Do speculators help or hinder the commodities markets?

Speculators help commodities markets to function effectively, providing liquidity and helping to transfer price risk away from commodity producers and users. Often, however, they are eyed with suspicion, with many arguing that they distort prices. Tensions flare when prices and price volatility reach uncomfortable levels, and speculators came under the regulatory spotlight when, in 2008, spikes in food costs resulted in riots in 31 countries. 

This tension is simmering again. In July 2011, global food prices reached the highest levels ever recorded, according to data from the UN’s Food and Agriculture Organisation (FAO). Staple commodities such as wheat and sugar were one-third more expensive than the year before. But this time speculators face more than just public ire. In October, US regulator the Commodities Futures Trading Commission (CFTC), finalised new limits on commodity derivative positions in agricultural products, energy and metals, in a bid to clamp down on 'excessive' speculation. 

Raw facts

The question of whether speculators contribute to price rises or whether prices are driven by fundamentals is a complex one. Proponents and critics each produce compelling but hard-to-prove arguments to support their case. The industry numbers by themselves are interesting.

For food products – the most sensitive market for households and therefore policy-makers – the overall price trend had been downwards for decades. Moreover, this was achieved at the same time as the proportion of the world’s population classified as malnourished declined – falling from 33% in 1970 to 16% today – during which time the number of mouths to feed doubled.

But in the past few years, this positive price trend has seen a reversal. While the amount of cereals harvested, for example, has risen by about 20% since 2000, the International Monetary Fund’s food price index has increased by 90% and the implied volatility for the most important traded commodities (wheat, corn and soybeans) is up by more than half since 2005.

Following the last price peak in 2008, the CFTC began an investigation into the impact of what critics call the ‘financialisation’ of commodities trading. Then, in 2009, it began to publish regular 'commitments of traders' reports, which break down derivatives market data by the type of actor (producer, user, swap dealer, managed money, etc) and by long and short positions.

In the wrong hands?

The data are startling: the number of commodity futures and options contracts has grown five-fold in a decade, and financial players now outnumber traditional market users (producers and users of commodities) by a ratio of three-to-one for exchange-traded products alone. 

The CFTC also argues that because about 90% of wheat futures contracts and derivatives on the Chicago Board of Trade currently trade long, this suggests that they are bought and sold by speculators with no connection to food production or distribution. According to a 2010 paper from the FAO, only 2% of exchange-traded futures result in the physical delivery of the underlying asset. 

In the spotlight for holding those long positions are the passive investment vehicles tracking commodity indices, the number of which has exploded in recent years. According to data from Barclays Capital, investment through tracking indices had risen to $376bn by the end of 2010, three times the level of 2005. According to data from the UN, index funds now make up more than 60% of overall financial holdings in agricultural futures markets.

A US not-for-profit group, Better Markets, says that passive funds do not increase liquidity. In a letter to the CFTC earlier this year, it classified index funds as liquidity takers, because they consume and compete for liquidity. In this way, the group argues that they have significantly contributed to futures price volatility.

In contango

Many policy-makers believe the trading motives of such index funds do not include commodity-specific supply and demand factors and, as a consequence, disrupt price discovery and tend to de-link futures prices from fundamentals. In addition, because the rolling of futures positions is inherent to index funds' structure, Better Markets argues that this biases futures markets to a contango forward curve.

This is the core of the debate: does the spot price lead the futures price or vice versa? The forward curve is in contango when futures trade above the spot price, or backwardation when futures trade below the expected spot price at maturity. Analysts and market participants disagree over what is driving the shape of the futures curve. Better Markets (and many others, such as a coalition of US airlines called Stop Oil Speculation Now) says that futures markets have been in contango for an extended period of time, driven by the growth of index trading in this period.

Others say it is driven by fundamentals: for non-perishable goods at least, markets are naturally in contango to include the cost of carry (such as warehousing fees). To confuse matters, of the two key oil markets – which will be subject to the CFTC’s new position limits – Brent Crude is in backwardation while West Texas Intermediate is in contango.

So far, so complicated. The data definitely tell an interesting story, but what will be the conclusion?