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Page added on April 23, 2011

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A Contrarian View On Commodity “Speculation”

Business

In response to the president’s moronic witch hunt of oil “traders” which, for a POTUS so set on distinguishing himself from the prior administration, was only missing the phrasing “read my lips, no more speculators” for people to suffer the biggest glitch in the matrix to date, we decided to present this note from Jared Dillian, editor of the Daily Dirtnap published back in January discussing the imminent surge in food prices, which however is just as applicable to the surge in any commodity, and most certainly crude. Dillian’s point is so simple we are not at all surprised that it is lost on all sock puppets in Washington. “I say that speculators have a very important role to play in setting commodity prices, and the very idea that we would limit the role that speculators play in commodity prices is an early signal that world food markets are about to get a good deal more unfree, which means we are about to undo all the progress we have made in the last fifty years. This is why speculators are important in setting prices. They make money. That is their job. Making money is an end in itself. But an interesting by-product of a speculator setting prices is that he forces the producers of the commodities to respond, and consequently, adjust production.” To be sure, there are always those speculators who in their pursuit of price disequilibria, through the wager of capital, will break the law, just as there are those who will commit criminal acts in every aspect of life. But for the most part, speculators operate within the confines of the law, as poorly drafted as it may be. Yet the core point remains: by pushing the clearing price substantially from the equilibrium due to excess demand (or supply) specs merely precipitate an equal and opposite reaction which promptly corrects this disequilibrium. As Dillian concludes when observing a hypothetical explosion in food prices: “Well, guess what: when prices are ten times higher, the market is going to be full of farmers, and nobody is going to complain very much about that.” Q.E.D.

Blaming speculators for price surges is beyond short sighted, especially when the proximal cause is infinite supplies of Fed produced liquidity which is merely looking for the path of least resistance to the highest possible returns. Yet it does bring up a point – while in most commodities price surges are short lived, when it comes to crude there is almost never any price elasticity to the downside. Meaing that suppliers, of whom the marginal block is a production cartel are either unwilling to, far more likely, unable to provide excess supply. Which is in line with what we have seen out of Saudi Arabia recently: instead of increasing production in March in the aftermath of Libya, Saudi came up with the most ridiculous excuse for demand destruction one could conceive, and lowered output. It is this act, in addition naturally to the excess liquidity provided by Bernanke that should be pursued by the Dynamic Duo of Obama-Holder. But to do so who distrurb the far more sensitive equilibria of the petrodollar bond producer on one hand, and, of course, the Wall Street capital base on the other. Which is why it is always easiest to blame the nameless, faceless “speculator” scapegoat. After all it worked so well for Greece which said it was all CDS traders’ fault… At least of course until Greece went banrkrupt for the first time… and then for the second time.

From Jared Dillian’s Daily Dirtnap “Food Fight”, January 2011:

Jared Dillian

You do not want to mess with food.

You know, we are not so far away from a time where we did not take food for granted. We are not so far away from a time in history when people really went hungry. Nobody goes hungry now, and I am not being exceedingly glib. We have an obesity problem, not a hunger problem. We have solved the problem of growing and delivering enough calories to everyone in the country at incredibly low prices. We have tamed agriculture, something our ancestors had been trying to do for millennia, and we can now feed everyone easily, with room to spare. To the extent that someone goes hungry in a developed country, it has to do with something else, not the production and delivery of food.

We have arrived.

Does everyone realize how incredible this is? Yes, there is still hunger in the world. But it is better. And it seems like the really, really bad famines on the planet these days are man-made (North Korea). Overpopulation? People were worried about being able to feed the planet when we were 4 billion people. Now we’re at 7 billion. To the extent that agriculture and markets are free and freely traded, there is literally no limit to what we can do.

But we go through periods of time in history when things get ugly (remember Kondratieff, he was all about agriculture), and the price of food can get very, very hairy. I am all about the prices of things getting hairy, I have said that it is going to happen to apparel (another commodity that comes out of the ground), but there is a tendency for the prices of things that had previously been dormant for decades to suddenly come alive. Do we care why this happens? Do we need to know? Or can we profit off it without knowing?

We can profit off it without knowing. But I will tell you why this happens, and it gets back to Kondratieff, K-waves happen over time because of long-term cycles in social psychology, and over periods of time, people will develop some very illiberal ideas about how food should be produced, managed, bought, sold, and distributed, ideas that, in the best case scenario, cause prices to rise, and in the worst case, severe shortages and even famines.

There is ideology in this, I admit. I remember sitting back in seventh grade social studies class and us having this in-depth discussion about how senseless it was to have a planned economy, who is omniscient enough to decide who gets what and how much to pay for it? Senseless. And this was the mid-eighties, and we knew back then that the Soviet Union and Eastern Europe was having a tough time, or at least we had a hunch, and we knew that our system provided more for more people than theirs did. That was twenty-five years ago.

But time will go by and people will start to question the very ideas which they held to be absolute truths, they see food prices starting to rise, and they say, hey, this isn’t a game, people shouldn’t be making money off of food, food is a necessity, people need food, and we shouldn’t let this vast unregulated casino going around deciding how much people who are already strapped for cash are going to be paying for bread. And it is always true in capitalism that any time you are talking about things that people need (like food and health care), those have the potential to be the least free, and the things that people really don’t need at all (like iPods), those are the goods with the really free markets. Right?

This is the age-old question in political economy (what exactly is political economy?), which is: should markets be trusted with something as precious and as sensitive as food? To which I ask, rhetorically: should government be trusted with something as precious and as sensitive as food? But we are getting ahead of ourselves.

The problem that we will be faced with imminently is the idea that speculators are making money being long certain commodities, the prices of which have doubled or so, and people are starting to get pissed. Why should somebody be turning into Richie Rich when I have to pay twice as much for a cup of coffee? Et cetera. And listen: people I respect a great deal disagree with me on this, and reasonable people can disagree on this issue, but I say that speculators have a very important role to play in setting commodity prices, and the very idea that we would limit the role that speculators play in commodity prices is an early signal that world food markets are about to get a good deal more unfree, which means we are about to undo all the progress we have made in the last fifty years.

This is why speculators are important in setting prices. They make money. That is their job. Making money is an end in itself. But an interesting by-product of a speculator setting prices is that he forces the producers of the commodities to respond, and consequently, adjust production. Let me explain.

So let’s say that a speculator thinks the price of grain is going to go up this year, and the reason he thinks that is because he is some expert on weather, he can forecast the weather better than anyone else, and this is a very lucrative skill to have. So prices right now are low, and by buying grain forward, he is causing prices to go up. Other speculators with their weather geeks are also buying grain forward in advance of nasty weather, and in doing so, they are all driving the price up.

In response, the farmers are going to plant and grow a lot more grain, because the price is higher! They are responding to price, which is a market signal. The higher the price, the bigger their eyes get, and the more they plant. And by planting more grain, they will be able to avert the weather crisis that is coming and will be able to feed everyone in the world at a reasonable price.

It’s so easy a caveman can do it.

But the idea that a speculator would make money off of someone else’s misfortune is a pretty repugnant idea for people, especially when they look around and see that the market is full of speculators. Well, guess what: when prices are ten times higher, the market is going to be full of farmers, and nobody is going to complain very much about that.

But in not allowing speculators to profit from near-term price increases, we are setting ourselves up for big-time failure, because prices are not being allowed to rise to the levels that would induce people to quit their jobs as newsletter writers and strike out to get rich as farmers. Oh, prices will get there eventually, but by limiting the role that speculators play, they will get there at the worst possible time, when people are not ready for it, and there is not going to be enough food to go around.

Most if not all of the preceding applies to oil as well.

ZeroHedge