Risk of a Raw Materials Bubble
by: Nicolas Madelaine, Les Échos
Without necessarily denouncing, as some have done, the "vile speculators who starve millions of the poor," one may legitimately wonder: aren't financial investors making the prices of foodstuffs and oil climb artificially? In spite of the assurance from financial milieus - which maintain that speculators merely go along with increases essentially due to the progress of physical supply and demand - this question is justified. For the debate is far from being settled.
At the end of May, fascinating hearings organized around this theme in the American Senate rather left the impression that a new type of financial investor is playing a big role in the present raw materials price explosion. So it was interesting to note the defensive posture of the chief economist for the Commodity Futures Trading Commission (CFTC), the American regulator for derivatives products. If, according to him, "our studies do not support the thesis [of speculators' influence]," he peppered his testimony with appeals for proof of the opposite. Witness for the opposing view Michael Masters, a hedge fund manager no longer active in these markets, pulled no punches. "My answer to the question you ask is, yes, unequivocally," he declared before asking pardon from those in his profession who might feel "disappointed" by his positions.
What are the arguments of the two sides? The CFTC side emphasizes that speculators - non-commercial market participants in the regulator's typology - do not represent a more significant share of the total trades on the markets involved than they previously did. Along these lines, all the studies conducted by this authority show that speculators follow, rather than provoke, a trend: they generally invest just after a price rise has been set in motion. Moreover, the markets for certain foodstuffs in which speculators do not invest have also mounted. Finally, still according to the CFTC, funds betting on a price rise and funds anticipating a price drop are about equal in number, at least so far as oil and wheat are concerned.
The opposing side showcases the appearance of a new category of investors on these markets - sovereign funds, pension funds, university foundations and other types of institutional investors. In search of advantageous investments following the bursting of the Internet and real estate bubbles, as well as of protection against inflation, they are massively investing in raw materials. According to figures cited by Michael Masters, their allocations reserved for that category went from $13 billion in 2003 to ... $260 billion in March 2008. And, according to that hedge fund manager, their demand on the oil market has grown by around 848 million barrels a year over the course of the last five years, or the equivalent of the growth in Chinese demand. They also are supposedly holding enough wheat to make all the bread, pasta and baked goods that Americans will swallow over the course of the next two years. Their impact on the market will be all the greater for their very long-term investment practices and their coverage of their exposure through derivative instruments.
It is, in fact, quite difficult to imagine, when big investment banks like Morgan Stanley boast in their marketing materials for clients about the merits of raw materials in an asset allocation strategy, that there's no impact on prices. For Andrew Clare, professor at London's Cass Business School and former chief economist for asset management at Legal and General, the impact of speculation is obvious. His models show that it has increased the price of oil by 30 to 40 percent and there are no reasons, he believes, why foodstuff prices should not, on average, be affected to the same degree.
How, then, should the CFTC, which studies the participants in these markets and assures that manipulation does not disturb them, have failed to identify this new type of investor? Because investment banks are authorized to intervene in the futures markets for the account of investors with which they place transactions by mutual agreement. And they do so virtually without limits, since these position-takings have been counted since 1991 as emanating from "commercial" investors, notes the Michael Masters camp. So, not only are these transactions not identified as emanating from non-commercial investors, but they are also not subject to any ceiling.
It remains to be known whether speculation poses a real problem should it prove that it does have a major impact on raw materials prices. The negative connotation of the term "speculate" cannot make us forget that etymologically this term means "to see far." Now it seems obvious that as of now we must get used to much higher oil and food prices than those that obtained in the past, and for fundamental reasons: the growth of emerging countries, climate [change], the increase in ethanol production, etc. The subprime crisis illustrates the weakness of this line of reasoning by reminding us that bubbles form quickly. And that their bursting causes serious damage. After the Internet and risky American real estate loans, an irrational exuberance is perhaps now taking possession of the raw materials markets. Now, the markets for foodstuffs are among those most vulnerable to the hazards of finance. Already today, small farmers, for whom there is no doubt that the new financial market entrants have changed everything, complain about having to work three more hours a day to understand the erratic developments of the complex derivative products that affect their commodities. They are all the more boxed in, in that the transformers who want to buy their harvests want less and less to acquire them for the future, before seeding time, since the risks of a price drop are high. The balance between short-term speculators and actors in this business, which prevailed rather harmoniously on the markets for agricultural products, is now disturbed.
Another reason to deplore the disturbances linked to financial investors is that agricultural commodities are not stocks and bonds. They affect the survival of certain populations. Even if it is not obvious how to correct possible imbalances provoked by finance without provoking still worse ones, it is important to continue to look into the question of the impact of financial investors on the markets. At least for agricultural commodities. The CFTC, which has increased its declarations to this effect in recent days, tends to confirm this conclusion.