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Equity markets provide fuel for the world economy by raising and reallocating much of the capital that companies need to invest and grow. Commodity futures markets, on the other hand, direct and allocate the specific resources used by that broader economy. We rightly focus on prices and the money flows in and out of these markets, but we also need to think of money flows and prices as critical ‘information’ needed by a complex world economy. If we restrict the flow of money into and out of futures markets, it forces these markets to operate without ‘information’ that is needed to generate an accurate price.
Speculators are an essential part of the process. Without speculators, futures markets cannot perform their function as clearinghouses for information and allocators of commodity resources, and they may not be able to do their job of anticipating shortages and heading off severe global supply problems.
The Results of a Closed Market
Overly restrictive position limits represent a gradual ‘closing’ of futures markets. And what happens when a market – or an economy – closes? There are plenty of examples. The Soviet Union is probably the most famous. China prior to Mao’s death was closed even tighter than the Soviet Union, and North Korea may be the most extreme example of a closed market/economy.
The general result of such closure is shortages. The Soviet Union, a nation bursting with natural resources along with vast amounts of arable land and water, was forced to become the biggest grain importer in history in the 1970s in order to feed its people and provide them with adequate protein. Free markets did not exist there, so their economy never received the thousands of small and large price signals that told people to redirect their resources and their energy. The only “signals” came from government bureaucrats who allocated resources based on 5-year plans. Those plans resulted in poverty and hunger in a land of unimaginable resources, along with almost comical gluts such as mountains of unwanted aluminum and the countless precast cement walls that littered the landscape as the Soviet Union was dying.
The Need for Volatility
When you start to tamper with free market trading by applying restrictions, it puts the futures markets’ vital role in regulating global commodity supply and demand at risk. While no system is flawless, over the course of history, futures markets have provided an early warning signal of commodity shortages and excesses, with active speculator participation and price volatility being the key components for this system to work. High and low commodity pricing plays a critical function in regulating both supply and demand, and strong speculator participation makes this happen.
Price spikes give a clear signal of supply side shortages and enable both producers and consumers to make quick adjustments. Without price volatility, supply changes would be slower to occur. Limiting a producer’s profit potential takes away the incentive to produce more when demand grows, and that could cause prolonged periods of shortages.
Futures markets can only work effectively and efficiently if high volatility is allowed to occur. In a free market environment, a commodity’s price and its supply are highly correlated. This can clearly be seen in the price swings in such commodities such as wheat, corn, sugar and oil. When Chicago wheat prices ran up to over $13.00/bu (and $25.00/bu for Minneapolis) in early 2008, this sent an urgent message to farmers throughout the world. A rapid expansion in global wheat acreage began, and tight world supplies were replenished in one season. As a result, prices fell to just $4.55 in less than 12 months. This only happened because high prices led to an increase in world production of nearly 12%, which was enough to boost ending stocks from 19.8% of total usage (the lowest level in decades) to 26.7%, which is near mid point of the past 30 years.
Sugar is another case in point. The anticipation of rising global ethanol demand lifted the price of sugar close to 20 cents per pound in early 2006. But sugar prices were more than cut in half over the next sixteen months, and a 12.6% expansion in world sugar production from the 2005/06 season to the 2007/08 crop year was certainly a factor bringing the price of sugar down.
In the wake of the housing and banking fiasco, we think the demand for investing in physical tangible commodities will remain in place. The world has come to realize that commodities are primary building blocks of the globalized economy, and as countries around the world raise their standards of living, they will want and need to consume more commodities. Investors have become keenly aware of commodity prices, and they want them in their investment portfolios. If large index funds are pushed out of the commodity markets, interested buyers will still find a way to get in. Perhaps this will be through the traditional avenue of individual commodity futures accounts, or perhaps, if the regulators push too far, it will be through exchanges in other countries.
