Commodities are on a tear, but speculation is not to blame.
The front page story that is making the rounds is that speculation is the demon that is responsible for driving up commodity prices.
There are two questions that need to be answered with regard to this story, as far as our investments in commodity stocks are concerned. First, there is the matter of whether or not the story is true. If the story is true, then investments in commodity stocks need to be re-thought. Second, regardless of the story’s validity, it undoubtedly has legs (speculators are an easy target). So the question becomes what do you do about the fallout?
In this post I’m going to concentrate on the first question. Is speculation driving commodity price appreciation?
To put it bluntly, I think the idea is a bunch of hooey. My argument is based on five points:
- Commodities have been mostly in backwardation. This has been the main argument of Donald Coxe. Backwardation refers to the situation where the future commodity price is lower then the spot price. Speculators buy out-month contracts because they do not want to be stuck with the delivery of the commodity. They sell those contracts as they come close to maturity, sometimes rolling over their position into a new out-month contract. If speculators were a driving force, you would expect out-month commodity contracts to be at higher prices than spot prices. For the vast majority of the last four year bull market in commodities, this has not been the case. Even today, while the 2016 contract is higher then the spot price, the 2010 contract is not.
- Commodities that are not on an exchange are the most impressive of all. The prices of potash, iron ore, steel, and coal have all increased more than more talked-about commodities such as copper, oil or wheat. Yet all four of these commodities are priced from negotiated contracts. There is no mechanism for speculation. Can it be considered a coincidence that so many non-exchange traded commodities are trading at such high levels along with the supposedly speculator driven exchange traded ones?
- Inventories remain low. I have written about this on enough occasions already, as it has been a large part of the thesis behind investing in base metal, agriculture and oil stocks. Inventories have been drawn down over the past five to six years. The supply response in many commodities has been muted. Grain inventories remain at decade-low levels. Base metal inventories remain at extremely low levels. Even woeful commodities like zinc have inventories that are fractions of what they have been historically. Ultra-low imports of LNG (liquid natural gas) in the United States demonstrate that the global supply of natural gas is not adequate for the demand.
- The demand is there. Shipping rates remain at all time highs. If you listen to the dry-bulk shippers, there is no sign of a slowdown. Figures coming out of China have not suggested a slowdown. Figures out of Brazil suggest that shipments of raw materials are, if anything, picking up. Keep in mind that we are now nine months into an OECD downturn and we still don’t see a significant demand slowdown in energy, base metals or agricultural products. The evidence is that commodities are being shipped, not hoarded.
- When commodities have gone into surplus, the price falls. Zinc, lead, nickel, and natural gas all provide examples of this. In each case, there was a large price increase as demand outstripped supply and as inventories became drawn down to critical levels. This caused demand destruction and a supply response, resulting in a downward re-pricing of the commodity. This is how a market is supposed to work. It is evidence of supply and demand dynamics playing out in both directions. Speculators may have exaggerated each move up and down, but that is their purpose. The exaggerations create incentive for a response. If there is no response, then the move was not exaggerated.
To think that speculation is the cause of the rise in commodity prices is just not reasonable. There are too many inconsistencies in the story, as evidenced above.
I have no doubt that speculation has played a part in creating both higher highs and lower lows. As I have already said, that is the purpose of speculation. Speculation creates temporary excesses which induce a supply response and demand destruction. That is healthy. But to suggest that commodity prices are primarily rising as a result of speculation, well it just doesn’t fit the data.
To read more work by liverless, visit his blog at Reminiscences of a Stock Blogger.
This article was written by a member of the Stockhouse community.
