The current bull market in commodities is affecting more than just oil prices. And although headlines explain the rise with “global recovery” and now turmoil in Egypt, those guesses are just recycled from the last bubble. There is nothing in the supply or demand of any of these underlying commodities to explain the price momentum.
Look at the price and supply/demand stats for copper over the past quarter century. Check similar stats for other commodities at the USGS website here, or prowl through Indexmundi, paying special attention to the overall commodities index for the past twenty years:
Look closely at the sustained boom that starts in 2002, collapses briefly during the crash, then skyrockets again in 2009 when the world was still locked in recession.
Price is always dictated by supply and demand. So why would prices for aluminum or cocoa spike this way if the supply and demand are relatively flat? You have to understand what buyers are actually demanding. Here’s a hint – it isn’t any of these commodities themselves.
This asset inflation is being driven mostly by two factors: extremely low interest rates and deregulation of asset markets.
First, a decade of extremely low federal funds rates made massive amounts of money available cheaply to financial institutions. That was supposed to be invested back into the economy; leant to small business and entrepreneurs and so on. But new business investment has been weak for a long time. Instead this cheap money went looking for returns in a different direction driven by the second factor – changes in the rules of the asset markets.
The markets that set price for the foundational elements of modern capitalism were carefully guarded for decades. Those markets needed speculators in order to function properly, but they needed a limited number of fairly sophisticated ones. Operating mostly in narrow bands of value, these were some of the most cutthroat markets in the world. For speculators these were mostly arbitrage markets – no place for the average investor to be squirreling away his retirement savings.
In the last few days of the Clinton Administration we started opening commodities markets to wider speculation with a new law that would set the table for the economic collapse of the ‘aughts. The first step was a set of provisions sponsored by Texas Republican Phil Gramm in the Commodities Futures Modernization Act. You could write a book about that law and what it meant, but in short it exempted derivatives from any Federal oversight, elminating a bunch of evil, Communistical rules that had kept big institutional investors from driving up commodity prices.
Soon, even federally insured banks were bringing their (your?) money to Chicago.
Commodities don’t trade like stocks. When you place an order on the Chicago Mercantile Exchange for 80 railcars of corn to be delivered in September, that order will be fulfilled in September. If you don’t sell that contract to someone else, you’re going to be feasting on a lot of cornbread this fall.
If you want to make money in the commodities markets and you don’t actually want a railcar full of corn you must rely on a large number of carefully balanced transactions. Big investors like banks, pension funds, and sovereign wealth funds are not organized to do that. They look for longer bets – the institutional long. They bought derivatives based on pools of commodity contracts that allowed them to hold something long-term. They flooded these markets with new capital, biased toward long positions, that could not be absorbed or invested.
Low conventional interest rates and the erosion of the old rules have driven up the demand for commodities as speculative assets. It has done nothing to the demand for, say, copper or corn themselves. But it has created intense new demand for securities based on those commodities’ market performance.
The result has been a very strange combination – inflation and glut. There was (is) not enough value in those markets to absorb the capital inflows. The new capital didn’t successfully stimulate growth because it was based on phantom demand – pure market manipulation. Just before the last crash we ended up with prices through the ceiling and oil tankers idling off the coast because storage capacity was exhausted. After the collapse the machine has started all over again.
What to do it about it? For starters, restore some of the sensible rules that once made these markets work. But that would only deal with part of the problem. This is tied to a larger set of ills that affect other markets as well. Our high corporate taxes, repeated personal tax cuts, public debt, weak economic growth, intensifying concentration of wealth, poor infrastructure development, and the growth of unregulated derivatives are all factors. But that’s another story.
For more on derivatives, you can watch the full episode of Frontlines’ The Warning.
And don’t worry too much about your expensive gas. The price will collapse again soon enough.
That’s what we should be worried about.
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