RIYADH: Speculators are part and parcel of all economies, varying in degrees. Speculation exists in a wide range of financial decisions, from the purchase of a house to a bet on a horse or even placing money in the stock market; this is what modern market economists call “ubiquitous speculation”. Speculation awards some and punishes others. In other words, not all speculators make money simultaneously. Speculation can cause price increases above their true value (although true value is open to subjective valuations which go beyond the simple calculation of true value - real value - inflation). In various situations, prices rise due to speculative purchasing causing further speculative purchasing in the hope that the price will continue to rise. This leads to price rising dramatically above the underlying value or worth of the items. This is known as an economic bubble.
Commodities prices have increased more in the aggregate over the last five years than at any other time in US economic history. Since 1749, most of the big moves in commodities occurred due inflationary pressures that were related to war or its aftermath. The price of commodities in this cycle has been far greater than any other cycle (greater than the 1968-1981 “super cycle”). The real effect of this cycle has been more advantageous for those who participated as inflation has become globally pronounced only over the past year or so. There is an undeniable fact that demand has increased for all commodities. Emerging economies are consuming all kinds of commodities from crude oil to steel to different kinds of foodstuffs, making demand steeper. On the supply side, a lot of commodities are viewed as having “peaked”, facing deposit challenges. Some precious metals, such as gold and platinum, face supply challenges going forward, due to high global demand but in the case of the world’s largest gold and platinum producer, South Africa, electricity shortages are more a cause of concern than mineral deposits.
But this high demand phenomenon - sometimes aided by manufactured supply panic - is used by investors/ “new speculators” who enter into investing in commodity futures. Specifically, these are corporate and government pension funds, university endowments and last but not least, the omnipresent hedge funds. Put together, these “new speculators” now account on average for a larger share of outstanding commodities futures contracts than any other market participant. The hedge fund, Amaranth is a case in point. This fund lost perhaps $6 billion or more in one commodity - US natural gas - in few weeks. By contrast, the nominal value of all the US natural gas derivative positions of all outstanding commodity baskets was not much larger than Amaranth’s loss. There are now hundreds of hedge funds dedicated only to the commodity sector, and all kinds of more diversified funds like global macro funds who speculate in commodities.
The advent of the “new speculators” began to look to the commodity futures market (through derivatives) after the equity bear market of 2000-2002. Assets allocated to commodity index trading rose from $13 billion at the end of 2003 to $260 billion as of March 2008. Data compiled by the Bank for International Settlements on over the counter commodity derivative positions, held on the books of the world’s banks increased from $1.02 trillion in December 2003 to $5.85 trillion in June 2006. Some involved in the commodity derivatives business estimate the size of commodity derivative at more than $10 trillion.
In this cycle, crude oil prices cannot be justified by simply supply-demand dynamics or the weak US dollar. According to a recent testimony before the Committee on Homeland Security and Governmental Affairs, over the last five years, Chinese demand for petroleum increased by 920 million barrels. Over the same period demand for petroleum futures, increased by 848 million barrels. Some 1.1 billion barrels of petroleum have been stockpiled through the futures market which is eight times as much as the oil stockpiled by US Strategic Petroleum Reserve since 2003.
The speculation in crude oil derivatives has precipitously inflated the price of crude oil even if there is enough physical supply. Lastly, the weak dollar has been used as causal factor for high oil prices. Oil as a hedge for a weak dollar is an attempt to protect dollar assets. Since recently, the correlation between oil prices and the dollar has been broken which raises questions about the genuine economic function of value protection and speculation. In this cycle, it is the latter that dominates.
— John Sfakianakis is chief economist at SABB (The Saudi British Bank).
