It’s the producers, stupid

By Chris Cook

For some time now the conventional wisdom has been that commodity market ‘speculators’ are to blame for current high prices across precious and base metals; in most energy markets; and of course in the sensitive agricultural commodity markets where high prices are in many countries a matter of life and death.

This has been propagated by lurid and ill-informed articles in the press – most notably ‘Daily Mail’ images of tankers full of oil moored off the UK coast. This greedy speculator myth has been taken up by politicians who have driven almost entirely useless action by US regulators in particular.

While the blame for high prices correlated across commodity markets is being firmly ascribed to greedy speculators intent on making transaction profits I do not believe that they are to blame.

QE and the Zero Bound

The US government has reduced interest rates to zero, and for good reason as the credit markets collapsed. They have also been assiduously pouring in money in order to save the US financial system through Quantitative Easing (QE) and other monetary strategies.

QE is the creation of credit (eg dollars) by Central Banks, and in the US this means the Federal Reserve Bank. This was necessary to replace the money draining out of the financial system as legions of US borrowers were unable to perform in respect of the unsustainable loans they had taken on, and had QE not happened there would have been massive defaults, and a Depression.

But a side-effect has been a huge pool of dollars roaming the global financial economy looking for a safe home, and this has reduced short term dollar interest rates on US government debt to zero.

Anything but Dollars

Investors see the Fed flooding the US financial economy with freshly created dollars and they conclude that this will mean that asset prices, and retail prices generally will rise. So if dollar interest rates are at zero what is an investor to do?

The answer is that investors are flocking to buy anything but dollars whether or not it carries an income. They firstly flocked to the traditional haven of gold, which soared in price to over 30 per ounce, but frankly this is a matter of indifference to the man in the street because he can’t eat gold, heat his house with it, fuel his car with it, or type e-mails on it.

But in recent years, facilitated by the financial services industry, new asset classes of Exchange Traded Funds (ETFs) and related ETCs and ETPs have sprung up which enable investors to invest in any commodity which is traded on an organised market. Tens of billions of dollars are therefore being invested in commodity markets through such funds or through other more exotic products.
The outcome has been that most markets: precious and base metals; energy markets except natural gas (which is an oversupplied and fragmented market); and of course many agricultural commodities; are being simultaneously financially inflated.

These markets have therefore become ‘correlated’, and move up and down at pretty much the same time. They are doing so because demand in these hugely diverse physical markets is moving in lock-step. But demand is not the same thing as consumption, and the difference lies in the ability to stockpile commodities, which is more easily achieved in some commodities than others. Metals are easy to store indefinitely, relatively inexpensively; crude oil and products less so; food commodities are bulky and perishable; while electricity is virtually impossible to store.

While China in particular is a buyer of most commodities, this is not necessarily for current consumption, but rather for future consumption, and like financial buyers they prefer spending their dollars on such hard assets to buying US T-Bills bearing zero per cent. The difference between buyers like China and purely financial buyers is that China at least has a use for the commodities.

While the purpose of physical markets is to enable ‘end user’ physical producers and consumers to transact at an agreed market price, it will be seen that in most markets that is no longer the case, since participation by risk-averse financial investors who are ‘hedging inflation’ has driven the physical price to levels at which demand dries up, because consumers can no longer afford to pay.

Cui Bono?

Who gains from high prices? The answer is obvious: producers gain from high prices, and if there is one thing that the history of commodity markets tells us it is that producers can and will attempt to maintain prices at high levels wherever possible. They do so publicly by creating cartels to support prices by stockpiling and otherwise – such as in the tin, cocoa, coffee markets in the past – or by privately manipulating prices, such as Yasuo Hamanaka’s escapades on behalf of Sumitomo over 10 years in the copper market.

While there are indeed speculators in these markets, for them it is a less than a zero sum game. Their motive is Greed, and in their search for transaction profit they may either buy first and sell later, or vice versa. While they certainly add to short term volatility, they have no medium and long term effect on market prices because they neither produce nor consume the physical commodity.

It is in fact producers, who are currently – in the finest tradition of market capitalism – dipping their bread in the economic gravy through selling at the highest possible price to risk averse financial purchasers whose motive is not Greed, but Fear.

The outcome is therefore a massive wealth transfer from consumers to producers as a result of the inflated prices in the physical market. But that’s just the way it goes when it’s the producers’ turn. When markets are over-supplied and investors are absent, then producers engage in a ‘race to the bottom’; the lowest cost producer is the last man standing; and it’s the consumers’ turn at the gravy.

The only constituency who always wins in our casino market capitalism are the casino operators: ie the exchanges, banks and brokers. Producers; consumers; speculators and traders all pay a ‘cut’ to the casino, but the problem is that on this roulette wheel there are at least half a dozen zeroes…

Re-inventing the Markets

The current generation of markets has become entirely financialised and dysfunctional, and is no longer fit for purpose. If and when interest rates rise; or investors become less fearful; or the price of commodities chokes off demand, as it did in 2008, then we shall again see commodity prices collapse to the ‘lower bound’ of over-supply. In other words, the market will transition from a ‘sellers’ market’ to a ‘buyers’ market’.

As long as dollar interest rates are at zero the demand will recover, and the market price will once again, as it has already, march up to the Top of the Hill, like the Grand Old Duke of York’s Men.

The only long term solution is to completely re-architect markets. Firstly, cutting out middlemen – which is a process already under way. Secondly, a new settlement between producer and consumer nations – a Bretton Woods II. This is not feasible unless and until commodity markets collapse from their current financially pumped-up unstable equilibrium – probably later this year. The currently triumphant and increasingly macho producers will then temporarily lose the whip hand, and at this point a sustainable market architecture may at last be achieved.