Reining in the commodities speculators

Happy Wednesday!

More of the regulatory changes are on the way. This time the push is coming from the Commodity Futures Trading Commission (CFTC) and the focus is on oil market trading. Thank God! Many of you know that I have decried the influence of speculators in oil markets several times on the blog. In summary, when oil was trading around $140/barrel I said that the overwhelming majority of that elevated price level came from speculators. I said that the price per barrel should be around $35. That was in May ’08. Now oil has popped back up from around $35/barrel to around $63. What would be the justification for such an increase in the midst of a global recession that is deep and broad? If supply and demand were based solely on the use of oil then the price would be below $35/barrel. But speculators have driven the prices to ridiculous levels. Unfortunately, many of them do not care about the absolute level of prices. What they care about are relative swings in prices. Since speculators never take delivery of the oil then if they buy oil at $60/barrel all they care about is to be able to sell it to someone else for more money. Most never really have to cough up the money for that $60/barrel purchase. It’s a grand game of musical chairs and only the last buyer – the one that buys at the top price – is the loser.

Oil is unquestionably the bedrock of the economy; I wish it weren’t so, but it is. Any mechanical device needs energy to operate. The sources for that power are pretty much electricity or oil. How do tractors plough fields? The tomatoes on your salad were brought to you by oil. Etc. Ad nauseum. So when oil is artificially high every single member of the global economy is affected.

So what is the CFTC proposing for oil, natural gas, and possibly other commodities?

The first proposal is to establish position limits for commodities that have a fixed supply. This is an important change. Because of leverage and other financial techniques speculators, in the aggregate, have been able to trade more oil than is able to be supplied! That is an absurd situation and creates the appearance of way more demand for the limited supplies of oil than would be the case with futures contracts being involved. This is an important step that deserves our support.

The second proposal is to severely constrain the ability of swap dealers, index-traders and exchange-traded fund managers to get around position limits through “special hedge exemptions.” The names here obscure the fact that this whole group of “investors” are really speculators. I feel that this second step is also an important step to reducing the manipulation of commodities markets. Any time there is a legal leak in the dam holding back bad financial market behavior, the dam always eventually breaks.

There are other suggestions, but these are the two most important. On the blog I have suggested another way to end the speculation immediately: require the purchasers of futures contracts to take delivery of the underlying commodity and require sellers of futures contracts to actually have possession of the commodity in question. That would limit the futures market to its original participants: the buyers and sellers of the goods in question. Another way to end speculation immediately would be to require the purchasers of futures contracts to hold the contract until its expiration and then bear the consequences of their decision. As it is now, if a speculator begins to lose money on a futures contract he may close his futures position by buying an offsetting contract to limit his losses. If required to hold the contract to term then the speculator would have to have a long-term view of the commodity he was buying. I assure you that the massive premiums in commodity prices would immediately disappear if either of these suggestions were put into place.

Be well!

Jason