Apparently Congress, the members of the press and other “important people” have decided that a host of commodity prices need “reform,” despite investigations that revealed no instances of market manipulation. It seems that they think the markets are wrong in the pricing of crude oil, just as they thought the ultra high price of wheat in early 2008 was wrong. This is similar to the tunnel vision that health care reformers seem to be exhibiting. They won’t acknowledge that the US offers some of the best medical service in the world. Their only concern appears to be the cost and availability for people who can’t afford coverage.
With the Congress and new administration’s focus turning toward commodities, one should not think for a moment that the goal is to end market manipulation. The goal is affordability and lower prices. In the wheat market run-up of 2008, special interest groups claimed that high prices were not a reflection of market fundamentals. But you know what? Eventually those “irrational” prices brought an explosion in global wheat production, and prices came back down. An important signal was sent when prices ran up. It said, “Produce more!”
Apparently seeing $140 per barrel oil in 2008, a subsequent decline back to $32 and now a rally back to $73 suggests to some that the energy market is malfunctioning. Clearly oil markets are volatile, but other forces beside “speculation” are at work. In 2007 China and India’s demand was growing at unprecedented levels, and last year China was building stocks ahead of hosting the Olympics. Oil production was running above consumption in 2008 but it fell short of consumption in 2007 and is expected to do so again in 2009 (EIA estimates). China and India are still seeing strong long-term growth potential. Furthermore, a large number of governments and or quasi government agencies are building massive strategic reserves. So even if the oil is not being consumed, it is being set aside, and that is keeping it off the market.
As in the 2008 wheat market analysis, the market reformers think that a few bearish physical supply side fundamentals should have prevented oil prices from rebounding. (Despite the “hope” and “wishes” that green energy will save the planet, the implementation of green fuels won’t make a dent in meeting the world’s fuel demand for some time to come.) Don’t forget that part of the solution to tight oil supplies was to be the implementation of more costly fuel sources like Canadian tar sands and deep sea natural gas wells. But if the goal of energy market regulation is to lower oil prices, it could mean even more dramatic shortages in the future as it would deter investment in those alternative sources.
In the grain markets, a number of special interest groups have pushed for an eradication of speculation. The immediate result of more restrictive action (or the perception that changes are coming) could be the liquidation of long positions and sharply lower prices. But then the incentive to aggressively expand production will be lost. For the better part of 50 years the profitability of an acre of corn was locked between $50 and $200 per acre, and only since corn prices moved to higher levels has the production of corn expanded rapidly. In addition to higher acres of corn in the US and higher acres of soybeans in South America, more money has been plowed into seed technology and farming practices, and that in turn has boosted production. However, if it is decided that corn prices are too expensive and governments try to force prices down through regulation, the result could be a rapid deceleration of output and massive shortages.
In the near term, it seems to be politically correct to claim that the rules of markets don’t apply, and with the proposed regulation coming at a time when corn prices are sitting at or just below the cost of production in some cases, it would seem like the US government is about to work its way into subsidizing US grain production on an even larger scale. In recent years US grain production has continued to expand at a record pace, and yet physical ending stocks of grains can’t seem to rebuild. Index funds aren’t making those bushels disappear. We want those in favor of aggressive regulation of the futures industry to show us where one single index fund has physically consumed a bushel of corn. Ultimately, ending stocks are destined to be whittled down to tight levels regardless of whether the funds are long or short.
