Opinion: Market Fundamentalism Versus the Speculators

John Kemp is a Reuters columnist. The opinions expressed are his own. This is the first in a series of three articles this week by Reuters commodities and energy columnist John Kemp looking at the relationship between fundamental influences and speculation on commodity prices during the recent boom, and what it portends in a slowing economy.
For three years, leading commentators have been locked in an increasingly acrimonious battle over whether the surge in commodity prices reflects changing fundamentals in the
underlying physical markets, or is being driven by speculation and the unprecedented influx of investment money into commodity investment vehicles and hedge funds.

As crude prices doubled in 2007, and doubled again in the first six months of 2008, pushing retail spending at gasoline stations from $33 billion per month to $45 billion in the United States, the debate spilled into the political arena and tempers have flared. Congressional committees held high-profile hearings into the cause of the price spike
during spring and summer 2008, and Sen. Joe Lieberman (I-Conn.) introduced the Commodity Speculation Reform bill to curb the inflow of money and ease upward pressure on the price of gasoline, food and other raw materials.

According to Mr. Lieberman, `there is little doubt that excessive speculation has had an effect on rising prices . Our bill will end that and help create a more orderly market for the industries and producers who must deal in commodities as a matter of business.`

The reality is more complex.

Proponents of the `fundamentalist` view argue almost all the rise in crude oil prices since 2003, as well as the subsequent fall, can be explained by the failure of both OPEC
and non-OPEC supply to keep pace with surging demand for subsidized energy from China and other emerging markets.

Strong demand growth and a sluggish supply response across the rest of mining and agriculture caused similar price surges for a broad range of raw materials from copper, iron ore and ocean freight to corn, rice and wheat.

The influx of investment money into commodity futures markets might have accelerated and amplified the adjustment to higher prices, but it was not a material cause.

Fundamentalists argue the subsequent sharp slowdown in global growth this summer and darkening outlook in the wake of the credit crisis also explain the recent halving in oil prices from $140 per barrel to $70.

Fundamentals are a necessary and sufficient explanation for price movements, and the focus on speculation adds nothing.

In contrast, advocates of the `speculation` thesis note the rise in commodity prices coincided with record investment inflows into long-only commodity indices and more actively managed commodity hedge funds since 2003. They argue the rise in such a broad range of commodities at the same time, doubling and even quadrupling within the space of a little more than 18 months cannot readily be explained by relatively minor adjustments in the underlying physical market.

Extreme daily price changes on the way up have been matched by similarly outsized declines on the way down as the credit crisis has forced liquidation of index positions and hedge funds have been forced to scale back their positions.

But ultras on both sides of the debate are wrong; the explanation for recent gyrations in commodity prices is a mixture of speculation as well as physical supply and demand.

The best way to think about price determination is that physical fundamentals establish a fairly wide range of feasible prices within which commodity prices are free to vary; the actual price at which the market settles within that range is determined by the interplay of more speculative short-term factors. (See chart here).

The upper limit of the range of feasible prices is fixed by demand-side fundamentals that determine how far prices have to rise before substantial volumes of demand are estroyed
and the market is capped.

The most important demand-side determinants are:

1. Substitution (the availability of acceptable alternative materials at cheaper cost).
2. Conservation (the ability to redesign products and production processes to use less of an expensive raw material).
3. Redesign and retooling (high upfront costs to re-engineer products and processes deter substitution until consumers are quite sure price increases are permanent; but once costs are incurred, consumers are very unlikely to return to the previous expensive raw material unless its price falls significantly).
4. New technologies (which change demand patterns in a profound way so the past is not necessarily a guide to the future - as with the emergence of fuel cells, bioethanol and mobile communications).

The lower boundary of the price band is fixed by supply-side fundamentals, of which the most important are:

1. Costs (for extraction, refining and transportation).
2. Required rate of return for investors (including the cost of equity and debt, and target return to shareholders for risk).
3. Industry concentration (competitive markets with nopricing power usually result in higher output and lower prices than more concentrated markets where producers are able to restrict output and raise prices).
4. Management behavior (traditional mining and oilfield engineers focused on costs, processes and output; a new generation of MBA-trained financiers is more likely to focus on pricing, marketing and profitability).

Actual prices are fixed by the interplay of speculative factors within this range:

Dominant positions in the underlying physical commodity market can give rise to market squeezes and create a degree of power over nearby futures prices, at least for a time.
Market movements are typically influenced by the emergence of a strong consensus viewpoint and herding behavior, which tends to be self-fulfilling. From tech stocks to mortgage-backed securities and oil futures, asset price movements show strong signs of momentum (price rises beget further rises, price falls beget further falls) as short-term traders try to spot and join the trend.

Negative margin calls and ridicule tend to discourage contrarian viewpoints (the market can remain irrational longer than the contrarian investor can remain solvent, as John Maynard Keynes noted long ago).

Crucially the media, conferences and water cooler conversations among traders often lead to the emergence of dominant `narratives` that foster and sustain a consensus among a critical mass of traders and investors. Narratives mobilize a large group of traders to establish similar, reinforcing and self-fulfilling positions. They draw in a wider group of investors over time to bolster the trade, and discourage early defections and profit taking.

In the short term, the range of feasible prices is very wide. Supply and demand are both fairly insensitive to price changes in the short run. Upfront costs of redesign and retooling discourage substitution and conservation unless price rises are very large and last long enough to seem enduring.

Similarly, commodity production entails high fixed-costs in plant and machinery and much smaller variable operating costs, so prices need to fall substantially before roducers
will close in output. With the range of feasible prices very wide, speculative factors dominate short-term price setting. But over longer time horizons, the opportunities for substitution and conservation increase, while producers need higher prices to keep attracting capital to the industry to replace existing plant and equipment and finance expansion. The range of feasible prices therefore narrows on both the demand side and the supply side.

Fundamental factors are more important and determinative over longer horizons as producers and consumers have time to adapt to price signals. With the range of feasible prices much narrower over long horizons, speculative factors play a much more limited role. Unfortunately, fundamentals are not constant over time-changing with cost structures, industry concentration, firm behavior and technology. As a result not just actual prices but the range of feasible ones changes over time. Crucially there are feedback loops from actual and forecast prices to decisions about production and consumption, and therefore future prices.

Forecasts therefore have to be dynamic and are sensitive to assumptions about feedback and behavioral change. This is what makes forecasting commodity and financial markets qualitatively different from forecasting meteorological and physical processes where this type of feedback is absent or at least much smaller.

For more hedge fund industry news, visit www.HedgeWorld.com

Source : Reuters