Commodities Trading Rules Are Flawed

Warning: this is another criticism of capitalism piece.

Commodities, especially oil and gold, have been soaring in price since the unfolding of Middle East crisis.  For me it is just the latest example of how commodities market trading rules are flawed.  Greatest among the errors is that commodities traders never need to take possession of the goods that they are trading.

Because commodities traders can open a long position – that is take out a contract to buy a commodity like oil – but do not have to ever take possession of the oil, it means that commodities markets are full of speculators.  What happens is that if the speculator feels that their bet on the direction of the price of the commodity is not going to work out, they simply sell the contract to buy the commodity.

Speculation is what drives the prices of essential economic goods higher and higher and higher.  This happens because speculators are less interested in the absolute price of the commodities they trade, and more interested in relative value shifts.  Someone actually participating in the commodities markets for business reasons, say an airline that is trying to keep its fuel costs low, wants prices to be very low on an absolute basis.  That is, they want a spot price for crude oil of $20/barrel of oil, not $106/barrel of oil.  An airline would participate in the commodities markets to hedge its future fuel costs, fuel that it will eventually take possession of.

On the other hand, speculators participate because they care about relative movements around their initial purchase price.  So if a speculator enters the oil market at a price level of $95/barrel they simply want the price to go higher.  Even a gain of $5 in the price of oil up to $100/barrel can be hugely significant if the speculator is using leverage to massively juice their gains.  A $5 gain for the commodities speculator is pretty similar regardless of whether or not it is a $5 gain on a $90 contract or a $110 contract because of the leverage they employ to increase gains.

[Leverage interlude: leverage for commodities speculators is the same as it is for a home buyer.  If you purchase a house you do not need to provide the entire purchase price of the home, just the down payment.  This is the equity.  If you put down 20% on a $100,000 home then your investment is $20,000.  The bank provides the leverage on the other 80%, or $80,000.  This equates to leverage of 5x, or $100,000 ÷ $20,000.  If the price of the home goes up just 5%, or $5,000 on that $100,000 initial purchase price, the home owner does not have to share that gain with the bank.  So the return to the homeowner is not just 5%, it is $5,000 ÷ $20,000 = 25%.  This is 5x leverage at work.  Some hedge funds that invest in commodities are leveraged at 50x!]

Because commodities markets are hugely liquid when geopolitical or economic events unfold speculators can enter commodities markets the way mold quickly forms on bread.  Again, because these traders never have to take possession of the oil they are “buying” it means that too many speculators are in commodities markets manipulating the price for short-term profit gains instead of long-term economic interest.  The result is that the commodity prices are much too high.  Ultimately, the problem of course is that the price of oil, or the price of wheat, or the price of orange juice, actually affects billions of people.

High commodities prices benefit a very narrow range of speculators at the expense of every other human being.  That’s why I am saying that commodities trading rules are flawed.  To correct this situation I strongly advocate two things:

1. Commodities traders should have to hold their contracts until the very end of the contract’s life, or for a period that is at least 45 days.  That would overnight drive out almost all speculators in commodities markets.  Only those who truly felt that they had an insight that countermanded the rest of the markets participants would buy commodities contracts.
2. Speculators should be required to take delivery of the commodities that they purchase.  So if you are a speculator speculating on 100,000 barrels of oil then you need to have a huge warehouse where you can take delivery of the commodity.  This again would overnight drive out all speculators from the commodities markets.  The overwhelming majority of participants would be those with an actual vested economic interest in the goods being traded.  Think: farmers, bread makers, airlines, and so forth.

Some would argue that this would destroy a valuable trading market.  I would argue: who cares?  For far too long commodities markets have been a rich source of profits for a very narrow band of people, speculators, at the tremendous expense of literally billions of people.

Jason