Commodities Speculators: More Help Than Harm?

Speculators often get a bad rep, especially when headlines report a crash in stocks, a spike in oil prices, or a currency's value is shattered in short order. This is because the media often confounds speculation with manipulation. Manipulation is fraudulent and unethical, many times leading to extensive economic damage; whereas speculation, while risky for the speculator, performs several important functions that keep our markets and economy healthy. In particular, speculation in the commodities markets keeps not only financial markets, but also our supermarket shelves and food supply chains running smoothly.

In this article, we'll look at the function of speculators in the commodities market.

While they are often given a bad name, speculators actually have an important place in today's markets.

What is a Speculator?

The speculator makes his or her money through buying and selling assets such as derivatives contracts that allow him/her to control assets such as commodities without ever directly handling them. For instance, commodities speculators don't arrange shipment and storage for the commodities that they control as a hedger might. Instead, they simply bet on price movements and close out their positions before they expire.

This hands-off approach has given speculators the erroneous image of aloof financiers jumping into markets they care nothing about in order to make profits from the producers—the salt-of-the-earth types that legislators are always claiming to defend. But this means that speculators take on a great deal of risk for themselves. If the price of wheat falls, a long speculator loses all of that value, while a food producer who has hedged by buying wheat futures will still benefit from buying cheaper physical wheat to make their products despite the declining value of their futures. Therefore, speculators can stand to make a lot, but also lose a lot.

Avoiding Shortages

The most obvious function that people overlook when criticizing speculators is their ability to head off shortages in certain commodities. Shortages are dangerous because they lead to price spikes or rationing of resources. If a drought kills off half the yield of hay in a given year, it's natural to expect the price of hay to double in the fall. On wider economies of scale, however, these shortages are not as easy to spot. That's why commodities speculators help to keep an eye on overall production, recognizing shortages and moving product to places of need (and consequently higher profit) through intermediaries—the middlemen who use futures contracts to control their costs. In this sense, speculators act as financiers to allow the middleman to keep supply flowing around the world.

A speculator should thus not be confused with the middleman or broker. Our economy would not be able to grow much if we only had access to the products we need or want that were produced nearby. More often than not, every product in your house has at least some component that required an international voyage to get there. The markup of the middleman accounts for the overhead costs used to ship, sort, bag and display those products in a store near you, plus some profit to keep the middleman fulfilling this function. This gets maple syrup to Hawaii, Korean laptops to New York, and other products to destinations where a higher profit can be realized.

More than merely financing middlemen, speculators influence prices of commodities, currencies and other goods by using futures to encourage stockpiling against shortages. Just because we want cheap oil or mangoes doesn't mean we should blame speculators when prices rise. More often, other factors, such as OPEC and tropical hurricanes, have raised the risk of a more volatile price in the future, so speculators raise prices now to smooth down the potentially larger future price. A higher price dampens current demand, decreasing consumption and prompting more resources—more people to take up mango growing or more funds for oil exploration—to go into increasing stockpiles. This price smoothing means that, while you might not appreciate paying more for gas or a mango, you will always be able to find some.

When we leave the contained world of commodities and look into one of the largest markets in the world, foreign exchange (forex), we can see how speculators are essential for keeping international trade and finance on-level and preventing currency manipulation. Governments are labeled as some of the most blatant manipulators. Governments want more money to fund programs while also wanting a robust currency for international trade. These conflicting interests encourage governments to peg their currencies while inflating away true value to pay for domestic spending. It's currency speculators, through shorting and other means, that keep governments honest by speeding up the consequences of inflationary policies.

Preventing Manipulation

While people may recognize speculators' importance in preventing shortages and smoothing prices, very few will associate speculation with guarding against manipulation -- the very bad behavior that people mistake speculators for engaging in. In markets with many different speculators participating, it is much harder to pull off a large-scale manipulation and much more costly to attempt it (and even costlier upon failing). Unusual price action in Mr. Copper and Silver Thursday are examples of ongoing manipulations that eventually collapsed as more market speculators entered opposing trades betting against unusually high prices in cornered markets. To avoid manipulation in markets we need more speculation, not less.

In thinly traded markets, prices are necessarily more volatile, and the chance for manipulation is increased because a just few market participants can have a much bigger impact. In markets with no speculators, the power to manipulate prices shifts between producers and middlemen/buyers according to the health of the crop or yield of a commodity. These 'mini-monopolies" and monopsonies result in more volatility being passed on to consumers in the form of varying prices. As speculators see these volatile markets as trading opportunities, they enter and smooth out the price action and reduce the manipulative tendencies.

Show Me the Money

Speculators can make a lot of money when they are right, and that can anger producers and consumers alike. But these outsized profits are balanced against the risks they protect those same consumers and producers from. For every speculator making millions on a single contract, there is at least an equal number losing millions on the trade—or a dollar on each of a million smaller trades. In very volatile markets, like those after a natural disaster or black swan event, speculators often lose money on the whole, keeping prices stable by making up the difference out of their deep pockets.

The Bottom Line

Taken as a whole, speculation helps us far more than it could ever hurt us by moving risk to those who can financially handle it. Despite the misunderstanding and negativity speculators have to face, the potential for outsized profits will continue to attract people, as long as governments don't regulate them into oblivion.

With all the negativity aimed toward short-sellers and speculators, it's easy for us to forget that their activities maintain prices, prevent shortages and increase the amount of risk they undertake. I don't want to become a speculator, but it's important that we preserve speculative investing for the people who do—more than important, it's a necessity for a healthy market and vibrant economy. You don't have to become a speculator, or even hug the next one you see, just remember that the next time you pay sharply more a gallon for gas, it's so we'll still have some left over for next week, year, decade and century.