TAMING COMMODITIES, DEFLATING A BIT THE OIL BUBBLE...

A FIX FOR THE COMMODITY FUTURES' MARKET.

06/22/08

Conservatives cling to the belief of the eternal return of the same. In particular they hope that sweet crude oil will always gush just the same, in the clear blue, unpolluted sky. In their world there is no greenhouse, temperatures are perfect always, glaciers stay put, and crude oil will always gush out, it's just a matter of drilling some more. So, as stratospheric oil prices threaten, US conservatives and market suspicious French illiberals have joined in a chorus accusing the commodities markets and their futures of having driven the price up by speculation.

This is partly silly: most biospheric and geological resources are limited. Once used up, that's it. They don't come back. A lot of the run up in commodities is driven by scarcity. Not only is the world's population quintupling in one lifetime, but the resource usage per person has skyrocketed, whereas the energy technology has stagnated. Nevertheless, there is something to the cries heard around the world to limit leveraged speculation in some crucial commodities.

The Futures Market was created in the US Middle West as a form of insurance for farmers. A very high leverage allowed them to afford such insurance at a cost much smaller than the cost of producing the commodity (as it should, because producing the commodity is their main social contribution on planet Earth). This is why a leverage as high as 1 to 7 are entirely justified, for such producers.

For example, if a farmer invested enormously in his crops, his work, his planting, his fertilizers, and his employees, he could still break even in case of a catastrophic flood, drought, or collapse of prices, by selling the market short, because his financial gain would compensate for his losses in agriculture, if any. The same reasoning holds for the producers of other commodities; the futures' market in that commodity insure them handsomely. So far, so good.

But now investors not connected to the commodities can invest in them. This provides "liquidity", and that's OK. This trading by investors exterior to the underlying business profits a bit the commodity producers themselves, because, knowing the business better, the latter can trade more cogently. But those "exterior" investors (to use a neologism) can use the same outrageous leverage as the producers, although they do not have the justification to the world community that they are insuring an underlying business profitable to the world (as the commodity producers do).

The sweet crude oil market, and the related (in two ways) grain markets are long term bull markets (scarcity and populations going up).

For example, everything indicates that we have passed (sweet crude) peak oil. Oil sands (1% of world oil production in 2008, expected to go to 3% in 2020) and (utopian) shale oils present huge pollution and extraction problems. A strike against mighty Iran would immediately cut off 25% of the world oil supply (by closing the straight of Ormuz), propelling oil towards $300. Using huge leverage in such mostly one way bull markets is spectacular for speculators. And relatively safe for them to do. Thus the leverage contributes to the spiking of the prices (since we are after peak oil, Saudi Arabia cannot quickly add a million barrels of oil a day, to collapse the price, as it did in the past; half a million in six months has been more like it).

So the solution is plain and simple: allow leverage in the futures market for producers, as it is now, and make it illegal, or at least reduce it, for investors who are not producers of the underlying commodity.

On a more general note, let's point out this. Access to extreme leverage has ballooned up financial sectors, making them obese and unhealthy (this can be quantified by looking at the market capitalization of financials versus other parts of the economy, especially in the UK and the US, and is so obvious that it is not a matter of debate). The financial sectors need to exercise, and go on a diet! The time has come for them to shrink and go back to their proper roles, as servants of the most serious trades. Exaggerated leverage has made rich money manipulators around the world much richer. Investment banks in the US (some now bankrupt) have used leverage of 1 to 33 (!). Hedge funds have gaily leveraged completely illiquid assets the value of which cannot be ascertained (on the book, in the trillions, in practice, nothing much). This has caused instability to the world financial system, and from there to its economy, and now its food intake. It's time to put the house in order, and deleverage (the market is doing this quickly, but worldwide laws should be enacted to avoid a repeat, and punishment should be administered, because a lot of these activities were a form of organized crime).

Patrice Ayme

http://patriceayme.com/