May 24, 2011

NOTHING BUT BUBBLE:

Lower gas prices are possible now (DENNIS KELLEHER & MIKE MASTERS, 5/24/11, Politico)

Commodity markets — including those for wheat, corn and crude oil — are remarkably different from capital markets. These exist primarily to ease investment. Commodity markets, on the other hand, exist solely for commercial purchasers and producers to control business risks when raw materials produced today are used at a later date.

Unfortunately, many investors don’t understand this key difference.

Commodity futures markets were created so that wheat farmers and oil producers could sell their products today — though they won’t produce and deliver them for months. A food manufacturer that uses wheat to make cereal, for example, could pay a farmer today for delivery in a few months. The farmer can then plant his crops knowing there will be a buyer come harvest time.

Similarly, the end-user can plan today because he knows what price he will pay tomorrow. Commodity futures markets offer a central location in which buyers and sellers match up and ensure that they get paid. The noncommercial traders, or speculators, participate because there aren’t always enough commercial producers and purchasers to take the other side. But historically, their participation has been limited to providing supplemental liquidity.

Not that long ago, commercial traders made up about 70 percent of commodity market activity and speculators the remaining 30 percent. For decades, this worked pretty well, serving the commercial participants and keeping prices fairly stable. Prices largely reflected fundamental factors of supply and demand.

But that ratio has flipped in the past few years. Now, speculators are about 70 percent of activity in many commodity markets and commercial hedgers only about 30 percent. This coincided with investment banks creating and selling commodity index funds. These products have poured more than $250 billion into the commodity markets in the past few years, with much of the money flowing into the oil markets. As in any market, when dollars go in, the market has to adjust through prices — in this case, by going up.

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Posted by Orrin Judd at May 24, 2011 5:36 AM
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