"The theories which I have expressed there, and which appear to you to be so chimerical, are really extremely practical -- so practical that I depend upon them for my bread and cheese."
-- Sherlock Holmes, A Study in Scarlet (1888)
The mysterious case of the commodity conundrum is sure to elicit passionate debate on either side of the equation -- is the commodity boom due to speculation or fundamentals? By the time you read this, a battle in this dispute will have taken place on April 22, 2008 with the CFTC roundtable on agricultural markets.
Two recent articles, "Commodities: Who's Behind the Boom?" (Barrons) and "High Commodity Prices? Blame Wall Street Before Speculators" (Reuters), explore the potentially complicit role of "speculators" as villains. This is a red herring -- these articles in truth are focused on concerns regarding the trespassing of Wall Street financial innovation into the commodity markets.
In the Reuters article I am accurately quoted as stating, "The ugly truth is that the securitization of commodities has eased the way for money flows to raise commodity prices beyond that which the current fundamentals of the global economy can sustain over the long term." Without proper context, this assertion is provocative, yet its crux is derived from our working paper.
I originally posted the draft of my speech to the IQPC Base Metals Investment Summit on March 19th, partly in order to raise attention to generally unnoticed issues surrounding the transformation of commodity futures from a hedging utility into financial investments. This speech contains the above quote, but my thinking was not isolated: Jeffrey Korzenik independently wrote a piece in Minyanville on March 24th, which was followed by Gene Epstein's article in Barrons on March 31st discussing the well-research and autonomously developed ideas of Steve Briese.
The resulting brouhaha from various sides of the commodity bull market debate is predictable, but misses the point. To add to the confusion, at stake are significant economic and policy issues.
Besides the 1/23/08 and 2/5/08 press releases from the National Grain and Feed Association, the reader should also refer to the list of signees of a letter dated 10/25/07 to the U.S. Senate from the Energy Oversight Market Coalition. These memorandums raise legitimate concerns from bona fide hedgers.
It seems I am not alone in my alarm at the consequences resulting from securitized commodity products and its abettor over-the-counter (OTC) derivatives, which is represented by the International Swaps and Derivatives Association (ISDA). In addition to members of Congress, there is a growing list of commercial hedgers, reputable analysts, veteran futures traders, and futures exchanges who are concerned too.
All the same, laypersons and policymakers must realize that speculators are a natural and necessary feature of the commodity markets. Fear of the speculator's role in the economy when viewed objectively is an irrational. (The following section illuminates why this is the case.)
Likewise, Wall Street, who has finally managed to get the commodity genie out of the bottle, must recognize it could kill another goose for the need of more golden eggs. Commodities are not securities, and regulated exchange-traded derivatives provide the proper forum for such trading.
Let me make clear here: I am a proponent of the speculators' role. The function of speculators is required to facilitate the hedging utility and price discovery mechanisms. In my humble opinion, the career of commodity futures speculation is an honorable trade if practiced honorably. And in that context, yes, a reflexively driven fundamental case can be made for rising commodity prices. However, we cannot be sure of this unless we have a level playing field of properly regulated markets.
Something systemic and possibly more insidious is afoot. Beyond questions of whether or not price distortions are a result of the development of securitized commodities vehicles, there is the political debate on "closing the Enron loophole." Those who are long commodities may arguably have good reason to be long, but there is no excuse for the opaque and unregulated OTC derivatives market.
As Schiller (2000) so eloquently stated in his book Irrational Exuberance, "We need to know confidently whether the increase that brought us here is indeed a speculative bubble -- an unsustainable increase in prices brought on by investors' buying behavior rather than by genuine, fundamental information about value. In short, we need to know if the value investors have imputed to the market is not really there, so that we can readjust our planning and thinking."
These two matters, the securitization of commodities and OTC derivatives, are in fact corollaries. My contention is that the reflexive interaction between market structure, functionality and price action is systemic. That said, whether mine and others' concerns are right or wrong, will ultimately be determined by public debate, political will, and eventually by the markets and the economy.
Admittedly, we all talk our book: I am a long-time participant in the regulated and transparent futures industry which marks-to-market, while others profit from trading unregulated and non-transparent OTC derivatives which marks-to-model. Then there is the CFTC itself -- a regulatory body whose 4/21/08 proclamation that there is no excessive speculation in commodity futures rings as hollow as Bush's praise of FEMA in response to Hurricane Katrina, "Brownie, you're doing a heck of a job."
Christopher Hausman, an Illinois farmer, provides a more open and frank assessment of the current situation in the commodity markets. He is quoted in a 4/22/08 New York Times article as bluntly saying, "I can't honestly sit here and tell you who is determining the price of grain. I've lost confidence in the Chicago Board of Trade." Caveat emptor... 'what the CFTC tells you is official, what he tells you is unofficial.'
So "before turning to those moral and mental aspects of the matter which present the greatest difficulties, let the inquirer begin by mastering more elementary problems."
Back to Futures Basics
Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated.
Derivatives are risk management tools, a "zero-sum game," fundamentally different from the "rising tide raises all ships" concept of the capital formation markets. While, there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, a legacy of academic disagreement supports the claim that, on an inflation-adjusted basis, the same cannot be said about commodities.
As noted by Greer (1997), the inherent problem is that commodities are not capital assets but instead consumable, transformable and perishable assets with unique attributes. Hence, speculative trading, by definition any commodity trading facilitated for financial rather than commercial reasons, likely results in "zero systematic risk."
The conundrum for financial "investors" is that for every buyer of a commodity futures contract there is a seller -- sine qua non, there is no intrinsic value in futures/forward contracts -- they are simply agreements which commit a seller to deliver an asset to a buyer at some place/point in time. Accordingly, the derivatives and securities markets require two different types of regulation.
For now, let's avoid any debate on the so-called roll yield, and focus instead on a more intuitive and economically meaningful explanation for potential sources of returns in the futures markets.
It is generally assumed that organized futures markets provide important economic benefits. This premise, that properly functioning futures markets serve a valuable economic purpose, is validated by government policy. The secondary benefit provided by the futures market is that it functions as a mechanism for transparent price discovery and liquidity, therefore mitigating price volatility.
The primary benefit provided by these markets, however, is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge. Hedging reduces the risk of adverse price fluctuations that may impact business operations, which in turn theoretically results in increased capacity utilization. It is indispensable to the well-being of our financial system.
Commodity theory mainly focuses on the transference of a "risk premia" from risk-adverse hedgers to speculators. The insurance-like context was first proposed by Keynes (1930) in his theory of normal backwardation. Essentially, Keynes believed that hedgers have to pay speculators a risk premium to convince them to accept their risk. Spurgin (2000) explained it this way...
There are four types of participants in futures markets: short hedgers (producers), long hedgers (consumers), speculators and arbitrageurs.
Most transactions result in symmetric responses. Speculator versus speculator results in a symmetric response, as does a long hedger versus a short hedger. Arbitrageurs, who perform a different function, exist to ensure consistent pricing across different types of instruments (cash, futures, forwards, options, swaps, ETFs, etc.) of a particular underlying asset or relationships.
In addition, there are theoretically four asymmetric scenarios which produce excess return to speculators:
1) a rise in commodity price (beneficial to producers) generates more initiative from producer short hedgers to lock in higher prices, hence a net short hedging position is established;
2) a rise in commodity price (detrimental to consumers) causes consumers to be more concerned about guarding against margin pressure than producers are concerned about locking in higher prices, hence a net long hedging position is established;
3) a drop in commodity price (beneficial to consumers) generates more initiative from consumer long hedgers to lock in lower costs, hence a net long hedging position is established; or
4) a drop in commodity price (detrimental to producers) causes producers to be more concerned about guarding against margin pressure than consumers are concerned about locking in lower costs, hence a net short hedging position is established.
Ironically, just ten years ago, mainstream thinking about commodities was largely negative. Schneeweis and Spurgin (1996) stated at the time that the low level of investment in managed futures (then the only way to participate in professionally managed commodity investing) was due to the fact that investors required both a theoretical basis and supporting empirical results. In other words, historically, the prevailing wisdom in the investment community had mostly been against direct speculation in commodities.
This understanding was based on the premise that -- if there were excess returns to speculative capital in futures trading, assuming there are participants such as risk averse hedgers willing to lose money over time, then since barriers to entry is low so much capital would flow to this area that returns would be driven to zero over time, and as a result returns would be spread so thinly that profits would not be possible.
Our working paper suggests that this supposition remains essentially correct. But due to a paradigm shift in supply-demand fundamentals from emerging markets, and increasing speculative capital inflows into commodities biased to the long side, the dominant sentiment began to change after the millennium...
"What one man can invent, another can discover."
End of part one of a three part series. To be continued...