Market Distortions Demand Reform
March 12, 2009 Demand for commodities from speculative investment vehicles was a double-edged sword. On one side, it created higher than average price levels as vast pools of money flooded into commodity markets ill-equipped to handle the increased order flow without a price reaction. On the other side, the money flow created a divergence between futures and the underlying cash values, resulting in cash flow problems for bona-fide hedgers as they could no longer rely on futures as a representative market-oriented hedge. As an unexpected outcome, producers were unable to capture much of the price increases seen during the commodity bubble due to the reluctance of hedgers to put on forward positions that required deferred hedges in these new questionable futures markets. In short, the market didn’t work for the actual commodity players; it worked for the financial investors.
Investment funds were increasingly dissatisfied with returns coming from global stock markets. Fund managers looked for alternate investment opportunities across the world, hoping to find more favorable returns than equity investments had provided. With the boom in China, commodities became the new hot topic. Thousands of commodity funds popped up seemingly overnight, throwing billions of dollars of financial market money into the much smaller commodity markets.
Index traders piled on higher cotton positions, driving the futures market higher, even though the U.S. cotton stocks mounted.
Recession Means Lower Demand
Then the onslaught of the global recession minimized physical demand. Bubbles popped and markets traded significantly lower. Speculative money fled in huge amounts. The resource scare created by the “Food for Fuel” convergence of agriculture and energy was no longer an immediate concern. In cotton, producers harvesting their crops were met with some of the lowest cash prices they had seen in modern history. According to the futures market, the value of cotton fell over 60% in only six months. Clearly futures were representing the demand created by money, not the true commodity demand.
The idea of allowing unlimited index positions with unlimited money to invest in commodity markets designed to handle physical flows instead of financial flows is a formula for failure. Price discovery becomes meaningless. Money drives values instead of commodity supply and demand driving values. 2008 was a clear case in point. Cotton stocks were accumulating to levels not seen for decades, yet prices rallied close to post-Civil War highs. The disconnect was obvious. Cotton firms had difficulty obtaining the financial resources required to hold their positions against the rally created by the flow of funds. At the same time, the price signals being sent to producers and consumers were false. Producers and consumers of the commodity itself no longer knew what its real value was.
The commodity industry finds itself in the middle of distorted prices and meaningless relationships between futures and cash. Money flowing into the market creates excessively high prices. The subsequent and rapid departure of that money creates excessively low prices. Conspicuously absent throughout the process is a discussion of the underlying fundamentals.
Index traders left cotton positions as prices fell to below loan levels.
There is one clear answer to correct these market distortions and return commodity markets to their true physical value representations; regulators must change the current structure. Commodity futures markets cannot allow hedge exemptions for any entity that is not a bona-fide hedger of the physical commodity itself. This requirement keeps the price structure oriented around the value of the commodity, and it prevents funds with unlimited money from moving commodity prices around at will. In the end, the futures markets will be able to represent true commodity market risks, values and forecasts over time as opposed to fabricated spot demand created by excessive speculative positions. Simply put, position limits must apply to all players outside of the true physical hedger, period, regardless of their financial size. There is no such thing as an investor’s right to access markets beyond acceptable position limits.
As we move forward, the need for efficient markets around the world will be essential. The tremendous changes in commodity demand created by energy concerns will not disappear. In any year, a given commodity might require more or less planted acreage than the previous year. If that market loses its ability to represent the underlying commodity’s value through its futures prices, the world will not get the appropriate signals and will therefore react incorrectly. Producers and consumers attempting to navigate their businesses through volatile times simply cannot afford to have inaccurate price discovery. A failure on either side could prove disastrous.
Economics teaches us that when we cooperate in trade, the benefits of employing competitive advantage create greater opportunities for everyone. Efficiently functioning markets through regulatory reform is vital to exploiting that synergy.
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