Conceptual problems in commodity regulation

May 5, 2009

John Kemp Great Debate– John Kemp is a Reuters columnist. The views expressed are his own –

The financial crisis and wild gyrations in commodity prices have exposed deep conceptual flaws in the way academics and regulators think about commodity markets that will force a fundamental re-think.

In particular, they have demolished three key main planks on which the laissez-faire approach to regulation has rested:

* Fundamentals linked to physical production and consumption of commodities are the principal drivers of prices. Speculators or investors provide an important source of market liquidity, smoothing out temporary imbalances. Their activity may accelerate the adjustment, or even cause the market to overshoot. But speculative influences cannot force prices away from fundamentally determined equilibria for any sustained period.

* Commodity markets are highly competitive, with many buyers and sellers, each accounting for a small share of the overall market, unable to influence the prices set to any great extent.

* Regulators can draw a meaningful distinction between attempts to “manipulate” prices (which are illegal) and the impact of “dominant” positions (which are not).

Each of these assumptions has proved incorrect, forcing a fundamental reappraisal.

(1) FUNDAMENTALS AND SPECULATION
Traditional theories about commodity markets assume there are two basic types of participant: producers and consumers using the market to hedge away existing price risks (“commercials”) and investors or speculators using the market to take exposure to price risk (“non-commercials”).

Prices are assumed to converge on an equilibrium based on supply-demand fundamentals, with commercial players acting as the main drivers of pricing behaviour and speculators playing a subsidiary role balancing the market and providing liquidity.

But as the scale of investment in commodity markets has grown, speculation has emerged a factor in its own right, a new “fundamental” alongside traditional physical supply and demand.

It raises the difficult question of what happens if the weight of investment money moves prices away from their fundamentally determined equilibrium value for a prolonged period?

Most analysts insist this is not possible. But the widely acknowledged housing bubble and mispricing of risk in credit markets have shown markets can deviate from fundamental valuations for years at a time. If credit and housing markets can misprice assets, there is no reason commodity markets should be any more “accurate”.

(2) MANIPULATION AND DOMINANCE
The idea commodity markets are characterised by lots of small buyers and sellers unable to influence prices is clearly not true in practice:

* Hedge fund Amaranth had positions amounting to more than half the open interest in certain natural gas contracts when it collapsed in 2006.

* One market participant was revealed to be running positions in the NYMEX crude oil contract amounting to more than 300 million barrels of oil in the first half of 2008 when the Commodity Futures Trading Commission (CFTC) corrected an error in its commitment of traders reports.

* Investigations by the Energy and Commerce Committee of the U.S. House of Representatives revealed NYMEX had issued 117 exemptions to the normal position limits in the NYMEX crude contract alone since 1991.

Positions on this scale clearly have the potential to disturb prices. Until now, regulators have generally tolerated them provided there is no attempt at active manipulation. But the difference between manipulation and dominance is mainly one of intent. If the practical consequences are the same, should regulators try to limit dominant positions as aggressively as they pursue outright manipulation?

(3) LIQUIDITY IN THIN, SEGMENTED MARKETS

Most commentators assume global markets, such as oil, are too large to be manipulated successfully. But most commodity markets are in fact quite small. Even in the U.S. government bond market, supposedly the largest and most liquid market in the world, a string of “settlement failures” has highlighted the limits of liquidity, prompting warnings from the U.S. Treasury about the behaviour of participants with dominant positions.

If liquidity and large positions can become a problem even here, the risks in smaller markets such as crude oil let alone niche markets such as carbon are far greater.

Market segmentation compounds these risks. Most futures contracts are in fact for very specific grades of material delivered in specific locations, restricting them to only a very small fraction of worldwide production and consumption.

Markets are also segmented into individual contracts which are not (completely) fungible: the market for Jun 2009 natural gas is not (quite) the same thing as Jul 2009 natural gas. Given this segmentation, it makes no sense to talk about the “bond market” or the “WTI market”. Individual market segments are much smaller and more vulnerable to distortions.

(4) MORE REGULATION, BUT HOW?

Excessive volatility undermines the function of price signals by making it harder for producers and consumers to differentiate real long-term signals from the mass of short-term movements (“noise”). It imposes real costs in terms of resource misallocation when producers and consumers get it wrong, and these costs are non-trivial.

The damage bubbles do to the economy and the planning-investment process by producers and consumers provides a strong intellectual justification for some form of regulatory intervention. But what?

If the concept of a unique supply-demand equilibrium based on fundamentals is abandoned in favour of one that allows other factors (including speculation) to play a role, does that make the regulator irrelevant (if there is no natural equilibrium, how can speculation be said to distort it)?  Or does it mean the regulator should step in to curb “excessive” volatility and ensure prices bear some resemblance to the physical supply-demand balance?

And if regulators do have a role, how should it be enforced?

Past practice in the United States has favoured position limits, what might be termed a “structural” solution.

But practice in the United Kingdom has favoured a more “behavioural” approach, allowing large positions but imposing additional burdens on those running them to do so in a way that minimises market distortions. Neither approach has proved effective.

In practice, any new regulation is bound to be more intrusive and will be strongly opposed by many market participants. But before regulators pick that fight, they need to forge a new consensus around how these markets work in reality.

Regulators are under pressure to consider whether some of the smaller, less liquid markets need special oversight, especially where they are linked to larger ones and there is a risk that a dominant position in the smaller market can be used to manipulate prices in the larger one.

The recent report on commodity market regulation by the International Organisation of Securities Commissions (IOSCO) admitted positions in unregulated over-the-counter (OTC) markets could, in principle, influence prices on regulated public exchanges, and called for greater information and oversight on positions in these markets.

So far the focus has been on soliciting greater information about OTC trading on larger markets such as oil and natural gas. But a case could be made that regulators should also concentrate on smaller markets (such as carbon) many of which are traded OTC and where linkages to larger markets such as power may make them more important than their size suggests.

11 comments

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How about looking into how to create an automated economic system that distributes “money” equally amongst the population while maintaining it’s value?

It’s not quite so strange when you consider that we already do it now. Our money has no real value. It’s only as good as our belief in “the good faith and trust of the American Government”.

Point is, we already work for worthless money and pretend to “buy” stuff with it. Why not simply take it the next step and completely remove the human being from the accounting process, and remove profit as a motive? Automate the distribution of this fake wealth we already give value to. Prioritize every human to be of equal value and priority, and “businesses” or “community projects” would be able to form organically. Since every individual would contribute their own ability to acquire resources to the task at hand, the only real requirement for being able to “make things happen” would be an adequate number of willing participants. And since there would be no economic anchor (paycheck) people would not be economically forced into doing things they no longer believe in. Thus projects and businesses would only be staffed by people who really believed in the value of what they were doing.

Things would still get done. But they would only get done if people agree to pitch in. Otherwise people still have a limited economic ability to fulfill their own goals. And because the economic system operates independent of central human control, there is no easy way to co-opt or disrupt the system.

I have absolutely no idea how such a thing would be done. But the fact that it CAN be done, is in my humble opinion, worth looking into.

A question to Mr. Kemp: Does the same apply to commodities such as grain and beef or only to energy?

Posted by SG | Report as abusive

To:
Benny Acosta

Your idea has be applied to an economic system before. It end in great suffering and loss of life. The system is commonly called COMMUNISM!!!
Yours,
GED

Posted by Gary E. Duff | Report as abusive

I always love reading John Kemps work. He’s so freaking smart it’s amazing. As much as I appreciate his work and his profund unbiased mental capacity, I can’t help but notice how he never really gives his own opinions on the matter. He’s great at telling facts. Not so great at helping the problem. It’s knowing when to speak up and how loud you do it that makes the greatest men. I trust Johns judgement and would hope next time he’ll give HIS OWN INSIGHT ON HOW THE SITUATION COULD OR SHOULD BE RESOLVED.

Posted by AncientXer | Report as abusive

’08 was extremely instructive not only about oil/energy but also food commodities. The wheat spot spiked more profoundly than oil and indeed produced starvation and strife in developing nations, their grain storage capacity empty. Some nations stopped real trade of food products as protection against short supplies not on production but on rapid inflation.

One of the greatest follies is that of attaching food production to energy production as is in the USA ’08 Farm Bill. Grains for people and animals increasingly imported as corn for ethanol more rewarding to grow, leaving a gap in this nation filled by producers overseas. The ’09 GAO risk assessment report reveals that 60-80% of fruits and vegetables are now imported, this while small/medium sized farmers/producers are forced out of business by depressed pricing at the wholesale level despite increased pricing at the retail level and near monopoly by big AG with industrialized production of food for people and animals and now the incentives of the energy market. The former breadbasket to the world as a result has produced a bumper crop of crooks and thieves emboldened by near absent regulatory oversight nationally and internationally.

The 1999 CFMA opened up commodity futures markets of all ilks to hedge funds, institutional buyers, broker/dealers. “Forecasters” of the large brokerages/banks publicly speculated on increased pricing of oil adding to the frenzy. The Enron loophole is still in existence. Brokers made billions trading futures trades in just oil in the first 6 months of last year. Oil companies PROFITS in the trillions during the same period. Exchanges around the world profit from the free-for-all in futures trading/speculation of digital trades which has little to do with “price discovery” squeezing out the suppliers options and adding false inflationary pressures to the consumer. Today, those same too big to fail brokerages are storing oil offshore in tankers taken out of mothballs to the tune of 75K a day on the US taxpayers dime.

International cooperation by exchanges of electronic trading rules is required to restore some sanity to commodities markets of energy, grains and other commodities. All economies require commodities and fair pricing. Populations of people suffer economically at the hands of those seeking the ‘fast buck” and neither a producer or supplier. The commodities market today is just as delusional, manipulated and subject to trading abuses in futures as the CDS, CDO, SIV, credit markets etc. Increased margin requirements is a small step but inadequate to stop abusive trading.

The lessons of the last Great Depression were ignored in the CFMA as speculation by traders never taking delivery on commodities in trading futures identified then as element profoundly deepening the world strife at that time.

Sober and brave adults internationally are required to draft/impose the necessary changes the commodities exchanges in the interest of their citizens rather than the interest of speculative traders or the profitability of their respective exchanges. Clarity in the supply/demand markets is necessary rather than the opacity which currently exists.

Posted by NS | Report as abusive

Garry. This idea has never been applied to any economic system.No country had any way to completely automate a national accounting system before. This is a chance to do just that. And with an automated system, the idea of “All men are created equal”, can actually be applied in an economic sense.

I notice you put communism in big letters. What was the meaning in that? I am in no way suggesting that we abandon our constitution. I am suggesting that in order to truly be a nation of free and free thinking citizens, the issue of equitable resource exchange MUST BE ADDRESSED.

NS

You have such insight as it relates to this commodity issue. The unfortunate thing is that this all boils down to the fact that money is being used as a means of control, rather than as a means to facilitate productivity and advancement in real human terms. There are some really bright minds in this country. Human beings with REAL ANSWERS to the problems we face today.

We have people in this country that if given a chance could solve these issues to the benefit of every citizen. But these solutions require that resources be readily available. Unfortunately those who value only money, and are skilled at its manipulation, understand that a system such as I propose would render those skills obsolete and remove their control over the less advantage in society.

Human beings work in their own interests first. This is just how we are right now. Therefore knowing this, and having the means to remove this source of error from our public systems, we should do so in the areas where it makes the most sense to do so.

The biggest impact will be felt by modifying the economic system first. It’s money centered instead of human centered. This is why so many spacious homes go empty while thousands of families go homeless. The money to pay the mortgage is more important to the institutions involved than making sure a family is housed. This is twisted logic. Money doesn’t need a home. Humans do.

Likewise, people go uninsured and are thus unable to have any health care, let alone any choice. Why? Because you don’t deserve to be helped if you can’t pay for it. So once again, your health, your life, your very value as a human being is thrown to the ground while the value of the money you worked for is held in high esteem. Should we be comfortable with the idea that our lives are only worth the amount of money we can generate?

How about looking into how to create an automated economic system that distributes “money” equally amongst the population while maintaining it’s value?

It’s not quite so strange when you consider that we already do it now. Our money has no real value. It’s only as good as our belief in “the good faith and trust of the American Government”.

Point is, we already work for worthless money and pretend to “buy” stuff with it. Why not simply take it the next step and completely remove the human being from the accounting process, and remove profit as a motive? Automate the distribution of this fake wealth we already give value to by automating the treasury and federal reserve. Prioritize every human to be of equal value and priority, and “businesses” or “community projects” would be able to form organically. Since every individual would contribute their own ability to acquire resources to the task at hand, the only real requirement for being able to “make things happen” would be an adequate number of willing participants. And since there would be no economic anchor (paycheck) people would not be economically forced into doing things they no longer believe in. Thus projects and businesses would only be staffed by people who really believed in the value of what they were doing.

Things would still get done. But they would only get done if people agree to pitch in. Otherwise people still have a limited economic ability to fulfill their own goals. And because the economic system operates independent of central human control, there is no easy way to co-opt or disrupt the system.

I have absolutely no idea how such a thing would be done. But the fact that it CAN be done, is in my humble opinion, worth looking into.

Look at it this way. If you’re a common working citizen, then what kind of situation would you rather be living in? Would you rather be part of a system that keeps you edgy at best or scared out of your wits at worst? Do you want to be part of an economic system that keeps you awake at night wondering if you will loose your home, your job, and end up living in poverty?

Or would you rather replace that system with an economic system that ensures you will keep your home or be able to buy the home of your choice without fear of loosing your income and living in poverty? Some people will say that the choice is not as simple as that. I’m telling you that it is.

When the opposition says it’s not that simple they’re talking about the “how”. “How will we do it? It’s impossible. People will never agree to it.” etc…
When I say it’s simple, I’m talking about making the choice to move in that direction. And we can start by automating the US Treasury and the Federal Reserve. Consider the fact that they are insulated from the other branches of government. This is for the purpose of avoiding conflicts of interest. This way neither government nor wall street is supposed to be able to interfere with the operations of these two bodies.

However, since only people that come from government or wall street are “qualified” to run these agencies, the decisions made by them will naturally favor wall street or government. The reason, humans always work in their own interests first. It’s just how we are. Sometimes this is done out of greed. Sometimes it’s done because when all you know is one thing, then you tend to see problems only in terms of how they relate to what you’re best at. Hence Hank Paulson took actions that favored wall street over main street. But Paulson is not alone by any stretch of the imagination. They all do it.

By automating those two agencies and turning them into an independently functioning system we can remove the human desire to maintain control. By making the replacement system so that it prioritizes all human participants to be of equal value, our wealth, which we already know is fake, and with which we still pretend to “buy” stuff would be distributed amongst the population equally.

This way you still have the money to buy the things you want and need, and not have to go to a job that you hate. Instead, you could have your own business. You could find a job in an organization who’s goals are In line with your own. You could choose to spend your life developing your greatest gifts and talents, and then teaching others to do the same. The possibilities are limited only by your choices.

The opposition will not and cannot offer any objections that speak the the human concerns of the current “crisis”, in other than monetary terms. In other words not a single supporter of the current economic system can speak to easing your suffering in any meaningful way, where money isn’t the most important part.

We keep begging for jobs. Because nothing is better than slaving your day away for wholesale pay, so that you can turn around and pay retail for all the stuff you help make (insert sarcasm here). Don’t think that’s the case? Why do you think we need a law that mandates a minimum wage? Because if we didn’t, corporate America would only pay you as much as you were willing to work for. And if that means you live below the poverty level, oh well.

Think Enron. Think MCI Worldcom. Think AIG. Think they really care about your future or the future of your kids? Think again. If they had your interests at heart would they have bled this economy dry the way they have? And then stick us with the bill?

Automate the money system. Make the system HUMAN CENTERED. Prioritize all humans as EQUAL. Let’s finally start turning this nation into a country where all are indeed created equal.
Let’s finally truly become a nation of free citizens.

Bring back Glass-Steagall and negotiate a fixed currency exchange system. The same speculative pressures on equities and commodities can be exerted upon currencies. The herd effect is unavoidable and hence hard to determine whether the 800 lb. gorilla is is manipulating prices or acting responsibly when putting in a big sell order.

Wall Street has collapsed and the opportunities to make ridiculous money gone. Some solutions to the problems we face can be found in the past. If we are going to rebuild let’s do it wisely. We fell in this same trap in the 1930s. The agreements and regulations that served to keep the economy stable that were repealed must be reconsidered and implemented again with the necessary modifications.

We have anti trust legislation that should be implemented. We should look at legal remedies as well to restrict the formation of conglomerates whose power and scope are too wide and far reaching. The FTC has been a rubber stamp for corporate mergers and aquisitions since the Clinton Administration.

The country has become like a 20th century coal mining town. One parent company owns and controls the company we work for, the bank that mortgages our house, the broadcasting stations that give us our news (propaganda) and the store we buy our food and clothing from. I urge all to study the mining and political histories of Montana and West Virginia.

The only way to bring these changes peacefully is to stop corporate funding of political campaigns. Britain did it. So can we.

Posted by Anubis | Report as abusive

Have you ever heard of the Baltic Dry Index? It also reached record highs in 2008, and it is one of the most volatile markets in the world. It is also notable for allowing no speculators. No specs, but more volatility. Likewise many years ago potato futures markets were blamed for volatility in potato prices. The markets were banned. Volatility in potato prices rose.

I’m assuming that the “bubble” in commodity prices you write about was the move in oil especially since oil is the master commodity. The biggest trouble with your implied argument that it was a speculative bubble is that you seem to deny the reality of supply and demand. Have you even given a cursory glance to the figures? From 2002 to 2008 demand rose while supply could not keep up. Demand up more than supply –> prices rise. Is this the conspiracy?

Puhlease! Crude was at $147 — higher in the deferred months — and yet the world could not supply enough oil to meet demand! If you were Hugo Chavez wouldn’t you pump as much as you could at those levels? Oil and related commodity prices rises triggered our current credit collapse (the stage had been very well) and demand finally dropped. When demand comes back the world will probably will not be able to produce more than 187 million barrels of oil a day. The price will rise until it causes another recession. And you’ll blame speculators again. Speculators could be banished. Prices will still rise if supply can’t meet demand. Maybe you’ll find someone else to blame. But there’s no one to blame! It’s just physical reality. Time for a new energy source, get moving, write about that, it’s really much much more important. Please stop building complacency in with regard to commodity prices, like it’s all the result of Amaranth gaming the market or people bidding up carbon contracts. Those are near meaningless details compared to the real situation — something like peak oil.

Sure there can be manipulation in the commodity markets. And maybe position limits should be lower. The monthly or quarterly structure of the markets has little to do with it I think. There can be speculative froth but it’s not the main driver — it’s the bandwagon.

Your concerns mask the momentous problems the world faces with an oil supply that will not grow and may fall. The market rang the alarm; you’re just saying that the alarm has rung so there must be something wrong with it!

It’s like saying your hand feels like it’s burning. Instead of looking to see that it’s on the fire you blame your nervous system and take a drug to numb the pain. There may be issues with your nervous system but the real reason you hand hurts is that it’s in the fire.

The oil market has fallen. It fell, if you remember, just after demand for crude oil fell. Well isn’t that the sign of manipulation! Now oil supply is high but it’s largely a result lowered demand not because of the world’s ability to produce more oil. Without more oil our world as it is cannot grow much. If oil supplies are falling then our world cannot grow at all. It just seems too horrible so we think it can’t happen. But peak oil has been affirmed by major oil companies, by national governments of G8 countries, by Boone Pickens of course, by the International Energy Agency which represents consuming nations, by members of OPEC, by many oil watchers and geologists. PLEASE take a look at the numbers. Oil markets rose because until supply can meet demand prices will continue skyward. Demand fell below supply and prices collapsed.

Posted by Mallory Margueron | Report as abusive

I wrote those comments as I was falling to sleep in my bed last night, so please excuse the typos and possibly shrill tone; I hope they don’t distract from the general message, namely that while there is of course room for talk about regulations, the “great debate” concern our options in the face of an energy crisis temporarily forestalled by a recession which it helped spark. Thanks.

Posted by Mallory Margueron | Report as abusive