Raising commodity and oil prices: irrational speculation or trending shortage of energy supply?

In the last G8 meeting in Osaka finance ministers have discussed about the recent rise in commodity and energy prices. Two opposite views have emerged. On the one side, it has been advanced the idea that price increases may be the result of hard speculation on the side of financial intermediaries eager to increase their profits by exploiting the recent turmoil. On the other side, it has been argued that the recent price increase can be reasonably ground on the trending conditions of demand and supply.

 

The first of those views is based on the observation that recently there has been a significant surge in the prices of derivatives for commodity and energy. Because of this, we might be observing an increase in current commodity and energy prices as a result of the fact that derivative prices might mistakenly drive up expectations. In other words, we could imagine that in presence of irrational behaviors derivative prices might anchor current prices along the wrong path. This order of causation would contradict the economic principle due to which agents do arbitrage across different prices, even in presence of informational asymmetries or irrational behaviors. Based on arbitrage conditions we should always expect derivative and current prices to be intimately linked and driven by expectations about future conditions of demand and supply. If agents correctly expect a future shortage of energy and a raising demand from emerging market economies, future prices will be trending up and current prices will do so as well given that expectations are discounted by the market. If we suspect that the markets are behaving irrationally, due for instance to a lack of information about the future availability of energy and food reserves, we might be tempted to foresee a link between the path of derivative prices and market failures due to asymmetric information. However based on the theory of price discovery we know that in these situations future prices might lead current prices, as the former appear more volatile, nevertheless the two prices would still be intimately related to each other and moving along the same path.

 

The idea that prices are driven by demand and supply conditions implicitly consider price increases, in face of supply shortage, as beneficial for the markets. In fact price movements are the main indicators to warn the markets to adjust toward the right path. What is this energy and food price increase signaling to market participants? It signals that in the near future the world will experience a dramatic shortage of energy and food reserves and that a technology upgrading is urgently needed to face scarcity. To assess whether fluctuations in prices drive the market toward the right path let’s recall the effects of the oil price crises occurred in the 70s: as a result of that cost push shock firms have been adapting their technology up to the point in which the percentage of oil used per each unit of final products decreased of about 50%. Total production has increased in recent years, also because of the significant growth rates experienced by emerging market economies, implying that total oil usage has increased as well. This suggests that alternative solutions should be taken to face the current situation. The use of alternative energies and technology upgrading to reduce the intake of oil usage are among possible avenues to pursue.

 

Can the proposal of reducing margin calls for financial intermediaries be beneficial? Clearly not since discouraging the use of derivatives would not help the market to drive down current prices, as the latter are still based on expectations about future market conditions.

 

Will the raising prices be a short term phenomenon or we envisage some long run trends? Once again this will depend on supply side conditions. As the growth rate of emerging market economies is significantly high and will continue to stay so in the future, demand will continue to increase. Technology upgrading to improve supply conditions is the only way to escape the problem.

2 Responses to "Raising commodity and oil prices: irrational speculation or trending shortage of energy supply?"

  1. interested reader   June 17, 2008 at 4:30 pm

    I’m not very familiar with energy derivatives but by following the latest credit cycle there was indeed evidence of credit derivatives prices diverging systematically from underlying spreads due to technical supply/demand conditions rather than changes in fundamentals (‘negative basis trade’ e.g.) This ongoing distortion might have been inefficient from an economic point of view but it was nevertheless lucrative for the parties involved.

  2. Barry   June 28, 2008 at 12:57 pm

    The Commodity market is no different than real estate market.The false expectation that house prices will keep going up and never go down significantly created the whole credit crunch. The same expectation and derivative trading in commodities market is doing the same now.As people can not afford houses as the prices went through the sky and demand falls, people also will start reducing consumption of commodities at some point. Then the whole thing will start again.This time it will be all those commodity index investors,will suffer.