Commodities Speculators: More Help Than Harm?

Do speculators provide more help than harm to commodities markets? Speculators often get a bad rap, especially when headlines report a crash in stocks, a spike in oil prices, or a currency’s value being shattered in short order. This is because the media often confuse speculation with manipulation.

Manipulation is fraudulent and unethical, and can lead to extensive economic damage. 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 necessary trading as well as our supermarkets and food supply chains running smoothly.

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

Key Takeaways

• Speculators are risk-takers who bet on the short- and mid-term future direction of an asset’s price movement without having, or intending to have, any stake in that asset.
• Speculators provide markets with liquidity, aid in price discovery, and take on risk that other market participants wish to unload.
• In commodities markets, speculators keep markets efficient and stave off shortages of goods by bidding prices up when they fall and financing the middlemen who link supply chains.
• Reports of market crashes or wild price run ups are sometimes tied to speculators.
• Speculation is legal, market manipulation is not and is prohibited by the Securities and Exchange Act of 1934.

What Is a Speculator?

A speculator makes money by buying and selling assets such as futures contracts that allow them 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.

Speculator vs. Hedger

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.

In reality, speculators take on a great deal of risk for themselves. If the price of wheat falls, a speculator who has gone long loses all of the value of that price drop when they close out their position. So while they stand to make a lot, they may instead lose a lot.

On the other hand, a wheat producer who has hedged their future product sales by selling wheat futures will be able to close out their futures position at a profit to offset some or all of their loss on sales. This is the nature of hedging.

Important

While they are often given a bad name, speculators actually play an important role in today’s markets.

Preventing Commodities 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 easy to spot. Commodities speculators help to keep an eye on overall production. They recognize shortages and move 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. They should not be confused with the middleman or broker.

Facilitating Supply

Our economy would not be able to grow much if we only had access to the products 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 demand can be satisfied and a higher profit can be realized.

The Use of Futures

Beyond 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 inexpensive mangoes doesn’t mean we should blame speculators when prices rise. More often, other factors, such as OPEC and tropical hurricanes, raise the risk of price volatility in the future. So speculators raise prices by buying to smooth down the potentially larger future price.

A higher price dampens current demand, which decreases consumption and pushes more resources—e.g., more people to take up mango growing or more funds for oil exploration—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.

Note

The Securities and Exchange Act of 1934 prohibits the manipulation of securities prices. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, signed by President Barack Obama, also prohibits price manipulation related to swaps and commodities.

Protection Against Manipulators

While people may recognize speculators’ importance in preventing shortages and smoothing prices, fewer realize that speculators also guard against market manipulation.

In markets where many different speculators participate, it is much harder to pull off a large-scale manipulation and much more costly to attempt it (and even costlier upon failing).

Heading Off Cornered Markets

Unusual price action due to 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.

Reducing Volatility

In thinly traded markets, prices are more volatile, and the chance for manipulation increases because a 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. But speculators see these volatile markets as trading opportunities. They enter and smooth out the price action and reduce the manipulative tendencies.

Keeping Governments Honest

When we leave the contained community of commodities and look at 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. They usually want more money to fund programs as well as a robust currency for international trade.

These conflicting interests encourage governments to peg their currencies while inflating true value to pay for domestic spending.

It is currency speculators, through shorting and other means, who keep governments honest by speeding up the consequences of inflationary policies.

A Balance of Profits and Risks

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 producers and consumers 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.

Are Speculators the Same as Market Makers?

No, although they both provide liquidity to markets and improve efficiency. Speculators are in the market trying to make money solely on the future prices of assets/securities. Market makers’ role is to buy and sell securities and ensure the smooth flow of trading. They make money on the bid-ask spread and aren’t concerned with the direction of prices.

Are Commodity Producers Considered Speculators?

No, generally speaking, commodity producers are in the market to hedge, or protect, the future price for their crops or processed products, which could go up or down for various reasons. Speculators in commodities markets are intent on making money by taking advantage of price fluctuations of futures contracts.

Can Investors Get Back Money Lost to Market Manipulation?

If you believe that you have lost money as a result of illegal market manipulation, you may be able to take legal action to recover your funds. Speak to a lawyer with experience in this field to learn about the options you may have.

The Bottom Line

Speculators help markets by transferring financial risk to those who can handle it. Their activities maintain prices, keep markets efficient, and prevent commodity shortages.

Speculation is necessary for healthy markets and a vibrant economy. Despite the misunderstandings and negative press that speculators may face, the potential for outsized profits will continue to attract people to the role.