Riding the Commodities Roller Coaster: Look, Ma, no hands!

Jayati Ghosh

Ma, why do we have futures markets?

We have them because there are all sorts of goods that people know that they will need to buy or sell in the future, say six months from now, and they want to be sure they can buy them at a certain price. Economists call this “hedging” against the risk that the price can change in a way that you may not be prepared for.

Which kinds of goods are these?

There can be futures markets in almost anything. They first started with agricultural commodities like rice and wheat, because no one could know exactly what the harvest would be like and so it helped some people to choose a price to buy or sell at in advance. Now futures markets cover not just agricultural commodities but also minerals and oil and metals, and also lots of other goods. And even some services!

So these futures markets stabilize prices?

Well, they are supposed to do that, but recently they have been very volatile, and have fluctuated even more than “spot” prices, especially for primary commodities. The price variations have really increased madly in the past four years. And funnily enough they seem to have moved together across all sorts of commodities that are not so connected, rising sharply and then falling sharply and then rising again to their highest levels. In the past month they have been falling again.

But why should that happen?

One way this can happen is if speculators are more important in these markets than those who are actually interested in dealing with the commodities. Financial deregulation has allowed “index traders” and other financial investors to hold futures contracts, and these are much more important in influencing price changes.

But don’t these price changes in commodities reflect real changes in demand and supply?

Actually the recent price changes are almost impossible to trace to demand and supply. Price fluctuations have been so large and rapid that they cannot be explained by aggregate real movements, which move more slowly. There may be underlying perceptions of longer term changes, but rumour is much more likely to play a role – and that has worked especially in the futures markets.

So why do traders enter these markets?

Some players in these markets are certainly still trying to hedge against risk, but others may actually profit from volatility, as the markets are driven by speculative activity. Recently this has been made even worse by high frequency trading based on computers following algorithms that just keep shifting money around. There are some estimates that this is now as much as up to 20 per cent of the futures trading in many agricultural commodities, 25 per cent of the trading in metals and 30 per cent in energy futures markets. Such activity benefits from volatile prices rather than stable prices that only reflect real changes in demand and supply.

Why don’t we just prevent the financial speculators from entering these markets?

While the role of speculation seems undeniable, there are empirical disputes about this, with different studies using econometric methods to come to opposite conclusions! Partly because of this empirical debate, effective legislation has been delayed – which is convenient for speculators. The Dodd-Frank Act in the US has rules (like trading only on regulated exchanges with rules like position limits) that try to curb such activity. The European Union is still working on its law. The G20 has a working group specifically to examine this issue. But even with regulation,  a lot depends on how these laws are implemented – the rules could be so watered down that they are meaningless.

What do people who are trying to hedge against the future do now?

This has actually become much more difficult to do. First, the volatility makes it more expensive for genuine traders to take part in futures contracts on regulated exchanges, because they have to post large amounts of money as collateral on futures contracts. Second, the volatility makes it harder for them to use the futures market as any kind of reliable guide to prices, or what is known as the “price discovery” function. Third, buyers and sellers of the commodity can no longer use the futures market as a way to ensure against price swings in the spot market. More and more companies are turning to other ways to manage price risk, such as long-term arrangements with particular suppliers or buyers. This means that those who are supposed to benefit from futures markets, like farmers or grain dealers or petroleum companies or purchasers of aviation fuel and so on, are not really able to use them for that purpose any more.

So Ma, why do we have futures markets?

Read more of Triple Crisis Blog’s discussion of financial speculation in commodities markets.