Chasing volatility

Published : Sep 12, 2008 00:00 IST

Financial firms have become the dominant players in commodity markets and their speculative activity has led to the price increases in oil and foodgrains.

FOR most of the past year, as global prices in oil and other commodity markets zoomed to stratospheric levels, we were told that it had nothing to do with speculation.

Eminent economists joined bankers, financial market consultants and even policymakers in emphasising that these price rises were all about fundamentals that reflected real changes in demand and supply, rather than the market-influencing actions of a bunch of large players with financial clout and a desire to profit from changing prices.

In the case of oil, the arguments ranged from peak oil, which pointed to the eventual (and imminent) problem of world oil consumption exceeding supply and known reserves, at one extreme, to the perfidious actions of the Organisation of Petroleum Exporting Countries (OPEC) cartel in restricting supply so as to push up prices, at the other extreme.

In between were other arguments such as the easing of monetary policy in the largest economy, the United States; the weakening of the dollar, which caused oil prices to rise since the oil trade is largely denominated in dollars; and the rapid economic growth worldwide, but especially in China and India, which have apparently become gas guzzlers.

These arguments did seem strange, especially as global oil prices more than doubled in the past two years when total world oil demand had scarcely changed, and, if anything, had fallen to some extent, and global oil supply had increased slightly.

Even so, the combination of voices providing so many reasons for the increase in oil prices did cause many of us to suspend disbelief and accept that there were real economic changes that justified the continued rise. In turn, governments, especially in developing countries, saw fit to pass on the increases to consumers because the dramatic price rise was seen as permanent. This has played a significant role in creating the inflationary pressures that are now plaguing these governments.

Similarly, the dramatic rise in the prices of food and other primary commodity was also traced to real economic causes and processes, such that talk of the global food crisis became commonplace. In the case of foodgrain and similar commodities, there is a large element of truth in this argument as the rising costs of cultivation (partly affected by high oil prices); the inadequate policy support for agriculture, resulting in falling yields; the acreage diversion to produce biofuels; and the reduced government grain stockpiles meant that there were imbalances that could explain some of the price rise. But even for foodgrains, the very rapid rise in prices, over just a few months, was hard to explain without bringing in the role of speculation.

As all these commodity prices kept rising, we were also told that this meant good times for the producers, not only oil-exporting countries but small farmers producing foodgrains that were now highly valued internationally.

Despite this apparent consensus, as prices continued to explode, there were growing murmurs of dissent coming from various quarters, including the U.S. Congress, which actually had a set of hearings devoted to examining the role of speculation in commodity prices. Once again, the arguments against such a possibility were many and diverse.

It was pointed out that there was no hard evidence that speculators were responsible for high prices. In the case of oil, it was argued that there was no evidence of hoarding of oil supplies, or growing inventories of crude, which would be expected if oil prices were actually above the real market clearing level. In any case, the most common argument in favour of allowing continued speculation was simply that the economics of speculation require such activities to be stabilising, rather than destabilising, if they are to be profitable.

The vital function of speculators was to predict market patterns and thereby reduce the intensity and volatility of change. Because speculators were supposed to buy when prices were low and sell when prices were high, they served to make prices less volatile rather than more so.

Futures markets in commodities play a similar role: they allow producers and consumers (say farmers and purchasers of foodgrain) to hedge against future price changes and, therefore, get on with their real work instead of worrying about possible price changes.

According to this perception, therefore, speculation has a positive effect on the market, cannot be blamed for rising prices, and certainly should not be curbed in any way. Taken to its logical conclusion, this argument suggests that the price rises we witnessed, especially at the start of the year, are inevitable, reflect economic fundamentals and must be adjusted to by governments and societies.

But this apparently plausible argument dissolves in the face of the more recent trends in prices. Indeed, what has been most marked about the prices of major commodities this year is not their continuous rise of but their sheer volatility. Chart 1 indicates global price movements in oil (Light Brent Crude in terms of dollars per barrel) and in the commodity that has traditionally been seen as the safe haven gold (dollars per ounce). So far in 2008, oil prices increased by 66 per cent between February 2 and July 2, and then fell by more than 20 per cent from that peak over just six weeks until August 18. On that date, oil prices were only 18 per cent higher than they were at the start of the year. Such volatility cannot be explained by any fundamentals.

Gold prices have largely tracked oil prices in the past few months, suggesting that gold has not been treated as an alternative investment but has been subject to similar kinds of market movements as oil.

This conclusion emerges even more sharply for foodgrains. Chart 2 shows global prices of two of the major foodgrains traded globally, wheat and corn, which are also commodities that have been subject increasingly to trade in the commodities futures exchanges. Other agricultural commodities such as soybean and rice, also show similar recent trends in prices.

For wheat and corn, the price volatility has been even more extreme. Wheat prices increased by 46 per cent between January 10 and February 26; fell by as much by May 19, increased, again but to a lesser extent (by only 21 per cent), until a minor peak in early June; and have been falling again in August, albeit with fluctuations. Corn prices followed a similar pattern but with a sharper fall of more than 30 per cent between mid-July and early August. Such wild swings in prices cannot be explained by seasonal supply-and-demand factors or any other real economy tendencies. They are clearly the result of speculative activity in these commodities. So the argument that speculation has not affected prices of these commodities simply cannot be sustained.

But then, what explains all this speculation? And what form does it take? Why is it not stabilising, as predicted by so many economic theories? The answer must relate such market involvement with broader tendencies both in the patterns of government regulation in financial markets and in the other changes in finance, such as the continuing credit crisis in the U.S.

As the global financial system became fragile with the continuing implosion of the U.S. housing finance market, large investors, especially institutional investors such as hedge funds and pension funds and even banks, searched for other investment avenues to make up their losses and find new sources of profit. Commodity speculation increasingly emerged as an important area for such financial investment.

The U.S. became a major arena for such speculation, not only because of the size of its own crisis-ridden credit system but because of deregulation at the turn of this century that made it possible for more players to enter into commodity trading. While commodity futures contracts existed before, they were traded only on regulated exchanges under the control of the Commodity Futures Trading Commission (CFTC), which required traders to disclose their holdings of each commodity and stick to specified position limits, so as to prevent market manipulation.

In 2000, the Commodity Futures Modernisation Act effectively deregulated commodity trading in the U.S. by exempting over-the-counter (OTC) commodity trading (outside of regulated exchanges) from the CFTCs oversight. Soon after this, several unregulated commodity exchanges opened. These allowed any and all investors, including hedge funds, pension funds and investment banks, to trade commodity futures contracts without any position limits, disclosure requirements or regulatory oversight.

The value of such unregulated trading, at around $9 trillion at the end of 2007, is estimated to be more than twice the value of the commodity contracts on the regulated exchanges. Unlike producers and consumers who would use such markets for hedging purposes, financial firms and other speculators enter the market to profit from short-term changes in price, and are therefore interested in volatility.

Commodity funds, which purchase and sell commodity futures contracts, have become increasingly popular investment vehicles. Typically, these are index investors, who focus on returns from changes in the index of a commodity, by periodically rolling over commodity futures contracts prior to their maturity date and reinvesting the proceeds in new contracts.

A well-known hedge fund manager, Michael Masters, testified to the U.S. Congress that even on the regulated exchanges such index investors owned approximately 35 per cent of all corn futures contracts in the U.S., 42 per cent of all soybean contracts, and 64 per cent of all wheat contracts, in April 2008. This excludes all the ownership through OTC contracts, which are bound to be even larger.

A similar process is under way in the oil market. Recently, the CFTC revised the estimated proportion of oil futures and options held by speculators to 48 per cent from 38 per cent. So the dominant players in these major commodity markets are those who benefit from volatility and sharp swings, rather than those interested in simple hedging against the future.

This makes it much easier to understand why primary commodity prices have been so volatile over the past six months. Such volatility is terrible for those actually engaged in producing and consuming these goods, and transfers income to financial and speculative players. Clearly, things cannot improve until more regulation is brought into financial markets.

Sign in to Unlock member-only benefits!
  • Bookmark stories to read later.
  • Comment on stories to start conversations.
  • Subscribe to our newsletters.
  • Get notified about discounts and offers to our products.
Sign in


Comments have to be in English, and in full sentences. They cannot be abusive or personal. Please abide to our community guidelines for posting your comment