Large Institutional Speculators are Messing Up the Commodities Game

by Fern Phan

Spiking prices reflect both a fundamental and momentum situation.

Large institutional holders speculating and/or "investing" in the commodities markets have lead to proposals for legislation in US Congress.  The FT’s Short View columnist John Authers, told Congress that investment in indices based on commodity futures has risen from $13bn five years ago to $260bn now.

The traditional role of commodities markets is for hedging by producers and manufacturers against the price volatility of physical goods.  That industry's push to get more speculators involved to increase liquidity in those markets might have gone overboard.

The unique quality of commodities is that they can literally  create a life or death situation for millions of people who need to eat and work...and it has, does, and will cause wars.  Whether it would be wise to regulate markets is another issue since it might make the situation worse.

Commodities are quite different from securities in that there's no real finished product or service, no projection of growth due to gaining market share, no p/e or balance sheet. There are real assets/raw goods behind every trade.  The fundamental analysis behind commodities is supply and demand for the raw goods, population growth, and structural shifts in modes of production i.e. BRICs and emerging markets moving to and beyond industrialization in less than one generation.

Peak Oil and the whole Peak idea behind non-renewable utilitarian resources has been bouncing around with increasing frequency...and the big debate is whether it should effect renewable resources so heavily.

• Renewable resources such as corn and wheat are reliant on non-renewable resources in it's production: everything from fertilizer (petroleum intensive) through processing and delivery.  The extreme oil dependence of massive agricultural production to support a massive world population tethers it to Peak Oil. 

• Developed nations are where they are today because of the coupling of agricultural innovation and increasing use of oil in producing and harvesting.  That will most likely change/decouple as new innovations and technology take replace old ways of doing things.

Current commodities prices are being driven by momentum since prices don't entirely reflect fundamentals.

• The original hedgers, producers (hold corn in silos) and refiners (horde) might begin to stockpile due to the rising value of physical assets. Since they either want to gain from appreciating assets (producers) or they want to keep cost of production down (refiners).

• Financial Institutional buying and holding has changed the dynamics of the original goal of the commodities industries to create a liquid market and lessen price volatility of real assets.

• Thinly or non-traded commodities are also being bought up by Institutions.  They lead to forward purchases and/or hording on an institutional level.  This creates huge price fluctuations in the short term.

• Demand has actually decreased for many commodities as growth has slowed globally so fundamentally, that should be reflected in prices.

At the same time, delivery of commodities depend on the production processes they need to move through before they get to market.  There may be huge bottlenecks along the production chain that lags in output, depending on the commodity.  In those cases, fundamentals are still intact.

Increase in agricultural commodity prices would continue in that direction by fact that they are extremely reliant on oil along their production process.  Crude oil is the driver of the price rise.  Institutional buy and hold of either physical commodities or holding the contracts is removing supply from the market.  Traditional hedgers see that as momentum and exacerbate it by trying to lock in current prices.  Traditional short term speculators still trade short term, not really messing with the physical demand and supply of physical assets.

There is a problem with the buy and hold method of institutions in that they are removing supply going forward by buying up contracts.  It removes theoretical supply from the markets and in turn creates volatility.  Hedgers do what they've always done.  They're concerned with locking in prices of raw commodities that are central to their business. Hedgers and now institutions make up the bulk of the market volume.  Short term speculators don't effect the market as much other than hopefully creating liquidity since they just don't have that volume.