According to a Commodity Futures Trading Commission official, the CFTC will soon unveil new speculative commodity position limits. Energy Risk magazine reported CFTC Commissioner Scott O’Malia had stated in mid-May the rules should be released within the next six weeks.
Energy Risk also noted Commissioner O’Malia “appeared skeptical that the CFTC would be able to craft a rule that would survive further court scrutiny.”
On September 28, 2012, a federal court struck down the agency’s previous efforts to impose speculative position limits because the CFTC did not explicitly demonstrate that its rules were “necessary and appropriate.”
If one could make the case that “excessive speculation” had recently caused price spikes in various commodity markets, then presumably the CFTC could demonstrate speculative commodity position limits are indeed “necessary and appropriate.”
Difficulty Apportioning Causality
It turns out that it is quite difficult to apportion causality for a price spike when a particular commodity has low inventories relative to consumption. Professor Brian Wright has lectured on how to intuitively understand this topic. He has used a delightful metaphor from the popular Australian (and New Zealander) children’s story, “Who Sank the Boat?” to illustrate how a nonlinear function can make it difficult to apportion blame among various contributing factors.
The Story of “Who Sank the Boat?”
“Imagine a pig carrying an umbrella, a sheep doing knitting, and a cow and a donkey and a mouse, all walking along on their back legs in single file.
What else is there to do on a fine sunny morning but to go for a row in the boat?
But there is one big question. ‘Who sank the boat?’
We are told the outcome right up front, but who was the culprit? The tension and suspense is fantastic as each creature in turn gets aboard. The donkey is a smart critter since he knew how to balance the weight of the cow. The sheep was just as smart since he got on the opposite side to the pig. We are now very low in the water now, but still afloat.
The smallest and the lightest of the friends [a naughty little mouse] now gets on board. … ‘You DO know who sank the boat’—don’t you?”
Source: Amazon review of the children’s story.
The relevance of this story to commodity price spikes is as follows.
Professor Christopher Gilbert has explained, “when markets become tight, inelastic supply and demand make prices somewhat arbitrary, at least in the short term. There will always be a market clearing price but its level may depend on incidental … features of the market.”
In Professor Wright’s retelling of the children’s story, the incidental factor is the naughty little mouse jumping into the boat. Professor Wright has also provided a technical chart to show how a supply disturbance has a dramatically different impact on price, depending on whether one is in a period of low-stocks-relative-to-consumption or not (see fig. 1).
In summary, Professor Wright has observed that the empirical evidence shows price “spikes occur [precisely] when discretionary stocks are negligible.”
Stressed Corn Market
In the recent past, we have been in a period where one had to be concerned about grain inventories. In 2011, for example, the inventory-to-use level for corn was at the “most precarious level … since 1974,” noted Michael Lewis of Deutsche Bank.
At the time, Professor Scott Irwin explained the corn “bull market rally, following so soon after the 2007-08 rally, seems similar to the early-mid 1970s series of rallies.” Irwin warned, “The true spike or boom phase will probably last longer in this episode because of the biofuels mandates and high fuel prices working together.”
Because of governmental policies mandating ethanol use, price cannot function as effectively to ration demand, a constraint that did not exist in the 1970s. (Irwin’s warning later proved prescient in 2012 when corn prices spiked yet again.)
As a result of this inventory situation, Richard Gower, who has been a policy advisor for Oxfam UK, has recommended developed countries consider introducing “a price trigger so that when food prices are high, you divert those stocks of grains from fuel to food.”
Small Crude Oil Cushion
Let’s now examine the oil price spike that culminated in July 2008. At the time, effective spare capacity in OPEC was only 1.5 million barrels per day, according to the International Energy Agency. One-and-a-half-million barrels a day was an exceptionally small safety cushion, given how finely balanced global oil supply and demand were. Considering the risk of supply disruptions due to naturally occurring weather events, as well as to well-telegraphed and perhaps well-rehearsed geopolitical confrontations, one would have preferred this spare-capacity cushion to have been much higher.
There were plausible fundamental explanations that arose from incidental factors that came into play when supply and demand were balanced so tightly, as had been the case with light sweet crude oil. In 2008, these incidental factors included a temporary spike in diesel imports by China in advance of the Beijing Olympics, purchases of light sweet crude by the U.S. Department of Energy for the Strategic Petroleum Reserve, political instability in Nigeria, and tightening environmental requirements in Europe. This is not an exhaustive list.
The large rise in the price of crude oil during the first seven months of 2008 signaled a pressing need for an increase in spare capacity in light-sweet crude oil, however achieved.
Empirical Evidence Regarding Volatility
So far we have briefly covered the plausible fundamental explanations for (the relatively) recent price spikes in corn and crude oil. For a brief review of the empirical evidence that commodity futures markets and speculative participation have actually reduced commodity price volatility during normally functioning markets, one can read “Good Logic Behind Federal Court Putting Position Limits in Limbo,” in the March 2013 issue of FIRE Policy News.
To be complete, there is a significant exception to the finding that “the expansion of market participants” has had a beneficial effect on commodity markets, as noted by the G20 Study Group on Commodities. This policy group reported in 2011 that the “increased correlation of commodity derivatives markets and other financial markets suggests a higher risk of spillovers” in the aftermath of the global financial crisis.
In 2012, the Chief Economist of the CFTC (of the time) and two coauthors found that in the aftermath of the 2008 Lehman crisis, “while financial traders accommodate[d] the needs of commercial hedgers in normal times, in times of financial distress, financial traders reduce[d] their net long positions [in commodities] in response to an increase in the VIX[,] causing the risk to flow to commercial hedgers.” (The VIX is an equity implied volatility index calculated by the Chicago Board Options Exchange and is frequently interpreted to be a gauge of market fear.)
Given the apparent synchronization of both financial and commodity markets during times of financial distress, a commodity speculator can no longer assume diversification across individual commodities (and other financial instruments) when managing commodity risk. As a result, wise financial participants have reduced leverage in this activity. Assuming this conclusion has been embraced in a widespread manner, the risk of future financial crises “spilling over” to the commodity markets could lessen.
Finding of Economic Necessity
One hopes the CFTC will carefully consider how necessary and appropriate the imposition of speculative position limits is across commodity markets. Before making such a finding, the agency should (a) review the empirical evidence on the causes of both commodity price volatility and price spikes and (b) study how market participants have learned and responded to the global financial crisis of five years ago.
Anti-Speculation Cycle
Professor Irwin has argued there is a reasonably predictable “anti-speculation cycle,” as illustrated in figure 2, caused by periodic bouts of inflation and deflation in commodity prices. Therefore, market participants have an obligation to periodically explain how commodity markets actually work. (see fig. 2).
