Plenty of Incentive to Speculate

(Video: AP/Story: Export Development Canada – Peter G. Hall)

One of the marvels of recent economic developments is the surge in commodity prices. It wasn’t anticipated, but it has persisted, and the debate about its causes rages on. Two key views have emerged: on one side, those who feel it’s mostly about supply and demand fundamentals, and on the other, those who see a heavy speculative element. Does the latter side have a point?

Price movements have been dramatic, and have involved a broad range of goods. Since the summer of 2007, oil prices have more than doubled to $130 a barrel. Base metals have been on a tear since 2005, with copper, nickel, lead, zinc, aluminum and steel now fetching several times their original prices. Food has more recently joined the fray, with wheat, coarse grains and rice prices, up 125% since early 2007, spurring price increases across the agri-food sector.

Is speculation a factor? Human behaviour suggests so. Sudden price spikes are usually spurred by shortages, or at least the perception of shortages. Consider food. A mere rumour that local supplies are running low is enough to trigger a rush on supplies. To the merchant, this looks like a surge in demand, so up go prices as the order book fattens. Does the demand surge reflect fundamentals? Far from it. Worry that the current food distribution system will fail them leads private citizens to buy, not just for current needs, but to build their own personal food inventories.

The mechanism is similar for producers. Rather than let short supplies shut down their production lines, savvy businesses will likewise build up stocks of what they need for the future. As this catches on across the world economy, demand swamps available supplies, putting pressure on the global production system and ultimately, prices. Why? Because global production maintains enough supply to meet day-to-day needs, but is not geared for sudden private inventory building.

The process doesn’t stop here, though. As with any sustained price rise, it is better for producers to buy additional supplies early, and sell at the latest possible point in time, either marking prices up to reflect rising input costs, undercutting competitors who didn’t pre-buy earlier at lower prices, or a combination of the two. Either way, there is a strong incentive to purchase a lot more than current needs dictate, adding further to the perception of a general supply shortage.

And then there are other market players. These have little or no direct connection to the commodity in question, but see large price increases, and want a piece of the action. They have significant clout, given the sizable liquidity generated by robust global growth in the past four years. And data suggest that they are quite active in current commodity transactions. Their incentive is strong. In the past year, major global stock market indexes have fallen on average by 15%. In the same timeframe, commodities in US dollar terms have jumped by almost 50%. What is more, the incentive has been magnified by crisis in other parts of the economy. This activity is enhancing the perception of shortages, but has little relation to demand and supply fundamentals.

The bottom line? Speculative bubbles are almost impossible to fully identify before they burst, but oddly enough, are always a no-brainer in hindsight. Knowing that the incentives to over-invest in commodities are currently very strong suggests that a near term price correction could well occur.