Some Inconvenient Truths can be Backed Up by Real Math and Science-Part 2

Thursday, June 09, 2011

Brain surgery is not rocket science to a brain surgeon.©

Some Inconvenient Truths can be Backed Up by Real Math and Science

The Reality about Speculators, Commodity Prices, Fiscal Policy and Inflation

 Part 2: Why Speculators are Not Responsible for Inflation

Jimmy Buffett sang “don’t try to describe a Kiss concert if you’ve never seen it.”  This is great advice, especially when talking with someone who has!  To describe that which we have never seen to someone who has seen it causes us to appear ignorant at best and dishonest at worst (stupid is in the middle) because our audience can usually tell we have no idea what we are talking about.

Part 1 talked about what is really causing inflation.  In Part 2 let’s explore what isn’t.

Lately we hear a lot of politicians and talking heads of all sorts blaming speculators for soaring prices, especially fuel.  Most of these people have never seen a Kiss concert.  Are they ignorant, stupid or dishonest?  I suspect we cover the spectrum.  The scary thing is that many of these individuals have the power to regulate activities IN WHICH THEY HAVE NO EXPERIENCE.  Ultimately, I don’t care who is incompetent or dishonest.  Either way the net conclusion is the same.  They should not be in charge of anything.  Here is all the information you need to understand why “blame the speculators” is, in a word, wrong.  It is worth keeping in mind that several in the current administration have, at one time or another, articulated a desire for $5.00 per gallon gas.  These economic concepts are very basic so if you’re wondering about ignorant, stupid, dishonest…

Perception, Reality and Reaction:

In the interest of full disclosure, what we said earlier is not entirely accurate regarding supply and demand causing price changes.  We do not operate on reality.  We operate on the perception of reality.  An announced increase in crude production by OPEC will not change the supply of gasoline by morning but it will sure as heck move the price.  That is because investors are reacting to a perceived future increase in the supply of crude that may or may not ever materialize.  Again, it is a reaction to a perception of future reality.  This is an important point in understanding commodity (futures) markets.


Commodities Markets:

Even though there are only around a hundred traded commodities, the futures markets account for more dollar volume than all the stocks and mutual funds combined.  That is quite impressive when you consider the tens-of-thousands of stocks and funds out there.

A commodity is a raw material like corn, silver, cattle, hogs, crude oil, cotton, etc.  These commodities are traded based on criteria including standardized quantity, quality, delivery date and, of course, price.  The deals or trades are made based on a contract between two parties, buyer and seller, which specifies the above, and any other, standard parameters associated with the commodity. 

There are two general participants in the commodities markets:

Hedgers: 2 types

                   i.      Producers: these are the producers of raw materials from grains to cattle to gold so they are the loggers, farmers, ranchers, miners, etc.

                   ii.      End Users: These are the folks that turn the raw material into finished products so a baked goods factory buys wheat from a farmer and makes bread


Speculators have nothing to do with the actual commodity.  They do not grow it, dig it up or raise it.  Their only relationship to the product is the contract specifying what the commodity is.  Their only goal is to make money on a change in price, up or down. 

By the way, contrary to what you may have heard in commodity legend if a speculator misses a date he does not get 300 bushels of corn dumped on his lawn.  He usually gets a warehouse receipt telling him where his corn is being housed and what it will cost to keep it there.

So, how does each of the above players fit into the picture?


The hedgers do not use commodity contracts to profit from price swings.  They use them to protect themselves from price swings, hence the term.  For example, a farmer is nearing the harvest around the middle of August and corn is trading for $5.00 per bushel. He deems that a satisfactory price based on his costs that year.  Based on a number of factors including weather, supply, demand, etc. he knows there is no guarantee that the price won’t change between now and the end of harvest in November.  An end user may see corn at $5.00 and feel that would be a safe price for a raw material based on his costs and pricing that year.  What they may do is enter into a buy/sell contract for $5.00 per bushel to occur in December.  Both parties benefit because the farmer knows in advance what he will get for his corn, allowing him to budget appropriately, and the end user has fixed what could otherwise be a variable cost allowing him to budget appropriately.  The risk they both share is, of course, that the price could change; go up before December, costing the farmer money or down costing the end user money.  In either case both have agreed on a price acceptable to each and they are protected (hedged) against adverse price swings.



The life’s blood of any publically traded market is liquidity.  Liquidity means that there is enough interest in something that it can be converted to cash very quickly.  For example, at any given time there may be three or four people that think our house is perfect for them.  In order to find them we usually need to list the house with a broker so that many people can see the house in an effort to sift the three or four would-be buyers.  The time from agreement to closing  may be weeks to months.  Our house does not trade in a liquid market.  We cannot put our house up for sale and expect to convert it to cash within seconds.  Compare that with the speed of selling stock on the stock market.  Blink, and we’ll miss the conversion of stock to cash.  The ideal situation for any home seller is to have more than one buyer interested.  Why?  Because they will compete with each other to make the best offer.


The commodities markets are very liquid.  Why?  Because in addition to the hedgers we have speculators adding to the interest in commodity prices and trading volume.   What would happen to prices if the only players were producers and end users?  The producers could demand, and the end users could afford much higher prices because there would far less competition over price.  Producers would set pricing and end users would pass a disproportionate product cost increase onto the consumer. 


Ahhh, I think we are starting to see the true role of the speculator!  They provide additional liquidity to the markets.  Speculators enhance the competition for price that keeps costs in line.  The sellers compete to have the lowest price to sell, even by a penny, to be first in line for the next contract and the buyers will compete to offer the highest price to buy, even by a penny, to be first in line for the next contract.  I hope you can appreciate how this competition (buyers vs. buyers and sellers vs. sellers) keeps the market liquid, efficient and as tight as possible.  Speculation is an exercise in reaction to perception and prediction.    We must realize, this is a zero-sum proposition.  That means there is a winner and a loser in every speculation contract.  A buyer of a contract thinks prices will rise.  The seller of a contract thinks prices will fall.  One of them is right, and one of them is wrong.  One will make money, and one will lose money.  That’s it.  News of a peace accord in the Middle-East will foster a perception of increasing future supplies of crude.  An early frost in the heartland will fuel a perception that the corn harvest will be adversely affected.  A strengthening of the dollar will decrease the perceived future demand for gold.  What we must take away from this is: Speculators REACT to perceived future conditions of supply and demand.  They do not create them!

Hedgers and speculators combine to increase trading competition making them the consumers’ guardian angels, not their nemeses.  Is the system perfect?  No.  None is.  Sometimes things heat up irrationally but those situations are short lived.  Sometimes people endeavor and/or collude to profit unethically or illegally.   Not only are they in the vast minority, these morons always get caught eventually because the sheer volume of legitimate trading activity exposes anomalies. 

It is always the thief that steals then deflects blame to someone else.  Blue World manages farmland.  We trade derivatives and we speculate on commodity prices.  Credentials matter when educating, opining or making policy.  So, the next time someone offers to describe a Kiss concert, demand they produce a ticket stub.


We always appreciate your time and consideration…stay tuned!

© Thursday, June 09, 2011Blue World Asset Managers

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