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In Rolling Stone's The Great American Bubble Machine, Matt Taibbi accuses Goldman Sachs of inflating and exploiting a great many economic bubbles, including the commodity market for oil, which, he claimed, crippled the average consumer by driving up the price of fuels for driving and heating. I have no doubt that Goldman Sachs did their best to profit from commodities, but I wonder if Taibbi has fallen for a post hoc ergo propter hoc fallacy.
In line with Peak Oil theory, James Hamilton of Econbrowser believed that increasing demand vs peaking supply was at the core of the price increases. AFAIK, Hamilton has not yet responded to the Taibbi article, but about a year ago, in response to persistent debate about whether speculation could or would drive prices higher, he posted this article by Scott Irwin, who holds the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois.
Index Funds and Commodity Prices... Here We Go Again by Scott Irwin
[Start with] the non-controversial observation that a very large pool of speculative money has been invested in different types of commodity derivatives over the last several years. The controversial part is [the conclusion] that money flows of this size must have resulted in significant upward pressure on commodity prices, which in turn drove up energy and food prices to consumers throughout the world. This argument is conceptually flawed and reflects a fundamental and basic misunderstanding of how commodity futures and related derivatives markets actually work.
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The first and most fundamental error ... is to equate money inflows into futures and derivatives markets with demand, at least as economists define the term. Investment dollars flowing into either the long or short side of futures or derivative markets is not the same thing as demand for physical commodities. My esteemed predecessor at the University of Illinois, Tom Hieronymus , put it this way, "for every long there is a short, for everyone who thinks the price is going up there is someone who thinks it is going down, and for everyone who trades with the flow of the market, there is someone trading against it." These are zero-sum markets where all money flows must by definition net to zero. It makes as much logical sense to call the long positions of index funds new "demand" as it does to call the positions of the short side of the same contracts new "supply."
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second error is to argue that index fund investors artificially raise both futures and cash commodity prices when they only participate in futures and related derivatives markets. In the very short-run, from minutes to a few days at most, commodity prices typically are discovered in futures markets and price changes are passed from futures to cash markets. This is sensible because trading can be conducted more quickly and cheaply in futures compared to cash markets. However, equilibrium prices are ultimately determined in cash markets where buying and selling of physical commodities must reflect fundamental supply and demand forces. This is precisely why all commodity futures contracts have some type of delivery or cash settlement system to tie futures and cash market prices together.
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A third error ... is an unrealistic understanding of the trading activities of hedgers and speculators. In the standard story, hedgers are benign risk-avoiders and speculators are potentially harmful risk-seekers. This ignores nearly a century of research by Holbrook Working, Roger Gray, Tom Hieronymus, Anne Peck, and others, showing that the behavior of hedgers and speculators is actually better described as a continuum between pure risk avoidance and pure speculation. Nearly all commercial firms labeled as "hedgers" speculate on price direction and/or relative price movements, some frequently, others not as frequently. In the parlance of modern financial economics, this is described as hedgers "taking a view on the market." Just last week, when commenting on new survey results of swap dealers and index traders , the CFTC stated that, "The current data received by the CFTC classifies positions by entity (commercial versus noncommercial) and not by trading activity (speculation versus hedging). These trader classifications have grown less precise over time, as both groups may be engaging in hedging and speculative activity."
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What all this means is that the entry of index funds into commodity futures markets did not disturb a textbook equilibrium of pure risk-avoiding hedgers and pure risk-seeking speculators, but instead the funds entered a dynamic and ever changing "game" between commercial firms and speculators with various motivations and strategies. Since commercial firms have the considerable advantage of information gleaned from their far-flung cash market operations, they have traditionally dominated commodity futures markets and speculators have tended to be at a disadvantage. (If you are skeptical, I recommend reading the classic study by Michael Hartzmark about who wins and loses in futures markets.) In this light, entry of large index fund speculators has the potential to improve competition in commodity futures and derivatives markets, particularly as index funds become smarter about moving in and out of their positions.
In plain language, a commenter notes:
Folks, if you buy a futures contract at twice the price of the commodity and you can never sell it to someone else, you will receive delivery on your doorstep of what ever the commodity is and you will pay twice the price for the commodity. Not a smart move.
So as I read this, peak oilers would not claim that the futures market was not manipulated, but they would argue that the actual prices were rising more due to demand than to speculation in the futures market.
