There is a discussion going on in the media about whether, and if yes to what extent, the current boom in commodities (both soft and hard, that is, raw materials and grains), is driven by speculation. Once again, a bit of simple economics goes a long way in explaining.
As ever, the best place to start is to try to reduce a complex situation into a few manageable ‘stylized facts‘. Here they are:
- Yes, there is a boom in most commodity prices going on
- Yes, hedgefunds have been involved, that is, there is a good deal of speculation. This is indeed true. Since the credit crisis, money has been flowing out of other securities like shares and bonds, and is looking for opportunities. It is noticeable on the exchanges where these commodities are traded (like the Chicago Mercantile), there is a marked increase in contracts that are not exercised, that is, are pure speculation (futures contract for a purpose not to secure the supply of a certain amount of a commodity at a certain date and price)
- There seems to be quite a good correlation between the acceleration of the increase in commodity prices and the increase in interest by speculators (the last six months or so)
Now, these facts alone have led people to conclude that there must be a relation between the two. However, there has also been fundamental trends at work:
- The world population grows and is getting richer, apart from needing more raw materials (hard commodities) it also causes a shift towards the consumption of meat, which requires eight times more grains to produce the same amount of calories
- China alone has been responsible for 40% of the growth in oil imports between 2000 and 2004, for instance.
And there are some temporary things going on like bad weather (in India and Australia) spoiling harvests, low inventories in certain commodities and a falling dollar.
Now, how to sort out the structural from the temporal and speculation? First some economics. The fact that the prices of most commodities can fluctuate so much has to do with two crucial ingredients:
- The supply elasticity, especially in the short-term, is very low. This means that even substantial price rises will not increase the supply of a particular commodity by a whole lot. The reasons have to do with the fact that it is difficult to produce more in the short-term.
- The demand elasticity, especially in the short-term, is also very low. This means that even substantial price rises will not reduce demand for most of these commodities by a whole lot. People still got to eat, cars and electricity centrals still need fuel, even if the price has doubled.
These low elasticities mean that supply and demand do not react much to changes in prices, but it also means that any change in supply or demand, will result in pretty exaggerated price moves, as both the supply and demand curves are near vertical, any even small shift in one of them will result in a hefty price change.
So, it seems entirely possible for speculators to influence the price, as they exert added demand, and with supply being very inelastic, this must result in significant price rises, right?
Well, not necessarily. The point is, does speculation exert added demand for commodities? That question is actually quite a bit more complex than might seem at first hand, as the basic fact stand that speculators rarely (if ever) execute the futures contracts they take position in.
They are not actually buying the stuff. They close the positions or sell it to someone who actually wants the stuff to be delivered, which is real demand. That this ‘real’ demand was already there cannot be in doubt, because without the speculators, this person or institution would have had to pay less.
An indicator for this is that future prices are above spot prices in most commodities. Now, having said that, there probably is still some price increasing effect from speculators, but this is limited, as they do not really alter the fundamental supply and demand equation.
And, since these elasticities are higher in the longer-term, even this limited ability to influence the price wanes over time. The more time buyers and suppliers have to adjust to higher prices, the more marked that adjustment will be.
An example: oil has indeed shot up in price in a most spectacular fashion. And in the short-term, there are few alternatives for oil, which is why demand hasn’t reacted a lot. But reacting it is, even now. That famed American driver has actually cut back in driving, by over 4% in relation to last year.
Now, that figure is probably an overestimation of the demand elasticity, because there are other factors at work limiting driving (the weaker economic conditions, for instance). But the fact remains, people respond to higher prices.
And over time, alternatives to oil become more viable (like solar energy), or people will be more efficient with energy, using more efficient lighting and cars, isolating houses, etc. The market respond in myriad ways to changes in prices.
It has been calculated that an oil price of $200 per barrel will decrease oil consumption by 10M barrels a day (based on a price elasticity of 16%). Unless speculators buy these up (they could do that for a couple of days at most), or OPEC will drastically decrease production, this will almost certainly lead to a price collapse.
So it’s fundamentals that are likely to be far more important. Speculators ride on the train, but they do not really alter fundamental supply and demand conditions, and even if they do, it’s not going to last.