Overbought commodity futures markets may be the next source of excitement for investors and economists. They also may make conditions even more problematic for households. The problem is that no one, even the most experienced and insightful commodity analysts, really knows what will happen or when. Congress is suspicious and is holding hearings, but pretty clearly does not know what to do.
There is irony in the renewed focus on futures markets. We live in the era of derivatives. A derivative is a financial instrument, the characteristics and value of which depend on the characteristics and value of an underlying security.
A share of stock is a fraction of the ownership of a corporation. An option to buy stock is a derivative that gives the purchaser the right, but not the responsibility, of buying a share of stock at a specified price during a specified period.
Mortgage-backed bonds derive their value from a package of home mortgages. Credit default swaps are derivatives tied to whether principal and interest payments on a particular bond are made as promised.
Commodity futures contracts are the granddaddies of all derivatives. In common use in Amsterdam, Antwerp and Milan more than 400 years ago, their value is tied to the sale or purchase of some physical commodity like grain, metal or oil.
Modern futures contracts involve three parties. One agrees to deliver a quantity of some physical commodity like wheat, copper or crude oil for some agreed-upon price at some specified future period. Another agrees to accept delivery and pay for the commodity at the same terms.
Finally, there is the clearinghouse of some futures exchange like the Chicago Board of Trade. The buyer and seller don’t deal with each other directly. Each deals with the exchange, and if either buyer or seller defaults, it is the clearinghouse that must enforce the contract and bear any loss.
Such losses are rare since both buyer and seller must deposit a sum of money, called “margin,” that covers the exchange’s loss should someone fail to do what they contracted to.
Futures contracts allow producers, say wheat farmers or a company with oil wells, to protect themselves against drops in price. They allow users, say a flour mill or refinery, to protect themselves against price increases. These parties seeking to reduce risk are termed “hedgers.”
There also are speculators, not engaged in the underlying business, who contract to buy or sell and hope to make money by prices moving in their favor. If you contract to buy corn this fall for $5 and it turns out you can sell for $6, you just made $1. If you contract to sell for $5 and you can buy for $4, you also made a buck. Of course, if prices move in the opposite direction, you lose.
Speculators add liquidity to markets, making it easier for hedgers to find a willing buyer or seller whenever they need one. They also fill mismatches when the number of hedgers seeking protection against price drops is not equal to those who want coverage against price increases.
Depending on their perceptions of market conditions, speculators may bet on prices moving either down or up.
In addition to basic futures contracts, there are options on such contracts. That is, one can purchase the right, but not the obligation, to buy or sell a commodity at a specified price and time. And nowadays, speculators and hedgers can buy an entirely synthetic derivative: price indexes based on commodity prices.
That is where new money, in all likelihood entirely speculative, is piling in. One expert testifying before Congress estimated that investment in such commodity indexes rose from $13 billion five years ago to $260 billion this year. Does a twentyfold increase in five years bring the word “bubble” to anyone’s mind?
Another estimated that the increase in demand for oil futures is about equal to China’s increase in demand for oil itself. Growing Chinese energy consumption often is cited as a fundamental factor driving higher oil prices.
Eventually, we also will know just how important investor bets on rising commodity prices are in pushing up grain, metal and oil prices. Right now no one really knows. If we could count on any speculative bubble deflating quietly and safely, there would be no cause for concern.
Because of margin requirements, there is little risk any futures market like the Chicago Board of Trade will go broke. However, there are large risks that some investment bank or highly leveraged hedge fund might. And at this juncture, there is little Congress or any regulatory agency can do to bring about a soft landing.
In a year we will know if there really was a commodities bubble or not. In the meantime, don’t jump at loud noises.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.