Tuesday, June 03, 2008

Commodities Markets: Now with Artificial Filler!

I posted a while back on the recent rise in food prices. The trend continues, and today the Commodity Futures Trading Commission (the commodities version of the Securities and Exchange Commission) announced an investigation into the manipulation of commodities prices.
Recently, the CFTC has been expending most of its energy on oil futures, but this announcement heralds an expansion of focus into the rising cost of food, cotton, and other important commodities. Some minor reforms to the futures markets have been proposed, and the CFTC (under pressure from Congress, including several prominent Democratic leaders) seems poised to implement them. As much as I applaud the rethinking of certain rules and procedures, I don’t think these efforts will do much to stabilize the markets, nor do I have much confidence in the CFTC’s leadership (see below).

The biggest contributing factor to the price volatility is not fraud or manipulation—it is simple economics. As reported by the AP’s Rachel Beck, over the past five years, investment dollars have been heavily poured in to commodity index funds, rising from $13 billion per year to $260 billion per year. In that same time span, the price of basic commodities (25 of which comprise the index) has risen 183%. Oil has a lot to do with this, as many “capital I” investors (institutional investors that handle unfathomable amounts of money) are pouring money into oil (as well as food), betting on a continued rise in price.

Before a Senate hearing, George Soros suggested that this rise in investment in commodities “mostly on one side” (up!) has the effect of distorting “the otherwise prevailing balance between supply and demand”. The above mentioned AP article contains a very telling quote from the chief market strategist at LPL Financial:

“The rise in the price of oil has weakened the demand for the physical commodity, but it has boosted the demand for the financial commodity since more investors are chasing returns”.

Exactly. And since commodities indexes have fantastically outperformed stock-based indexes, it may be some time before a correction comes. Many investors are slogging money into commodities to offset stock losses and hedge inflation, but the very act of inflating commodities prices is driving inflation. With all of this information, much of it fueled by Michael Master’s excellent research and congressional testimony, you’d think the CFTC would listen.

But, no. The CFTC’s chief economist has stated in a rebuke to Masters that “fundamental economic forces and the laws of supply and demand” are solely to blame. Not that he isn’t somewhat correct—fundamental economic forces are the issue, but because they are affecting the laws of supply and demand.

It is my hope that in a new administration, with new presidential appointees to oversee the CFTC, that we take a long and hard look at the volatility of the commodities market. It is vastly and inherently different from the stock market. Changes in the former affect nearly everyone in the world (and most acutely the poor and working class). It needs to be regulated much tighter, and at this point, it just doesn’t look like it’s going to happen.