REVISITING SPECULATIVE COMMODITY BUBBLES

In June of 2008 Goldman Sachs released a research report titled “Speculators, Index Investors, and Commodity Prices”.  The report was intended to defend the growing role of speculators and “investors” in the commodities markets. If you’ll recall, it was around this time that many were wondering whether there wasn’t an irrational exuberance in the commodity space that was being largely driven by irrational participants.  Goldman, being one of the larger participants, defended their role in the markets and concluded that speculators were not driving prices beyond their fundamentals and that there was no evidence of a bubble in the commodity markets.  A single question and answer from the June 2008 paper succinctly summarized their position at the time:

“Q12: How do we know if fundamentals support prices at these levels, or how do we know this isn’t a speculative bubble?

A: If commodity futures price were too high relative to the underlying supply and demand fundamentals, we would expect to observe large inventory builds, which we do not observe.

The simplest way to address the question of whether the underlying supply and demand fundamentals support prices at these high levels is to ask what would happen if they did not. Suppose commodity prices were too high, then we would expect to see those high commodity prices curbing demand too much, bringing too much supply to the physical market and the resulting excess of supply over demand generating a large build in the physical commodity inventories. Consequently, increasing physical commodity inventories would be the main indicator that current prices are not supported by current fundamentals. The fact that across the commodity markets, we are not observing anything approaching sustained growth in physical inventory indicates that current prices are supported by supply and demand fundamentals.

Therefore, we find the concerns that commodity markets are in the midst of a speculative bubble unwarranted. Physical commodity inventories are not growing, and in fact remain near the bottom of the historical range for many commodities. Net speculative length in the petroleum futures markets has not increased significantly since 2004, even as WTI crude oil prices have risen from $40/bbl to near $140/bbl. In sum, the commodity markets are not behaving in a way that a speculative bubble would suggest.“ (emphasis added)

In retrospect, it’s clear that there were distortions in the commodity markets and that fundamentals were nowhere near in-line with actual market prices.  Speculators and irrational market participants were clearly helping to drive prices on both the way up and the dramatic way down in 2008.  Goldman later backed down from their 2008 comments admitting that speculators did indeed contribute to the speculative run-up:

“Conversely, speculators bring fundamental views and information to the market, impacting physical supply management and facilitating price discovery. As a result, speculators have a loose relationship with price. In other words, as speculators buy, prices generally tend to rise, and vice versa. Accordingly, speculators also contributed to the extreme price movements over the last two years. For example, new data suggests that speculators increased the price of oil by $9.50/bbl on average during the 2008 run-up. Thus, speculators exacerbated the volatility that was nonetheless rooted in the fundamental imbalance.” (emphasis added)

With a generally weak global economy and surging commodity prices I wonder if we aren’t beginning to experience shades of 2008.  I fear Wall Street is having a far more negative impact on commodity prices than even Goldman is willing to let on.  Since the crash of the Nasdaq bubble investors have found commodities as a reliable alternative to equities despite the asset classes poor historical performance.  This non-correlated asset class has become the perfect sales product for Wall Street.  Over the last 10 years Barclays says the investor class allocation towards commodities has increased from $6 billion to $320 billion and that’s excluding hedge funds.

This looks to me like one more case of the mass financialization of our economy getting out of control.  In their effort to generate profits Wall Street has created a new financial product that is more readily accessible to the public.  In doing so they have increased the number of players who provide no real service to the industry, but merely shift paper from one pocket to another.  This problem is prevalent across most financial markets these days as more and more college educated people decide that it’s easier to make a living sitting in front of a computer than it is to try to generate real wealth through productive hard work. Flipping shares of Apple Corporation back and forth (though largely unproductive), however, is far different from flipping oil contracts back and forth.  The latter has very real impacts on the global economy and if, as Goldman finds, speculators are substantially exacerbating the price of commodities for their personal gain (at the expense of the rest of us) then we have to begin asking ourselves if this mass financialization isn’t getting out of hand.

I am the first person in the world to defend free market speculation, however, there must remain a real market underneath this speculation.  Speculation, no doubt, has very real benefits, but ultimately, there is a fundamental purpose behind the existence of shares of Apple and contracts of oil.  They represent the real wealth of the economy, the hardwork that men and women put into the economy and the productivity of the global economy.  If the world reaches a point where people are merely shifting pieces of paper amongst eachother as opposed to using commodities and markets to generate real wealth then the global economy has a very serious problem on its hands.  I fear we may already be reaching this critical juncture and the turmoil of the last few years is exhibit A.

Unfortunately, the people who have a vested interest in the perpetual growth of the financialization of the global economy have convinced the world’s leaders that what’s good for markets is good for the world.  The deregulated markets have become too powerful for their own good.  Even worse, we are still influenced by the failed theories of men like Alan Greenspan and Milton Friedman who helped build this behemoth on the ideas that markets are self regulating and always working in the best interests of the global economy.  But as I often say, markets are made up of irrational participants and irrational participants require boundaries that ensure they do not cause systemic problems.  As the bubble in commodities re-emerges and the “Bernanke Put” becomes increasingly impactful it is likely that the imbalances in this financialized USA will once again cause turmoil.

Unfortunately, it is now abundantly clear that it will take a crisis far larger than 2008 to reach through to the people who can actually enact change.   For the sake of us all let’s hope that Milton was more right than I have come to believe and that markets self regulate before they self destruct.