Blog Report: An Insight into Speculation on the Commodity Exchange

INTRODUCTION

My report will provide a detailed analyse of speculation on the commodities market during the past couple of years.

It will analyse what speculation is, how it has distorted markets and affected prices of such commodities, the impact it is having upon buyers, sellers and consumers, who has profited from this type of investment and background what politicians and lawmakers are doing to combat it.

 WHAT IS SPECULATION AND HOW DOES IT WORK?

According to Investopedia, Speculation is defined as “the process of selecting investments with higher risk in order to profit from an anticipated price movement”. CLICK HERE to read more.

 The Seattle Times, using oil as an example, provides a nice summary of how speculation works. CLICK HERE to read.

 Investopedia also has an article which defines the role of a speculator. CLICK HERE to read more.

 HOW SPECULATION HAS AFFECTED THE MARKET?

There is a general consensus amongst politicians and those participants in the market that speculative investment has played a major role in distorting prices of commodities over the past couple of years.

 Perhaps the best example of commodity market speculation occurred during mid-2007 and the summer of 2008 when the price of oil rose from US$60 a barrel to an all-time high of $147. CLICK HERE to read a transcript of 60 Minutes investigation.

Wheat was another commodity that was heavily speculated upon, according to a story by Reuters.

A year-long Senate probe found “substantial and persuasive evidence” that non-commercial traders pushed up futures prices, disrupted convergence between futures and cash prices and increased costs for farmers, the grain industry and consumers.

The price of wheat soared to a high of US$13.34 a bushel after commodity index traders snapped up more than 200,000 wheat contracts by mid-2008 on the Chicago Mercantile Exchange.

The Senate study found index traders increased their holdings from about 30,000 daily wheat contracts in 2004 to 220,000 contacts in mid-2008. CLICK HERE to read more.

The Financial Times aluminium – despite a “gravity-defying recovery in the face of falling demand and a growing supply surplus” – rose 30% this year on the back of speculators buying up the commodity and storing it in warehouses to create a fear that supply was running low, hence pushing prices upwards. CLICK HERE to read more.

Matt Taibbi from RollingStone magazine predicted that carbon credits could be the next commodity to boom on the back of speculative investment.

Like commodities, carbon credits will be traded on futures markets, meaning could mean similar scenario to oil, wheat and aluminium prices is likely.

 It all hinges what happens in Copenhagen. CLICK HERE to read more.

WHO IS SPECULATION HURTING?

The Guardian also reported that those suffering from malnutrition rose from about 800 million to more than 1 billion due to speculation on the world food market, with pasta protests in Italy, tortilla rallies in Mexico and onion demonstrations in India.

Joachim von Braun, the head of the International Food Policy Research Institute told the British newspaper that “food market remains seriously exposed to short-term flows of indexed funds into commodity exchanges” and that speculation was, among other factors, were contributing to higher prices.

“What we didn’t foresee two years ago is how speculation exacerbated the real market issues. It was not a primary cause but a second-round amplifier, which added seriously to the problem,” he said. CLICK HERE to read more.

Speculation also makes it difficult for buyers and sellers to hedge. (CLICK HERE to see the difference between hedging and speculation).

During the first hearing held by the Commodity Futures Trading Commission (see WHAT IS BEING DONE TO CURB EXCESSIVE SPECULATION?), the New York Times reported that senior vice president of Delta Airlines, Ben Hirst, said speculative investment in oil had added US$8.4 billion to his company’s bill. Around $1.7 billion had come from hedging against price increases. CLICK HERE to read more.

New Zealand has also been impacted by speculation, though of a different variety.

In a column called ‘The Las Vegas of the currency world’, financial guru Brian Gaynor wrote in the NZ Herald that the New Zealand Dollar was one of the most heavily speculated currencies in the world. CLICK HERE to read more.

While this may seem off topic, it must be noted that specualtion on the dollar has had a huge impact on New Zealand commodities like the diary industry.

In October, The National Business Review reported that diary giant Fonterra milk powder prices on its online auction rose 5.7% from the previous month, but most of that gain had been wiped out by the high Kiwi dollar. CLICK HERE to read more.

The Otago Daily Times also had a similar story which looked it how speculation on the dollar impacted Meat company Alliance Group. CLICK HERE to read more.

WHO HAS BENEFITED FROM SPECULATION?

Among those who have made some serious coin from excessive speculation is American investment banks Morgan Stanley and Goldman Sachs.

In fact, they’ve made so much moolah from the 2007/08 oil market bubble, they’re swimming in a safe full of money much like Scrooge McDuck!

According to a story by Reuters, non-commercial investors accounted for 71% of oil contracts bought on the world’s largest energy trading market, the New York Mercantile Exchange, as of April 2008 – over twice what it was eight years ago.

Moreover, fewer than one in every 10 barrels traded is delivered to customers. CLICK HERE to read more.

Matt Taibbi wrote a scathing analytical piece for RollingStone magazine about how Goldman had orchestrated every market manipulation since the 1929 Great Depression.

His story gives an insight into the role Goldman played in the speculation of black gold.

“In the six months before prices spiked, according to the U.S. Energy Information Administration, the world oil supply rose from 85.24 million barrels a day to 85.72 million. Over the same period, world oil demand dropped from 86.82 million barrels a day to 86.07 million. Not only was the short-term supply of oil rising, the demand for it was falling — which, in classic economic terms, should have brought prices at the pump down,” Taibbi wrote.

“Between 2003 and 2008, the amount of speculative money in commodities grew from $13 billion to $317 billion, an increase of 2,300 percent. By 2008, a barrel of oil was traded 27 times, on average, before it was actually delivered and consumed.” CLICK HERE to read more.

Equally scathing of Goldman’s and its speculative activities was Raymond J Learsy. The author of ‘Over a Barrel: Breaking Oil’s Grip on Our Future’ highlighted, among other things, how Goldman and Morgan Stanley how the investment banks turned themselves into bank holding companies  following the financial meltdwon in the U.S. so they could access the TARP Fund and other taxpayer bailout money from the Federal Reserve Bank and Treasury to speculate heavily in oil markets instead of lending to businesses and financing mortgages, which the money was intended for.

“Both banks reported enormous gains from their trading activity over this second quarter, enough for Goldman, according to the WSJ (“Big Pay Packages Return to Wall Street” O7.02.09) to be on track to pay out $20 billion this year or $700,000 per employee nearly double the firm’s $363,000 average last year!” he wrote.

Learsy also questions how the banks keep the prices of oil artifically inflated: “They are chartering supertankers for months to a year at a time, loading them with hundreds of millions of barrels of crude oil and oil products, taking the oil and oil products off the market thus helping to sustain and propagate ever higher oil prices at vast additional cost and burden to the nation’s consumers. The oil is held at sea for months, thereby tying up hundreds of millions of dollars, in anticipation of yet higher prices for the oil/oil products cargo at the end of the tanker charter period.” CLICK HERE to read more.

WHAT IS BEING DONE TO CURB EXCESSIVE SPECULATION?

After the prices of oil and wheat skyrocketed to record highs, there was a general concencuss among world leaders, politicians and lawmakers that steps needed to be taken to curb excessive speculation.

They admitted as much during this year’s G8 meeting in Italy. CLICK HERE to read more.

In July 2009, the Washington Post reported the chairperson of the Communities Futures Trading Commission (CFTC), Gary Gensler, floated measures to reduce the volatility in commodity prices and ensure did not monopolise the market.

The announcement came as a somewhat of a surprise to those on Wall Street given the CFTC had a history of having a rather hands-off approach toward market regulation during the last two decades.

But moves by the CFTC are part U.S. President Barack Obama’s efforts to overhaul the regulatory regime after critics said its laxity contributed to the global financial meltdown over the past several months.

Gensler’s suggestions included setting position limits on an investment any single firm could make in a particular commodity and requiring more public disclosure about the holdings of commodities traders.

Hearings would be held to gauge people’s thoughts on the proposed changes, he said. CLICK HERE to read more.

Reuters reported the CFTC was hopeful regulation would be in place by late October.

It must be noted, however, that Mr Gensler, who is an ex Goldmanite, seems like a strange choice to be pushing for tighter market regulation given his reluctance towards it in the past.

According to a story in the Los Angeles Times, questions were asked about whether he was suited for the job after being part of the team that exempted derivatives from regulation when he was a member of the Clinton Administration. CLICK HERE to read more.

USAToday details Gensler’s time at Goldman and in the Clinton Administration. CLICK HERE to read more.

Not surprisingly, big market players like Goldman Sachs were critical about the CFTC’s proposals to tighten up markets which they had heavily profited from.

Goldman Sachs chief financial officer David Viniar told the Reuters the bank’s energy trading was hedging and should be exempt from the proposed legislation.

“Consumers need hedging. Producers need hedging. And you need financial intermediaries to help do that,” he said. CLICK HERE to read more.

Ari J. Officer of Time Magazine argued there needed to be more oil speculators not less. CLICK HERE to read.

Others like former Chief Investment Strategist and Head of the Investment Strategy Group at Merrill Lynch, Richard Bernstein, believes it was hedge funds and excessive lending from banks – not tradional speculators – which fuelled the speculative bubble in the oil market in 2007/08.

Plans by the CFTC to regulate speculation would merely push speculators to the non-regulated over-the-counter markets, he wrote in a column on the businessinsider.com website. CLICK HERE to read more.

In August, the Washington Post reported Gensler was also calling for tougher measures to be taken on derivatives after he felt proposed measures would leave parts of the derivatives market out of the reach of regulators and undermine efforts to combat fraud.

He wanted derivatives to be subjected to mandatory clearing through clearing houses. CLICK HERE to read more.

Alibaba.com reported on November 20 that regulations may not be as tough as first proposed, as there are fears that they could drive investors overseas markets, too, where regulation is not as stringent. That would rob the U.S. economy of a river of investment.

It also appeared the CFTC was divided on the proposed measures, which included applying speculative limits on spot market and expiring contracts, but for all months and all monthly contracts combined. It also proposed applying limits to all traders except those those that intend to take physical delivery of the product, or legitimate hedgers. CLICK HERE to read more.

A nice and simple breakdown of the propsed legislations can be found HERE.

CONCLUSION

The evidence I have provided clearly shows that speculative investment has distorted the commodity market to a huge degree and has had a major impact on legitimate buyers and sellers when hedging and consumers.

One only has to look at the highs oil reached, despite an increase in supply and decrease in demand, or wheat which also skyrocketed to record highs.

Some, however, will argue that it is not legitimate speculators per se that have caused these distortions and, of course, they are right – but only to a degree.

For it is speculative investment made by those types of massive hedge and pensions funds held by the likes of Goldman and Morgan Stanley – which, it must be reiterated, have made a truckload of dosh from this type of trading – who have done the most damage.

While I applaud efforts from the CFTC, in particular Gary Gensler, who has pushed hard for tighter controls, to do something to combat the problem, I am inclined to agree with the skeptics somewhat.

They are right when they argue that regulating trading of certain commodities will merely push investors into other unregulated or overseas markets.

If politicians and lawmakers are serious about curbing speculation and other market manipulation, they must consider universal and wide-ranging controls across all exchanges.

 Only then can we curb excessive speculation.

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Fonterra milk prices on the up

The National Business Review has a story about how Fonterra’s milk powder prices on its online auction are up 5.7%  or $US3022 a tonne from last month.

Again, the high Kiwi dollar wipped out most of the gain.

The NBR’s story includes comment from Fonterra Global Trade managing director Kelvin Wickham:

Whole milk powder prices surged further on the back of Fonterra’s latest online auction early this morning.

Prices averaged $US3022 a tonne, up 5.7% against last month’s trading event.

This flies in the face of global analyst predictions last month that forecast a drop in the average price which has climbed about 65% since July. CLICK HERE to read more.

Fonterra close to unveiling plans

The New Zealand Herald has a story about how Fonterra is expected to announce its second proposal for capital reform within the next fortnight.
 
Fonterra is facing pressure and increased competition from other dairy nations, including America, Ireland and the Netherlands.

It needs more moolah to stabilise its balance sheets against drought and other shooks and to advance its global growth ambitions into the highly lucrative ingredients and brands markets (see Paediatric and health and wellness nutrition, proteinised beverages and nutraceuticals and specialised cheeses).

The proposed restructure would be done in stages and take up to four years to achieve, says Fonterra chairman Henry van der Heyden (above right):

Dairy giant Fonterra is expected to unveil its second proposal for capital structure reform within days as the threat to its world-beating exporter status gathers pace in rival dairying countries.

Parties close to the capital structure reform plan indicated New Zealand’s biggest company would reveal the long-awaited proposal within a fortnight. READ MORE.

Speaking of the New Zealand dairy giant, Scoop has a story about how the price of milk powder jumped more tha 24% on its Cooperative Group’s online auction.  CLICK HERE to read more.

NZ Farmers dump wool levy

The Otago Daily Times has a story about Meat and Wool NZ will lose $6.4 million from its 2010/11 income after farmers decided to dump a wool levy.

The levies would have been spent on activities such as on-farm research, monitor farms and extension, shearer and wool handling training, Sheep Improvement Ltd, and the collection of wool sector data by the Meat and Wool New Zealand Economic Service:

New Zealand’s sheep farmers have dumped one of the last reminders of the former Wool Board and baulked at continuing to pay a levy for “industry good” work supporting the national wool clip.

Their decision will trigger a restructure of the Meat & Wool New Zealand industry board which evolved from the old farmer-controlled Meat Board and Wool Board. Existing funding will run out on April 18 next year.

“When the board meets this week, we will be looking across all current and planned activity areas to consider the implications,” said Meat and Wool New Zealand chairman, Mike Petersen. READ MORE.

NZ dairy futures taking shape

The New Zealand Herald has a story about how the first global dairy futures market being established by the New Zealand Stock Exchange (NZX) will cement the country’s position as a leader in the industry.

However, there is concern that some dairy farmers won’t be financially literate enough to use or understand how the markets work.

There are comment from NZX head of traded products, Fiona Mackenzie, Fonterra’s head of global trade, Kelvin Wickham, and Fonterra Shareholder Council chairman, Blue Read, and veteran farming leader Charlie Pedersen:

The development of the world’s first global dairy futures market could cement New Zealand’s position as an industry leader, NZX says, but there are doubts that farmers will have the financial sophistication to use it.

Sharemarket operator NZX is designing the futures platform to help world dairying players manage their risk in increasingly volatile markets. READ MORE.

Aluminium leads gain on NZ commodity prices

There’s a story on Scoop about how aluminium, wood pulp, lumber and logs posted the biggest price gains amonst New Zealand commodities in July, according to the  ANZ Commodity Price Index.

Seafood  on the other hand, posted the biggest price decline for the same month. Kiwifruit, apples, lambs and lamb skins also declined. READ MORE.

High NZ Dollar impacting meat and dairy exporters

The Otago Daily Times has a story about how the high exchange rate of the New Zealand Dollar (NZX50) is impacting on meat and dairy exporters like Fonterra and  Alliance Group in New Zealand:

The often-touted export-led recovery could be threatened by a soaring exchange rate which some economists believe could reach US69c. At 5pm yesterday, the currency was trading at US67.33c having opened at US66.99c. READ MORE.