later.

I’m not an expert on this, and certainly not on commodities. But consider stock for a moment, with which I am more familiar, and let’s think about it.

It is entirely possible for a person to manipulate a stock if he has the resources to do it and has good information about “normal” volumes and a good idea what the “specialists” who MUST “make a market” in the stock are able and willing to do.

Let’s say that normally there are about 1,000 people who regularly invest in XYZ. Let’s say XYZ volume is about 1000 shares/day. Right now the price is $30. Let’s say the normal amount brokers keep on hand is 100,000 shares, and the specialists keep about 2,000.

If I know XYZ has reasons to perhaps go down a bit, I “borrow” as many of the “on hand” shares from brokers as I can, and sell short. I sell short in ever-increasing increments, creating the appearance of a “run” on the stock. I will create the appearance that the stock is worse than it is. The “usual” investors may start to panic and start dumping too. Maybe the stock really is overvalued from its present $30. Perhaps a more realistic value is $20. But because of the panic, I force more shares into the market than I actually have to work with myself. It drops to $10. I then go in and buy the stock, deliver it back to the brokers and pocket $20. But because its realistic value is more like $20, I buy more than I had to deliver. I keep doing that, in increments greater than normal, thus creating the appearance of greater value than it really has. The stock goes to maybe $40 on the perception that there’s more intrinsic value to the stock than there really is. I then start selling out again, but in volumes that have a more “normal” appearance.

This is particularly troublesome when I buy and sell in increments greater than what I figure the specialists normally keep on hand, forcing the specialists into the market all the time to keep up the inventory they maintain in order to “make a market” in the stock; something they have to do to remain specialists. I thus keep “hitting” the price because the specialist, who has a regulatory limit on what he can drop the stock in one given session, will keep going down the maximum all the time.

In a small cap stock, and in a market that’s a little skittish anyway,. it’s not too hard for a manipulator with a lot of money to do this. If you look at it right now, small cap stocks in disfavored sectors have a lot more short sellers relative to total capitalization than large cap stocks in the very same sector, even those of the latter with worse fundamentals. That’s because it takes a lot more money to manipulate a big cap stock, and because it’s much more profitable to play games with small caps than it is with large ones. One can make the small cap stock look a lot worse, or better, than it really is and force the specialists to make abnormal moves more often.

Finally, there is “accounting”. Since fund managers are big forces in the market, they tend to “wash out” results on at least an annual basis. Even if they believe a stock is being “hit” abnormally, they will often get out of it if they can’t really see where the “game” will end, in order to get into something in which the “turnaround” is more foreseeable. In fact, as now, they will drop a volatile stock (often the small cap) and get into a less volatile one (often the large cap) even if it has less promise for the future, because the manager has to report fund results at a given point in time. He will “sacrifice” this year in order to look good next year. In a “bad” year, like this one is at present, everybody will forgive it. This actually increases a manipulator’s “leverage”.

Obviously, supply and demand puts limits on what even a strong manipulator can do, because there is an inherent value to everything. Still, by causing people to get distorted, even panicky views of what is going on in a particular market, a manipulator can make the highs higher and the lows lower than they otherwise would have been. And they can make the changes occur much more rapidly than would otherwise have been the case.

It’s not exaclty a zero sum game because some people “ride it out”. Just because what I own goes from $30 to $10, it doesn’t mean I lose $20 except on paper and for now. Nor do I gain when it goes the other way, except on paper and at this moment.

Again, I’m shaky on commodities because I never deal in them.
And, when it comes to commodity futures, there is a limit to “riding it out”. But if a producer is facing ever-increasing futures prices on an ingredient, he’s going to build that increase into his finished product price if he can, even if he is not, at that moment hedging with futures, because it will color what he thinks about his input costs down the road. That will tend to be true even if the futures prices are unrealistic.

But in a sense, I guess it is a “zero sum game” with commodities in that somebody pays the price of artificially high or low futures prices, even if it’s the producer or the ultimate consumer of the finished product.

Speculation, if the speculators are correct, is quite desireable. Because the speculator is buying when the price is low, and selling when the price is high. This bids up the low price a bit and brings down the high price a bit. Therefore, price fluctuations are minimized under correct speculation. Of course, if you buy when prices are high and sell when they are low, that is when speculation is undesireable.

The greatest speculator that ever lived was Joseph in the book of genesis. He bought grain during the seven years of fat, and sold it during the seven years of lean. Think of where Egypt would have been without his speculation?

Today we would probably arrest him for insider trading. And I would hate to have to convince a jury that I got my information from a dream.

Speculation is one thing. Manipulation is another. I still say the latter exists as well as the former.

Yes, stocks can be manipulated – most recently we had a case where a company created another company, assigned all losses to that company, and thus showed the “mother” company as being more profitable that it was.

But speculators cannot do that.

The biggest cheating I know of in the commodities market was where a company bought futures on both sides (equal amounts, one betting on higher prices, the other on lower prices) then assigned the winning account to a politician.

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