The Pros and Cons of Speculation in Commodity Futures

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The role of the speculator in commodity markets has always caused a great deal of debate among market regulators, policymakers, and even other market participants. The word speculator has a negative connotation. But this is often due to being misunderstood.

Learn more about speculators, how they work, and their pros and cons.

Key Takeaways

  • Speculators take a long or short position in anticipation of profit based on how they think the asset will be priced.
  • Speculators bring liquidity to the market; some investors and other stakeholders believe they cause damage to the financial interests of consumers or companies.
  • While speculators don't make or break the market, they do help keep it going with their activities.

What Are Speculators?

In the world of commodities, a speculator is a party who most often does not handle the actual physical commodity. Instead, they take a financial position (long or short) with the expectation of profit from a move in the price of the asset.

Important

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 is a party who shows a bid and an offer price at all times. This is a type of speculator who makes an assumption: 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. Let's say they sink millions into a mine with the hope of extracting gold at a cost that is lower than the market price. They are certainly a speculator, speculating that the investment will yield a positive return.

Finally, a proprietary trader may look to buy at low prices and sell at high prices in a myriad of assets; this could include commodities.

What Impact Do Speculators Have?

Here's a story about Paul Jacobson, who was the senior vice president of finance for Delta Airlines. Years ago, he shared an opinion on speculators. In an interview, he said 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. He called for policymakers and regulators to do something about the problem, as he saw it. 

Here's what Jacobson's article did not highlight: A speculator can take both long or short positions in the market. The speculator must eventually close out their position either way by selling longs and buying back shorts. Over the long run, this group of market participants has a zero-sum effect on markets.

What Are the Advantages?

The speculator does bring something important to the table in commodities. We must remember ​commodities producers must sell and consumers must buy. But 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.

What Are the Disadvantages?

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.

Some have argued 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 Bottom Line

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 is far from a perfect place. Speculators add liquidity to markets. So, as 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. This causes 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 depends on this group of market participants. After all, without liquidity, everyone—producers and consumers alike—will suffer increased costs over time.

The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future performance. Investing involves risk, including the possible loss of principal.

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