The Pros and Cons of Speculation in Commodity Futures
The role of the speculator in commodity markets has always caused a great deal of conjecture among market regulators, policy makers, and even other market participants. I remember flying on Delta Airlines a few years ago and reading an article in the airline magazine written by Delta's CEO. At the time, oil prices were north of $100 at the time. The airline CEO wrote that high oil prices were the result of speculators pushing the price of oil higher to make paper profits at the expense of oil consumers, like Delta.
He called for policy makers and regulators to do something about the problem, as he saw it. As I sat back in my seat on the flight and pondered the words of the CEO, I realized that many who do not have a deep understanding of markets share his opinion. The word speculator has a negative connotation. However, what the article did not highlight is that a speculator is as likely to go short as long and that the speculator must eventually close a position by reversing and doing the opposite. Therefore, over the long run, this group of market participants has a zero sum effect on markets.
In the world of commodities, a speculator is a party who typically does not handle the actual physical commodity but takes a financial position (long or short) with the expectation of profit from a move in the price of the asset. Speculators tend to do their homework. They constantly monitor and analyze the fundamental and technical factors affecting the markets in which they trade.
There are various forms of speculation. A market maker, a party who shows a bid and offer price at all times, is a speculator who assumes that making a two-way price will offer the opportunity to profit or make the spread between the buy price and the sell price. An investor in commodity production is a speculator.
Consider the case of a gold miner who sinks millions into a mine with the hope of extracting gold at a cost that is lower than the market price. That investor is certainly a speculator, speculating that the investment will yield a positive return. Finally, a proprietary trader who was the likely target of the Delta CEO's wrath looks to buy at low prices and sell at high prices in a myriad of assets including commodities.
The speculator does bring something important to the table in commodities. We must remember commodities producers must sell and consumers must buy. However, often those producers do not necessarily wish to sell at times or prices that coincide with when consumers desire to buy. The presence of the speculator in the market often bridges this gap. The speculator adds liquidity to markets.
The interesting thing about the ongoing debate surrounding the pros and cons of speculation is that those who favor a curb on speculative activity in commodity markets are most vocal during bull markets when prices are on the rise. As the Delta CEO, they argue that speculators make raw materials more expensive for the ultimate buyer, the consumer, by pushing prices even higher. However, when prices move lower, the speculative presence in markets is just as strong.
As prices drop, speculative activity may temporarily push prices even lower which actually benefits consumers at the expense of producers.
The role of the speculator in commodity markets is misunderstood. In a perfect world where commodity producers could sell directly to commodity consumers at all times, there would be no need for speculators. However, the world that is far from a perfect place. Speculators add liquidity to markets and so long as they remain within regulatory rules these participants bring a great deal to commodity markets. The liquidity provided by speculators serves to grease the wheels of markets causing them to operate efficiently for all parties.
The debate about the role of speculators in markets is bound to continue. It is important to understand that the effective functioning of modern-day markets depend on this group of market participants.
After all, without liquidity everyone, producers and consumers alike, will suffer increased costs over time.