Clearing the usual suspects

NO ONE likes paying more to fuel their car. The fluctuations in the oil price caused by political turmoil in the Middle East are hard enough to bear. But the idea that speculators are driving commodity prices beyond their “true” level seems particularly galling.

To many, that oil went from $65 a barrel in June 2007 to $145 in July 2008, and back down to $31 in December of the same year, is proof the price was not being set by supply and demand. Academics who have proclaimed on the issue come down on both sides of the argument. A recent report* from the OECD analyses the literature, applies its own statistical tests and finds investors not guilty.

Technically speaking, the report does not deal with the influence of speculators on commodity markets but with the role of index-tracking funds. But the spectacular growth of these funds (from $90 billion at the start of 2006 to almost $200 billion at the end of 2007) coincided with the boom in raw-materials prices, so it is hardly surprising they have been fingered as suspects.

The big buyers were pension funds and endowments. They became convinced, after the bear market of 2000-02, that they were overcommitted to shares. So they started to diversify into “alternative” asset classes that were not correlated with equities yet offered the prospect of hefty returns. Commodities fitted the bill.

Surely this lumbering herd must have had an effect on prices? There are some sound theoretical reasons why they might not. For a start the index funds buy futures—a contract to buy or sell an asset at a future date—not the physical good. They are not cornering the commodity, as the Hunt brothers from Texas attempted to do with silver in the late 1970s.

Higher futures prices could have sent a signal to commodity producers, who then decided to hoard their stocks rather than sell them in the cash market. The shortage might then have pushed spot prices higher. The evidence, however, is that inventories were falling, not rising.

An even more telling argument is that commodities without futures markets (apples, edible beans) or futures markets where index funds did not get involved (milk, rice) also saw price rises during 2006-08. Nor was there any correlation between the size of index funds in particular commodities and the price rise for those raw materials.

After analysing data on both prices and individual holdings from America's Commodity Futures Trading Commission, the OECD study found that there was “no convincing evidence that positions held by index traders…impact market returns”; indeed, the OECD reckons that larger positions led to lower market volatility (although data issues mean the finding is more convincing for agricultural products than for energy markets).

So if the funds are innocent, who was guilty? The report does not give an answer but some economists have made the attempt, variously citing demand from China and other developing nations, the diversion of crop use from food to fuel oil, and production constraints.

These explanations may seem to strain plausibility, given that the oil price fell by 79% within five months. The Chinese did not suddenly cut their oil consumption by four-fifths. But if supply and demand are in close balance (as they were in the oil market), even very small changes in either component can lead to large price shifts.

In his book, “The Logic of Life: Uncovering the New Economics of Everything”, Tim Harford postulates a “marriage supermarket” in which men and women who agree to wed can present themselves at the checkout and share $100. Given equal numbers of men and women, say 20 apiece, one would expect couples to split the $100 down the middle. But assume there are 20 women and just 19 men. If the women are determined to get married, this shortage of males will cause a bidding war. None will want to be left in the aisles so they will agree to cut their share of the pot. In theory, the lack of just one male will mean the men get to keep $99.99 of the proceeds, leaving the women with one cent.

Similarly, in boom conditions commodity consumers will be so desperate to get their hands on raw materials that they will drive prices up to absurd levels, at least for a short time. When demand falters, or new supply shows up, the price bubble can evaporate as quickly as it arose, without a speculator in sight.

* “Speculation and Financial Fund Activity”, Draft Report, OECD Trade and Agriculture Directorate



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