As you might know there’s a lot of discussion at the moment about whether the high price of virtually all commodities is the result of speculation or true demand. Various politicians are decrying the evil speculators and it seems fact finding commissions are deployed daily.

Before we begin, lets separate spot prices from future prices. It would require a hardcore speculator to push up the spot price directly. With hardcore I mean someone who is actually prepared to take physical delivery. Of course there are highly publicized examples of this happening, but let’s face it; it’s pretty darn rare.

No, usually people buy futures with absolutely no intention of holding them to maturity, in the hope of selling them for more than they bought them. Pretend we buy the right to buy a barrel of oil for $100 in 6 months time, this right costs us $110. In three months time, if the spot price of oil is still at $100 that right might only be worth $5. We would then have lost $5 on the trade.

As you can see this speculation will do nothing to the actual price of the oil sold (spot price) if real oil producers and consumers are not affected by changes in the prices of futures. But do you really believe that?

Let’s take oil again with the numbers we used above. Pretend you’re the CEO of Exxon for instance. Your company has invested X amount of dollars to get all the equipment in place to extract oil from a well containing Y barrels of oil.

With the bearded madman and his colleagues having pushed interest rates to virtually zero that X amount of bucks you borrowed to put everything in place are pretty cheap, the yearly interest payments are not much, some 5% maybe. Having established that fact lets look at some more components of the cost of carry, what will for instance the infrastructure cost that contains that oil you are planning on not selling right away?

Ah yes it’s the subterranean cavity containing the unpumped oil, you got that one for free… That leaves us with personnel costs because unfortunately you can’t just fire those oil platform workers and rehire them in 6 months, even if you could it would be a very stupid and expensive way of saving a few bucks so we add that to the “tab” which now contains salaries for more or less idle workers and interest payments.

Now pretend this is all happening in January and the plan is to suck up 10 million barrels from this particular well this year, the current price is $100 / barrel so the total take on this year’s oil from that well is a cool billion bucks. But then this news hits the screen about the June futures going to $110. That’s a hundred million difference…

The loan amounts to 500 million which means 25 million in interest payments, add to that 20 million in staffing costs / year. A total of 45 million. Now of course you could lock in this sudden “profit” by issuing June futures at 110 since obviously there are buyers at that price in June. By doing that however you would need to somehow make 5 million barrels available instantly in June which means you can’t make that oil languish in the well in the meantime since it’s impossible to pump 5 million barrels in a month or a few weeks. No, if you sell futures in June you will have to store 5 million barrels in tankers or cisterns which ups the cost of carry by amounts that are not insignificant. They are in fact very significant, so significant that that plan is off the table.

However, if you could lower production in the first half of the year by 50% and then run at 150% during the second half you could sell 2.5M barrels for 100 and hopefully 7.5M barrels for 110. That would net you $1075M. Sure staffing costs would increase during the second half of the year but you see how the 75M contrasts to the 45M we talked about earlier. A more realistic scenario is probably running at 100% in the second half and taking home a total of $800M and still have 2.5M barrels left in the ground.

A quick call to the PR department which announces that “production has hit a snag and we can only run at 50% capacity for the first half of the year bla bla bullshit” and we’re a gogo. The spot price shoots up as a result of rising June futures which went up because speculators bid it up…

The same logic applies to any other non perishable commodity, in fact the storage costs for metals are much less than oil so you can continue extraction at whatever rate you wish, you don’t have to “store” this stuff in the ground to lower the cost of carry.

But what about food?

A wheat farmer can probably not wait for “better” times too long before the grain rots, at least not more than one year when the next harvest comes in if he doesn’t want to build more silos and I suspect he doesn’t want to. For the more productive farmers that can get both 2 and even 3 harvests per year the procrastination time is even shorter.

The result should be that sure, speculators can bid the price of food up but the produce needs to hit the market much sooner than other commodities which means that any speculative dislocations will probably have to correct much sooner than a non food commodities bubble. Neither the producers nor any speculator taking delivery can store this stuff for long so it needs to hit the market pretty soon and therefore push prices down.

To add injury to insult, it’s much easier for a farmer to switch crop than it is for a miner to switch metal, if suddenly the price of one particular crop goes up a lot more than what the farmer in question normally grows he might be able to switch to the expensive one and therefore help push prices down in a few months time.

What we can infer from this is that speculating in non perishable commodities, especially metals, is probably better than speculating in agricultural commodities since the very nature of non perishables enable more severe speculation which in turn should result in bigger swings. On the other hand when the bubble pops the fall will probably be so much harder due to all the speculators dumping their stocks at the same time.

Note that by the above reasoning the very fact that futures markets will turn producers into speculators to some degree is more or less certain. Especially oil and metals extractors. Any other behavior (with regards to the CEO for instance) would be either stupid or disloyal towards the share holders and we didn’t even bring up bonuses here.

So next time someone tells you that speculation doesn’t really affect real prices of commodities you can call him out for what he is, a pot head or an academic.

Jesus Christ, god almighty, WTF is this.

The writer, of DOW 36000 now advocates a 50/50 mix of stocks and gov bonds at a time when interest rates can only go higher.

This is just too much…

Furthermore the idiot in question suggests you also own bear funds/ETFs/whatever. Why on earth would you want to do that at the same time as you are long as a retail investor?

As a retail investor you can simply get out of your longs within the blink of an eye if you think you’ve topped.

This is just one of the most ridiculous idiots alive at the moment, if you want to make money do not listen to him and do not buy his stupid books.