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Commodity Prices, Again: Are Speculators to Blame?

In the 1955 movie version of East of Eden, the legendary James Dean plays Cal. Like Cain in Genesis, he competes with his brother for the love of his father, a moralizing patriarch. Cal “goes long” in the market for beans, in anticipation of an increase in demand if the United States enters World War I. Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father to make up money lost in another venture. But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and angrily tells him that he will have to “give the money back.” Cal has been the agent of Adam Smith’s famous invisible hand: By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, thereby increasing the supply so that more is available precisely when needed (by the British Army). The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to.

Among politicians, pundits, and the public, many currently are trying to blame speculators for the high prices of oil and other mineral and agricultural products. Is it their fault?

Sure, speculators are important in the commodities markets, more so than they used to be. The spot prices of oil and other mineral and agricultural products — especially on a day-to-day basis — are determined in markets where participants typically base their supply and demand in part on their expectations of future increases or decreases in the price. That is speculation. But it need not imply bubbles or destabilizing behavior.

The evidence does not support the claim that speculation has been the source of, or has exacerbated, the price increases. Indeed, expectations of future prices on the part of typical speculators, if anything, lagged behind contemporaneous spot prices in this episode. Speculators have often been “net short” (sellers) on commodities rather than “long” (buyers). In other words they may have delayed or moderated the price increases, rather than initiating or adding to them. One revealing piece of evidence is that commodities that feature no futures markets have experienced as much volatility as those that have them. Clearly speculators are the conspicuous scapegoat every time commodity prices go high. But, historically, efforts to ban speculative futures markets have failed to reduce volatility.

One can distinguish three kinds of speculation in the face of rising prices. First, there is the “bearer of bad tidings” like Cal in East of Eden. The news that, in the future, increased demand will drive prices up is delivered by the speculator. Not only would it be a miscarriage of justice to shoot the messenger, but the speculator is actually performing a social service, by delivering the right price signal that is needed to get real resources better in line with the future balance between supply and demand. Without him, the subsequent price rise would be even greater, because supply would be less. But it does not appear that speculators played this role in the commodity boom that started earlier this decade: as already mentioned they, if anything, lagged behind the spot price.

Second, when the price is topping out, stabilizing speculators can sell short in anticipation of a future decline to a lower equilibrium price. This type of speculator again adds to the efficiency of the market, and dampens natural volatility, rather than adding to it.

Third, in some cases, when an upward trend has been going on for a few years, speculators sometimes jump on the bandwagon. Market participants begin simply to extrapolate past trends. Self-confirming expectations create a speculative bubble, which carries the price well above its equilibrium. Examples of previous peaks in speculative bubble peaks include the dollar in 1985, the Japanese stock and real estate markets in 1990, the yen in 1995, the NASDAQ in 2000, and the housing market in 2005.

It is the third kind of speculation, the destabilizing kind (also called bandwagon behavior), about which people tend to worry. As noted, there is little evidence that it has played a role in this run-up of commodity prices. So far, that is. Just because the boom originated in fundamentals does not rule out that we could still go into a speculative bubble phase. The aforementioned bubbles each followed on trends that had originated in fundamentals (respectively: rising US real interest rates, 1980-84; easy money and rapid growth in Japan, 1987-89; US recession, 1990-91, and Japanese trade surpluses; the ICT boom in the late 1990s; and easy US monetary policy after 2001).

It is not hard to identify in economic fundamentals the origins of this decade’s boom in commodity markets: easy money in the US; rapid growth worldwide, but especially in China and India; instability among oil producers, especially in the Middle East; misguided ethanol subsidies; drought in Australia, etc., etc. Even so, a bubble could take hold yet.


Originally published at Jeff Frankel’s Weblog and reproduced here with the author’s permission.

4 Responses to “Commodity Prices, Again: Are Speculators to Blame?”

interested readerAugust 5th, 2008 at 3:33 pm

"It is the third kind of speculation, the destabilizing kind (also called bandwagon behavior), about which people tend to worry. As noted, there is little evidence that it has played a role in this run-up of commodity prices." Yes, there is evidence: hedge funds as a group turn in their worst monthly performance since July 2002 after leveraged bets on rising commodity prices went wrong. It seems to be quite a crowded bet…

J.August 5th, 2008 at 11:12 pm

Indeed, expectations of future prices on the part of typical speculators, if anything, lagged behind contemporaneous spot prices in this episode.Is an interesting statement and leads to questions such as what are ‘typical speculators’? The traditionals such as hedge funds and CTAs, or these plus nontraditionals which began reallocating into commodities over four years ago and which the CFTC improperly placed into the commitment of traders category of commercials, a miscategorization which also distorts? (Recognizing that this easily leads to inaccurate notions of who in fact was/is ‘net short’). Degrees of lag, and not, vary according to commodity but then no idea of what is meant by ‘this episode’ is provided nor does there appear recognition of the more than national nature of fund flows and cumulative amounts. (At least on BIS data for over the counter commodities trade, we see a rise in notional from December 2004′s $1 trillion to December 2007′s $9 trillion).One revealing piece of evidence is that commodities that feature no futures markets have experienced as much volatility as those that have them.Well, yes that would be revealing if it attempted to take account of physical spec by hedgies (e.g. pgm metals), or, for the more mundane, de facto oligopolies (e.g. potash). Clearly speculators are the conspicuous scapegoat every time commodity prices go high. But, historically, efforts to ban speculative futures markets have failed to reduce volatility.True but often enough smoke and fire have been related even as every conjuncture is distinct, nor have I heard a single thing about ‘banning speculators, rather quite a bit of ‘time to re-regulate’ mumblings.

GuestAugust 6th, 2008 at 4:58 am

All I can say re: Oil-Demand Destruction was evident Prices kept rising-CFTC announces limited re-regulation Prices down $25 per barrelSir, your argument is typical of the academic variety; when Enron rigged electricity market in California I recall no one thinking folks were cornering the market.Where this is smoke there is indeed fire…Regulation as bad as it is from the 30′s was introduced for a reason. We forgot that just as much as we ignored common sense and gave 200, 300k to folks who never paid a phone book on time AND to housing flippers (hmmm speculators again). What stabilizing effect did flipper have on that market. You can sure as heck see the empty houses/condos just as sure as Cal could see the beans.Moral: People can and do dumb things like attempt to corner markets and to overbuild when easy credit abounds. It appears as we get further and further away from a true value added economy that dumb ideas are easier to be accepted to the detriment of many!! Cal would be crying today…

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