Last week the Senate released a report that concluded that non-commercial participants, particularly index speculators have been disrupting the wheat futures market (for those not inclined to read the 247-page report, there’s a good summary in this BusinessWeek article). The term, “index speculators,” refers to that new breed of market participant that treats commdodities as buy-and-hold investments rather than as short-term trading vehicles. Index speculators are often people and institutions one would not associate with speculation — endowments and pensions, for example. They generally have bought into the notion that a basket of commodities (or commodity futures) is a legitimate investment asset class; this is a view I dispute — I know of no other “investments” where the inherent value can only be realized in the consumption and destruction of the asset.
The wheat report highlights one of the dangers of “overspeculated” futures markets, a condition where non-commercial interests so outnumber commercial participants that the relationship between cash and futures prices (the “basis”) breaks down. An erratic basis in a commodity futures contract is more than a mere curiosity: it can mean that the futures markets no longer offer reliable risk mangement tools for producers and users. It’s worth remembering that these markets were never intended to serve investors, but were chartered from the begining to serve the commercial commodity industry. Dramatic shifts in the basis can also cause severe financial problems for commercial hedgers who must meet margin calls.
A spike in the cotton basis in March of last year was devastating for that industry. I’ve often thought that the cotton problem was the “canary in the coal mine,” warning us of dangers ahead. Wheat going down the same path is troubling indeed. From the standpoint of greatest economic risk, one must wonder whether crude oil is also heading in this direction. If crude oil is “overspeculated,” there’s a particular vulnerability given the geopolitical risks that can crop up with oil. My sense is that much of the oil in storage is part of a cash/futures arbitrage play which means, as I believe happened with cotton, a sudden influx of futures buying would have no natural constraints, sending futures prices soaring. With the central role energy prices play in the economy and the heavy participation in the crude oil markets by our wounded financial companies, a price disruption of this nature could have far reaching consequences.
Last year there was a great debate about the role of index and other speculators in disrupting commodity prices. Unfortunately, too much of this debate centered on the oil industry, not only one of the deepest markets, but also one of the most opaque. It’s simply hard to get the data needed to see the risks in crude. Looking at smaller markets like cotton, it is easier to grasp that treating commodity futures as investment assets can cause grave problems. Although the debate is still tainted by politics, it’s good to see that these dangers are getting the recognition they deserve.