The politicians who demanded a ban on futures trading on farm produce in India would be delighted to see that there’s now a debate raging in the US whether the large funds pouring money into futures markets are behind the soaring crude oil prices.
It is interesting that hedge fund managers, including billionaire George Soros, have testified to US Congress that speculation has spurred the rise in crude prices. He was joined last week by a former commissioner of the Commodity Futures Trading Commission, or CFTC, and the president of a company that runs gas stations in the US, both of whom essentially said the same thing at a hearing of the Senate’s commerce, science and transportation committee.
Soros reportedly told the committee that the ability of institutions to invest in the futures market through index funds was creating an oil market bubble. Michael Masters, another hedge fund manager, pointed out in a similar testimony to the Congress last month that at the end of 2003, $13 billion (Rs55,770 crore) worth funds tracked commodity index funds. This has risen to $260 billion by 2007, and the demand for them continues to grow.
But some experts find it preposterous that the futures market and large inflows into them are being blamed for the price rise. Ajay Shah, senior fellow at the National Institute of Public Finance and Policy, says he is baffled at the tirade against futures markets. “For every buyer on the futures market, there is an equal and opposite seller,” he says.
“The balance between the buyer and the seller makes the price of any commodity. If the futures market is indicating that prices are higher than what they ought to be, short sellers won’t give up the opportunity; they will bet on a fall in prices by selling futures,” he adds.
The more the number of players in the market, the better the chances of arriving at a fair price for any commodity. True, large players could corner the market by taking large speculative positions by hoarding a commodity and affecting supply to genuine users. But authorities have found no evidence of inventory hoarding. Besides, a CFTC report released on 30 May shows speculative net long positions on crude futures traded on the New York Mercantile Exchange have fallen by 80% since last July.
In any case, just bidding up the futures price through excessive speculation doesn’t change the dynamics of the spot market. There, artificially high prices would hurt demand and reign in prices. Besides, there could be supply-side initiatives to take advantage of the high prices.
While futures prices normally lead the spot markets in terms of price discovery because of their higher liquidity, they cannot be out of whack with the underlying fundamentals in the spot market.
Take, for instance, the price of wheat, which having risen to record levels, was also a cause for concern. But a bumper harvest this year has led to a correction in prices. Wheat prices have fallen by 35% from their highs three months ago, ending in large losses for speculators with long bets, and in profits for short sellers. The oil story could end the same way, perhaps worse for those with long bets.
Unlike Soros and Masters, there are a number of traders who believe that the rise in oil prices is a simple case of supply not catching up with demand. Billionaire hedge fund manager and oil veteran Boone Pickens told Bloomberg recently, “What you’re trying to do is find a scapegoat and place blame on it when what you have is demand that is greater than supply. You’re gong to bid for the oil, and the highest bidder’s going to get the oil until you finally kill demand with price.” Some oil analysts feel countries with large reserves aren’t ready to grow supply fast enough to meet incremental demand, and with spare capacity at the Organization of Petroleum Exporting Countries small distortions in supply could lead to sharp spikes in crude oil.
Proponents of futures markets argue that commodities such as rice, coal and iron ore, which are not available for investing through index funds, have also risen sharply. Also, unlike in a commodity bubble situation, prices of a number of agricultural commodities such as wheat and sugar and base metals such as zinc and nickel have corrected this year. It’s vague to say that commodity index funds, which are buyers in these commodities as well, are causing a spike in oil prices but not in other commodities.
Yet, it’s not to say that all’s well with the functioning of the futures markets for crude oil. Some investment banks, for instance, can trade without any curbs on position limits. This has come in for criticism and CFTC is now considering a proposal to reclassify these banks as speculators, which would subject them to trading limits.
Just as in the Indian agricultural futures market, what’s required in crude oil futures market is proper regulatory oversight rather than bans on the markets or on participating players.
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