Comment Text:
The fundamental purpose of limiting speculators’ influence in the commodity market is not to eliminate volatility or to control prices, it’s to shift the power of setting prices from speculators to producers and users. Basic economic principle states that price is set by supply and demand. But the sheer volume of investor interest has skewed the demand equation which has driven up prices far beyond the cost of profitable production. This further induces inventory hoarding whether to profit from further expected price increases by hoping to sell at higher prices or due to protect from anticipated price increases by buying excess inventory to consume over a longer period of time than normal. Back in 2008 the Philippine government prosecuted rice distributors because they were buying government subsidized rice, re-packaging it and reselling it at higher prices. There was no actual shortage but the poor were priced out of the market because investors were setting high prices. Certainly what the distributors did was wrong but if the speculative element was not setting high prices, the distributors would not have had that incentive.
Contrary to the notion expressed my Michael Dunn “If we limit participation in these markets through position limits, producers may receive inaccurate market signals when making production decisions,“ producers and consumers are already receiving inaccurate market signals. Take comments from Starbucks CEO, Howard Schultz, for over more than a year, that coffee prices have been hitting historic highs despite a surplus of coffee. Farmers are allocating land to crops where prices are the highest and those prices are not necessarily set by fundamental supply and demand. This can create temporary shortages and surpluses due to skewed prices.
The notion that investor interest doesn’t impact pricing completely misses what happens on the ground level. Look at this article from Bloomberg yesterday: http://www.bloomberg.com/news/2011-10-16/hedge-funds-add-to-wagers-in-biggest-rally-of-2011-commodities.html
The very first paragraph says “Speculators boosted their wagers on higher commodity prices for the first time in five weeks as increasing confidence that the global economy will avoid another recession spurred the biggest rally of the year.”
If that’s not a direct correlation, I don’t know what is.
The financial theory behind a futures price is to use the spot price as the starting point. But today the futures price is driving the spot price as producers look to the futures market when setting or negotiation prices. The tail is wagging the dog and the tail is being controlled by speculative interests. Investors get excited when commodity prices go up because they think that implies greater confidence in the economy. But rising prices are BAD for the economy and consumers, all else equal. One of the main reasons economic recovery has been so sluggish is because high commodity prices have been sapping funds from other parts of the economy.
Also according to economic theory, producers will produce to the point where they squeeze out all the profit, where the marginal cost of production equals price. But currently prices are significantly above the marginal cost of production. And that’s not because of shortages, it’s because of massive investor interest.
Jamie Kozak, CFA
Portfolio Manager
North Growth Management Ltd.
Suite 830, One Bentall Centre
505 Burrard St, Box 56
Vancouver, British Columbia
Canada V7X 1M4
Direct: 604.697.5645
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Home Page: http://www.northgrowth.com
