Commodity Speculation: Krugman leaves questions unanswered

Timothy A. Wise

The debate on commodity speculation continues, generating lots of heat but not as much light as I was looking for in my last post. Paul Krugman has responded to those of us bewildered by his position, basically reiterating that because these are physical commodities speculation can only happen if there is evidence of inventory accumulation by, essentially, hoarders. He sees no evidence of that now, except maybe for cotton and copper but not for food commodities. Instead he points to real weather issues that have reduced supplies. Yves Smith, at Naked Capitalism, called his analysis flawed, but took issue not with dismissing financial speculation but rather by pointing to the many flaws in the available data on inventories.

Okay, sure, weather and imperfect information, but please: Are you two really saying that the influx of non-commercial speculative capital into futures markets has no impact on real prices, on the functioning of these markets? If it doesn’t, why bother re-regulating the commodity derivatives market, as Dodd-Frank mandated and the CFTC has proposed?

There seems to be agreement that financial (as opposed to commercial) speculators entered commodities futures markets in a big way. There also seems to be agreement that they did so through largely deregulated financial instruments. The still-unanswered question is whether all that new money simply provided added liquidity to futures markets, with no ill effects. That seems to be Krugman’s argument, because in the end it’s all about the physical commodities.

But doesn’t all that financialization make a mess of price discovery? After all, why are some of the most vocal groups that are demanding re-regulation and strict derivatives reforms the commercial hedgers themselves? Check out the Commodity Markets Oversight Coalition. To listen to Krugman, they should be thrilled that Wall Street is throwing money into their markets. From what I can tell, they’re not thrilled at all. And that makes a whole lot of sense if futures markets actually affect the decisions of economic actors in the real world. Guess what: they do, from farmers deciding what to plant to governments deciding what to buy.

Mexico recently locked in a contract on corn futures in fear of another round of tortilla riots from a future price bubble. A “panic buy?” Maybe, maybe not. Sure, Yves, it depends on whether they’re reading the inventories numbers right, and when China considers its inventories a state secret that’s a tough read. But it also depends on how reliable the price signals are in the futures market, whether rising corn futures are indeed a reliable indicator of tight supplies. Financialization can make a mess of that critical process of price discovery. And all indications are it did just that in 2008 when prices spiked and then crashed in a way quite disconnected from supply and demand.

Those were speculative, overheated markets, and I’m still waiting for some light from all that heat. Hopefully, the CFTC won’t wait and will use the available light to enact prompt derivatives reforms, as some US Senators recently urged.

15 Responses to “Commodity Speculation: Krugman leaves questions unanswered”

  1. Trader says:

    I think you are missing a key point that Krugman made.

    Commodities futures that do not result in physical delivery (i.e. 99% of commodity futures) are a zero sum game. They are created in pairs: one buy contract and one sell contract.

    Furthermore, they are time-limited: they expire on a given day within the expiry month.

    That structure limits the effects of futures on delivery prices: financial speculators may affect the price within the month (they can and do increase volatility) but they have to close their futures positions before the delivery date.

    This means that the actual physical delivery price is only set by those who take physical delivery. If you look at the monthly delivery prices you will see confirmation for this: it’s much smoother than the intra-month charts.

    If a speculator wants to manipulate the price then real physical delivery of thousands of tons of material has to be organized and tankers, silos or warehouses have to be rented and filled – and the risk of holding an actual physical commodity has to be assumed. (which, for food, is substantial: food commodities lose value with time.)

    And *that* is something that is visible in the real world: flotillas of tankers parking off the coast for months without entering harbour, tanker rent rates spiking, etc.

    Krugman stated in his article that he saw little sign of such kind of physical speculation – and he reported those kinds that he did detect.

    He may be wrong – but to make that point you have to point to tankers, warehouses, etc. – not to futures positions.

  2. tim wise says:

    Well, this then is an answer that suggests that futures prices have no impact on real prices, and therefore financial speculators have no impact on real prices either no matter how much they influence futures trends. If so, why are the commercial hedgers looking for derivatives reform? And why, beyond that, are functioning futures markets so vital to functioning commodities markets? Questions still unanswered from where I sit….

  3. Lawrence says:

    Both Morgan Stanley and Goldman Sachs have oil subsidiary companies that have been stockpiling crude oil for years now.

    The price of commodities has been rising in the past 10 years due to the increased size of investment banks’ commodity index funds. This is where traders would like to see re-regulation. It’s easy to see the trail of funds from the Money Markets into these funds when the run on the shadow banks occurred.

  4. Murray Worthy says:

    The key point here is the fact that futures markets play a price discovery role for the physical markets, giving price signals to the physical markets and being based on (theoretically) a wider pool of more informed participants. In this way no traders need to take physical delivery to move the physical price. And the issue of rising stocks only make sense if the stocks were privately held by profit-maximising individuals. In fact in many cases stocks a publicly held, designed to be used up in a time of high international prices to meet local demand.

    For a full response to Krugman’s post on speculation see:

  5. Ilene Grabel says:

    Great post Tim. I find Krugman’s take on this matter puzzling to say the least. I can almost imagine a future NYT op-ed in which he criticizes those whose ideological blinders prevented them from seeing this speculative bubble. But wait, then he’d have to criticize his own writing on the subject…

  6. Trader says:

    Tim: futures prices can be volatile, but right before delivery date they converge on the ‘real’ price, based on physical delivery intentions only – as all the financial speculation rolls over to the next month(s).

    That is why you will rarely see the kind of volatility in delivery prices that you can see in futures prices.

    Furthermore, those firms taking real delivery do their math well and can sort financial effects in futures from physical supply/demand effects. If then they profit from the speculators.

    Physical prices can be manipulated – but that requires physical buffering: tankers, silos, warehouses – which activity is highly visible in the real world. You cannot easily hide a few hundred supertankers and you cannot store millions of tons of grain without that being fairly obvious.

    And yes, such kinds of extreme levels of physical speculation would be required to explain the very significant price movements in these markets …

    Just watch how cheap WTI crude is these days. Don’t you think Wall Street billions would be driving up the prices in Cushing, if it was possible via the futures market only?

  7. Timothy A. Wise says:

    Drawing the distinction between the physical and futures markets is certainly valid and important, but it doesn’t really explain the role of the latter in price discovery for the former. And it certainly doesn’t address whether financial speculators have overwhelmed or distorted those futures markets. Many people point to “price convergence” at the delivery point, but we have seen recent evidence of prices not converging, as explained in an earlier post on wheat by Steve Suppan:
    In that case, a Senate investigation concluded that financial speculators had distorted markets:
    Steve also cites a study from Better Markets, Inc. that points out the flaws in one of the main studies claiming there was no connection between financial speculation and real price rises:
    Again, I would reiterate that the question is not whether financial speculation has contributed to food price volatility but how, and how much?

  8. ozprof says:

    Tim: the question is, what is the mechanism by which derivatives markets affect real commodity prices? Let’s say I enter into a futures contract to buy a barrel of oil for $200. Someone must agree to sell me that contract (willing sellers will be easy to find). But unless I am really wiling to pay $200 for a barrel of oil I will unwind the contract before the delivery date. Those people hoping to sell me oil for $200 a barrel will see that demand disappear. The only way I can affect the real commodity price is by taking delivery. Krugman’s point is that there’s no evidence of speculators taking delivery.

  9. tim wise says:

    We all agree: futures markets are not the same as physical commodities markets. No one needs to educate me about the difference, nor defend the point Krugman is making that physical hoarding is speculation and that this relates to supply, demand, and inventories. That is not the question here. The question is: what is the relationship between the futures market and the physical market? Do futures markets have any impact at all on the functioning of physical markets? To listen to these explanations, the answer is no. But that’s ludicrous. Futures markets have played a key role in price discovery and market functioning for a long time. Do they affect real prices? Of course. An anticipated shortage is not the same as a real shortage of a commodity, and herd behavior can rule in these markets just as it does in financial markets. And when the commercial traders are no longer the main ones doing the hedging, and when the hedging is based on a basket of commodities in which oil is the primary driver, herd behavior can drive prices all over the place, and price discovery completely out of whack. Does that affect real commodity prices? Did Mexico buy corn futures on the basis of a real or an anticipated shortage? Sound price signals from the futures market or speculative noise? Who would know? But you can bet those price signals are telling farmers to plant more corn this year, even if the shortage ends up being in petroleum.

  10. Commodity ETFs have made it even easier to speculate. And since the ETFs do not expire,
    longs can lock up a commodity for a very long time. In my opinion, until excess speculation in foods is curbed, the bubbles will only keep occurring. No one should starve because of Wall Street greed.

  11. HesseH says:

    I agree 100 % that the question is that what is the relationship between the futures market and the physical market? Therefoire, one should be carefull when stating that the “speculators” are the reason behind the problem. They are a good scapegoat.

    “If it doesn’t, why bother re-regulating the commodity derivatives market, as Dodd-Frank mandated and the CFTC has proposed?” This is not a valid arguement. Dodd-Frank mandate / CFTC can be a result of power politics and not of carefully studying the issue.

    I believe that this is a supply & demand problem where both sides are inelastic at the moment …

  12. Nimrod says:


    Both sides need not be inelastic at all. All that would need to happen is for producers and consumers alike to believe in the futures market and use it for spot pricing, then both the supply and demand curves would move up (price goes up) while the equilibrium quantity remains fixed.

    This is exactly what happens in the real world. In the regime of totally opaque pricing, people do not “assert” prices by changing the quantities they produce or consume, they “take” prices based on the quantities they have always been using. Dominating financial speculation and extreme volatility have made everybody on the spot market a reluctant price “taker.”

  13. Nimrod says:

    Basically, Krugman makes a really dumb mistake by assuming that supply and demand curves don’t change.

  14. Luis Kruer says:

    Throughout the grand scheme of things you’ll receive a B+ just for effort and hard work. Where exactly you actually lost us was on your specifics. You know, they say, the devil is in the details… And it couldn’t be much more accurate at this point. Having said that, allow me reveal to you what did give good results. The writing is certainly quite persuasive and that is probably why I am taking the effort to comment. I do not make it a regular habit of doing that. Next, although I can easily see the leaps in logic you come up with, I am not really confident of how you seem to unite the details which make the conclusion. For the moment I will subscribe to your point but trust in the foreseeable future you link the dots better.

  15. Ada Poeppel says:

    good Kharma keeps the wheel turning…