Friday, October 3, 2008
FOR most of the past year, as global prices in oil and other commodity markets zoomed to stratospheric levels, we were told that it had nothing to do with speculation. Eminent economists joined bankers, financial market consultants and even policymakers in emphasising that these price rises were all about “fundamentals” that reflected real changes in demand and supply, rather than the market-influencing actions of a bunch of large players with financial clout and a desire to profit from changing prices. In the case of oil, the arguments ranged from “peak oil”, which pointed to the eventual (and imminent) problem of world oil consumption exceeding supply and known reserves, at one extreme, to the perfidious actions of the Organisation of Petroleum Exporting Countries (OPEC) cartel in restricting supply so as to push up prices, at the other extreme.
In between were other arguments such as the easing of monetary policy in the largest economy, the United States; the weakening of the dollar, which caused oil prices to rise since the oil trade is largely denominated in dollars; and the rapid economic growth worldwide, but especially in China and India, which have apparently become “gas guzzlers”. Strange Justifications
These arguments did seem strange, especially as global oil prices more than doubled in the past two years when total world oil demand had scarcely changed, and, if anything, had fallen to some extent, and global oil supply had increased slightly. Even so, the combination of voices providing so many reasons for the increase in oil prices did cause many of us to suspend disbelief and accept that there were real economic changes that justified the continued rise. In turn, governments, especially in developing countries, saw fit to pass on the increases to consumers because the dramatic price rise was seen as permanent. This has played a significant role in creating the inflationary pressures that are now plaguing these governments.
Similarly, the dramatic rise in the prices of food and other primary commodity was also traced to real economic causes and processes, such that talk of the global food crisis became commonplace. In the case of foodgrain and similar commodities, there is a large element of truth in this argument as the rising costs of cultivation (partly affected by high oil prices); the inadequate policy support for agriculture, resulting in falling yields; the acreage diversion to produce biofuels; and the reduced government grain stockpiles meant that there were imbalances that could explain some of the price rise. But even for foodgrains, the very rapid rise in prices, over just a few months, was hard to explain without bringing in the role of speculation. As all these commodity prices kept rising, we were also told that this meant good times for the producers, not only oil-exporting countries but small farmers producing foodgrains that were now highly valued internationally.Role of Speculation Despite this apparent consensus, as prices continued to explode, there were growing murmurs of dissent coming from various quarters, including the U.S. Congress, which actually had a set of hearings devoted to examining the role of speculation in commodity prices. Once again, the arguments against such a possibility were many and diverse. It was pointed out that there was no “hard evidence” that speculators were responsible for high prices. In the case of oil, it was argued that there was no evidence of “hoarding” of oil supplies, or growing inventories of crude, which would be expected if oil prices were actually above the real market clearing level. In any case, the most common argument in favour of allowing continued speculation was simply that the economics of speculation require such activities to be stabilising, rather than destabilising, if they are to be profitable. The vital function of speculators was to predict market patterns and thereby reduce the intensity and volatility of change. Because speculators were supposed to buy when prices were low and sell when prices were high, they served to make prices less volatile rather than more so. A well-known hedge fund manager, Michael Masters, testified to the U.S. Congress that even on the regulated exchanges such index investors owned approximately 35 per cent of all corn futures contracts in the U.S., 42 per cent of all soybean contracts, and 64 per cent of all wheat contracts, in April 2008. This excludes all the ownership through OTC contracts, which are bound to be even larger.
A similar process is under way in the oil market. Recently, the CFTC revised the estimated proportion of oil futures and options held by speculators to 48 per cent from 38 per cent. So the dominant players in these major commodity markets are those who benefit from volatility and sharp swings, rather than those interested in simple hedging against the future.
This makes it much easier to understand why primary commodity prices have been so volatile over the past six months. Such volatility is terrible for those actually engaged in producing and consuming these goods, and transfers income to financial and speculative players. Clearly, things cannot improve until more regulation is brought into financial markets.