Crumbling Commodities

GREETINGS FROM SEDONA

The commodity markets crumbled last week because the government forced the exchanges to change the rules of the game in order to screw the speculators. Most investors are familiar with the concept of buying stock on margin – borrowing up to 50% of the cost of the securities purchased. With commodity futures, as with stocks, you do not have to pony up the full price of the contract, but with commodity futures you are not borrowing anything because there is no actual purchase until the expiration date of the futures contract (the time when delivery of the commodity is due). When you purchase or sell a commodity futures contract, you are actually making a good faith deposit. Commodity prices cracked because the required down payment was doubled for silver over just a few days causing a ripple effect throughout the markets.

Silver futures contracts trade in 5000 ounce units. At $30 per ounce that is $150,000. The price of silver was rising rapidly from the teens to nearly $50 per ounce in a matter of only a few months. Rather than look to the government cyber cash creation at the fed as the cause, the speculator scapegoat was trotted out for its regular thrashing. To back up the jawboning the authorities know the best way to punish these horrible humans is to make speculation more expensive, in this case doubling the required deposit from about $11k to $22k per contract. Look at it like a margin call you did not expect because your stocks were going up. Most of us would have to sell some of our positions in order to meet the extra requirement. That is exactly what happened with silver.

However there was more. Serious threats were made to restrict speculative positions throughout the commodity complex. In English that means there would be a relatively low cap placed on the total amount of contracts a speculator could own or be short at any time. The increased deposit requirement on silver sent chills throughout the markets because the participants had every reason to believe this would not be limited to silver. The threat of position limits had the same chilling effect. The combination cracked the entire market.

Many of you may find comfort in the suffering of the evil speculator. However, you may want to reconsider upon reflection that the new rules result in increased costs for the commercial producers and purchasers of commodities. It means everyone will have to raise more cash to accomplish normal hedging activity. Some, like the airlines hedging jet fuel costs, will find this particularly onerous. During the surge in oil prices from 2006-2008 only Southwest Airlines had the financial strength and cash available necessary to lock in its jet fuel costs by hedging on the commodity exchanges. Of course, special exemptions can be allowed for legitimate commercial interests. Unfortunately, that type of thing never works in the long run once the lawyers and accountants inevitably figure a way around the rules.

This is serious stuff folks. Commercial hedging is crucial to untold number of enterprises and the increase costs will hurt. So called speculators are necessary to the smooth functioning of these markets. On top of that, the moves by regulators will not stem the tide of rising commodity prices as long as the fed keeps creating new confetti cash.

In the interest of fairness, there have been numerous reasons cited for the increase in commodity prices besides speculators. They include instability in the Middle East and North Africa, drought and so forth. If those explanations had any validity, then why did the war between Iran and Iraq in the 1980’s fail to stem the decline in oil prices during that period? Also consider that Saddam Hussein literally blew up all the Kuwaiti oil fields with nearly zero lasting effect as oil prices languished at around $20 per barrel for most of the following decade? The answer is that the fed was not churning out new cash at today’s alarming rate.

Another explanation for the lack of effect on the oil market in the aftermath of the first gulf war is that the fed’s cyber cash found a different home. We often love the initial side effects of fed profligacy. For example, we never seem to complain about speculators when stock prices are rising as a consequence of easy money. On the contrary, everyone does contortionate intellectual cartwheels to prove that stocks are actually cheap and must go much higher. Just go back to the newspapers in 1999 if you have any doubts. The same may be said about rising real estate prices. Everyone loves sharply escalating home prices. This must be good for America and great for homeowners achieving the American dream. There is never a need for the regulators to step to stop house flipping speculators from driving prices ever higher.

Another way of looking at this is that speculation is hard work. You not only have to do thorough analytical work on the fundamentals of the marketplace, you must also anticipate the capricious behavior of the ruling class. If profitable speculation were easy, we would all be doing it and getting rich in the process. Unfortunately, in the end, we the people are the ultimate victims of the erratic and usually thoroughly irrational behavior of the regulatory authorities.

All the best to you all,

Stephen Reiss
[email protected]

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