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Commodity investors: speculators or hedgers?

Wednesday, July 22, 2009

For quite a few years now, I've had great difficulty with the various definitions that have been somewhat casually applied to what is truly one of the most loaded words in the financial lexicon - "speculator".

This is particularly irksome when the word is used to describe what goes on in commodities futures markets.

According to The Intelligent Investor author Benjamin Graham (is there really anyone better to consult on this subject?), the word "speculator" is not defined for what it is, but, rather for what it is not, namely, the slightly-less nebulous term "investment" which logically leads to the word "investor" to describe those who engage in this activity:

"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
Though it may have come as a surprise to your typical 401k/retail investor prior to the events of last fall, most individuals (save for those who have still not dared open up any of their statements to see just how bad the damage has been) who believed they were "investors" last year must surely realize now that, by Graham's definition and its "safety of principal" proviso, their money was directed toward "speculation" and not "investment".

Lest there be any doubt, today, blue-chip stocks like General Electric are speculative.

Investors Speculate on Commodities

But things get complicated very quickly when you turn to commodity markets because, during the entire 18-year run of the late, great secular bull market in stocks (a bull market that most people still don't realize came to an end nine years ago), the word "investor" and "commodities" would rarely be heard or seen in the same sentence.

Up until early in this decade, when the long stock bull market ended and the new commodity bull market began, the only players you'd ever hear about in commodity markets (if you heard anything at all) were "speculators" and "hedgers".

Speculators were doing what speculators do - mostly "price discovery", or, put another way, trying to make money in the short-term by buying and selling based on breaking news and/or technical analysis - while "hedgers" were those involved in producing or consuming goods such as oil, corn, or copper. Through futures markets, established back in the 19th century, they sought to "lock in" future prices and "hedge" their risk in order that their businesses could run a bit more predictably, the vagaries of price changes in the months or years ahead eliminated as a concern for the bottom line.

The term "investor" didn't really creep into discussions of buying or selling commodities until a few years ago and, in part due to the definition of "hedger" being so much more clear-cut than "speculator", these new market participants have come to be classified as not the former, but the latter.

Pension funds, endowment funds, and those planning their retirement via ETF purchases in 401k plans are all considered speculators, not hedgers.

But is this the right thing to do?

The Commodities Futures Trading Commission (CFTC) certainly thinks so and, as part of the sweeping changes that have recently been floated for ways in which to deal with the excessive volatility (and rising prices) in futures markets, they aim to "clamp down" on these "investor-speculators", in the hopes that less money directed toward food and energy might calm these markets down a little (and, maybe, help keep a lid on prices).

Unfortunately, they might be wrong on both counts as these changes could make commodity markets even more volatile and lead to even higher prices.

A Different Kind of Hedger

Now, to many people, it's still not crystal clear what you should call someone who buys IBM stock - an "investor" or a "speculator" - but, these days, whatever it is that you call that person, that's what you should probably call someone who buys a gold ETF.

They're both just trying to make some kind of a positive return on their money. Whether they're investing Harvard endowment money or putting an inheritance to work in hopes that it'll pay for their kids' college someday, both are looking to do something with their U.S. dollars that, here in 2009, not only pay a trifling amount of interest but have a decades-old track record of losing value rather quickly.

So, when you think of things that way, it doesn't make complete sense that these new participants in commodity markets are being classified as "speculators". And, as opposed to stock investors, they really do have something that they are "hedging".

Why else would you buy commodities?

As financial advisers often recite, "Commodities don't pay dividends".

It's not so much that commodity prices have been going up in recent years, it's that the purchasing power of the currency is going down.

While this new breed of commodity futures holders may not be "hedging" for their business, they are certainly "hedging" something.

Part of the problem here is history. You see, futures markets were originally conceived as a place for only three types of players - producers and consumers (the "hedgers") and traders (the "speculators"). But an even more important aspect of the advent of futures trading was that, back then, money was sound and no one felt the need to even consider hedging against the loss of purchasing power of their money.

When you think about it, creating a third class of commodity market participant might make some sense - just call them "investors", in the same sense that GE shareholders are "investors" (with apologies to Benjamin Graham).

Then, separate rules could be applied to this group without interfering with the other two groups. After all, what the CFTC is trying to ensure is that these markets are not manipulated and pension funds don't seem to be the manipulating type.

Then again, if the CFTC is really just trying to cap prices, then there's a real problem with all of this because, buyers and seller will just go overseas, transforming U.S. exchanges into something of a laughing stock over time.

Nixon's wage and price controls didn't work back during the last bull market in commodities and new CFTC regulations are not likely to prove any more effective in keeping prices from rising this time around.

Does the CFTC Understand the Problem?

Someone really should bring this up during the hearings that the CFTC plans to hold this summer on the subject of limiting position sizes - it would dovetail nicely with ongoing efforts in Congress to audit the Federal Reserve as the two are intimately related, though they may not seem so at first.

It all comes down to the nature of fiat money and, once again, we're treating a "symptom" of a problem here rather than the problem itself.

For the first hundred years that commodities futures markets existed, nobody felt the need to "invest" money there and for good reason - the nation's money was generally sound and banks usually paid a rate of interest that more than satisfied dollar holders.

Now that our money is anything but sound, interest rates are anything but satisfying, and we find ourselves smack in the middle of a nasty secular bear market in stocks, those who "hedge" their currency risk or want to reduce the probability of outliving their money in retirement by purchasing commodities shouldn't be punished.

The "market" is sending a loud signal to both the CFTC and the U.S. government as a whole, but neither seems to want to hear it.

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Anonymous said...

The big problem is that small investors are not generally buying commodities directly, but someone's promise to pay if commodity prices change. Futures contracts are only as reliable as the entity issuing the promise, and there is currently no way for the small investor to monitor how sound the issuer of the contract is. All too many institutions were not able to honor futures contracts during the recent crises. Futures markets would have lost trust they needed to operate without heavy duty bailouts of AIG et al.

Small investors need some reliable way to buy actual commodities in order to be reliably protected from inflation. They can currently do so with gold, but not so much with oil and wheat.

Dan said...

Anon wrote ~ "Futures markets would have lost trust they needed to operate without heavy duty bailouts of AIG et al."

How so?

The Capitalist said...

I think it really depends upon the approach of the person involved and what they do. Large institutions hedging with commodities would make sense, but then again some of them do make speculative calls as well. Each move has a different purpose. Also, as reported on Bloomberg 60-70% of the commodity trading (oil) is performed by algorithmic trading that is automatically performed by computers.

With the retail investor or even a large institution... purchasing physical gold bullion for instance would be a clear sign that there is not only hedging, but a desire to have a real source of value. The retail investor who thinks they are hedging by going long or short on gold futures is a fool unless they have multiple positions and it is part of their trading strategy. XAU/USD and XAG/USD has become much easier to trade for retail investors because the FOREX market-makers and brokers have jumped on with including it as a derivative to be traded... it also is much less expensive to do now than ever before because the spreads have decreased. Now you can long or short gold futures for as low as 30 pips, which is dirt cheap compared to a year ago where the lowest spreads were around 80 pips.

Anonymous said...

AIG et al issued a large number of contracts on bonds. They could not honor the contracts. So many contracts were not being honored after Lehman defaulted on its contracts that people were losing confidence in the system. Demands for collateral and margin calls were proliferating. Virtually all financial institutions were on the brink of shutting down. Even Warren Buffett had to put up collateral on his contracts. The bailouts gave AIG et al enough money to honor the contracts (costing AIG et al billions in losses).

So I ask, if a serious run on the dollar starts, will commodity contract issuers be willing and able to pay out a trillion odd dollars to cover rapidly rising commodity prices? If not, will anyone bail them out?

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