Speculators Play a Key Role in Commodity Markets

August 2009

• It is possible the US Government will introduce legislation which would place restrictions on commodity market speculation.
• Speculators are the parties willing to accept the risk that hedgers are trying to shed.
• Fewer speculators in a market could affect the ability of hedgers to find the kinds of transactions that offer protection from adverse price movements.
• It remains to be seen whether regulators will recognize this very constructive role that speculation plays in the commodity market.

Over the last year, speculators have re-emerged as a target for those bewildered or punished by the large price fluctuations for commodities.

Until recently, the Commodity Futures Trading Commission (CFTC), the regulator of commodities trading in the US, downplayed or countered claims that speculation was the prime factor behind the rise in crude oil prices in 2008. However in the current political environment, it is now expected the CFTC will soon release a report indicating that speculation was indeed a strong factor behind the increase in prices. There is also a possibility that the US Government could soon table legislation which would restrict speculation. Depending on the nature and extent of the restrictions, other activities, whose benefits derive from speculation, could be affected, with unintended consequences.

Speculating versus investing

Speculators in financial or commodity markets can be broadly defined as market participants who perform transactions with assets in order to earn a profit from fluctuations in the price of the assets, regardless of their intrinsic or underlying value. Such participants often have no need for the asset itself.

Consequently, many activities frequently described as investing are better defined as speculating. For example, people who receive a pension rely on speculation done by the pension fund's manager. Pension fund managers have a duty to provide financial benefits to the beneficiaries and thus seek out opportunities to buy and sell assets that can best fulfill this duty. The contributions made by beneficiaries of the pension plan are often used to buy and sell stocks, bonds and other financial assets with the aim of increasing the pension fund's value and thereby the income streams due to beneficiaries. However, it is unlikely the pension plan's beneficiaries have much use for the products or services tied to the assets that are bought and sold with their contributions.

Mutual funds and exchange-traded funds also operate under comparable conditions. For example, holders of units in a resource-based exchange-traded fund have little need for the physical commodities that underlie the fund's asset mix, but rather seek to maximize capital gains by buying and selling units of the fund as the price of the underlying commodities changes.

Speculation is an important element of the market

In commodity markets, speculation is an important part of the hedging process for parties who have a strong interest in managing their commodity prices for a defined period of time.

Consider an industrial operation that consumes a large volume of natural gas. The operator of the facility faces price risk from adverse movements in the price of natural gas, and is not guided by a desire to earn profit from fluctuations in the price. A sustained but unexpected rise in natural gas prices may increase production costs to an unmanageable level. By committing to buy the commodity in the future at a price that is agreed-upon in the present, the industrial consumer has set a maximum price for future natural gas purchases and avoids potentially unfavourable budgetary effects caused by higher natural gas prices. On the other hand, the hedging counterparty must adhere to the terms of the hedge and deliver as agreed upon.

Speculators are the parties willing to accept the risk that hedgers are trying to shed. If the commonly held view is that prices will rise, most consumers will want to fix a price and most producers will want to let the price rise. Who could the consumer find that would be willing to offer a fixed price? It is the speculator who is prepared to bet against the commonly held view.

View speculation with caution, but recognize its key role

Speculation can sometimes yield undesirable results. Speculators are fallible and can incur losses because of their view of the market. In addition, speculation may cause deviations from the intrinsic value of an asset for the short-run. If the price of an asset is rising over time, speculators may be attracted to the asset and buy it with the aim of selling it in the future at an even higher price. This type of situation can lead to a "bubble", where the price climbs ever higher as demand rises. The opposite may also occur, where upon seeing the price of an asset falling over time, speculators short sell the asset in the present with the aim of buying it in the future at an even lower price. The extra selling activity could force prices down further and encourage more short-selling and a subsequent decline in price. And bubbles do burst. As evidenced this past year, the speed at which crude oil prices changed may be a very good illustration of speculative pressures working on both the upside and downside.

There is no question that speculation should be viewed with caution. To a great extent, the success of speculators depends ultimately on whether or not their market view is correct. However, fewer speculators in a market could ultimately affect the ability of hedgers to find the kinds of transactions that offer protection from adverse price movements. To this end, speculation plays a very constructive role in the commodity market. It remains to be seen whether regulators will recognize this positive role when determining any restrictions to be placed on speculating.

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