Home / Markets / Commodities /  Chaotic trading in energy, metals and food spills into real world

A rally in commodities prices more intense than anything seen in the modern trading era is shaking the markets meant to ease the flow of raw materials around the world.

Wild swings in futures markets are complicating business for the people and companies who actually produce and use natural gas, zinc or soybeans, to name a few. They are driving speculators and others from the markets, an exodus that has led in turn to even choppier trading and higher prices. Russia’s invasion of Ukraine has added to market disruption, especially in energy and grain sectors. Bouts of inclement weather and supply-chain problems have complicated delivery in some markets.

These market increases have filtered through to higher prices for consumers, adding to pressure on the Federal Reserve to raise interest rates.

U.S. natural-gas prices have jumped 79% in 2022; usually they decline into the mild weather of spring. Oil has fallen about $23 a barrel from a recent high, but the benchmark U.S. price is still up 34% this year.

Appalachian coal, soybean oil, oats, canola, rapeseed oil, natural gas in the Netherlands, wheat in Paris and Chicago, gasoline, diesel, propane, palm oil, copper and tin have all notched new highs in 2022. Soybeans, lean hogs, frozen pork bellies and zinc aren’t far off their records.

The surge has been propelled by demand from consumers emerging from the pandemic flush with savings and government stimulus and ready to spend.

Mills, mines, drillers and farmers are playing catch up on supply. War between two of the world’s largest commodity exporters threatens production and delivery in important markets, such as corn, oil and wheat. And an ongoing weather cycle has parched farmland and sapped fuel reserves.

“Inventories across energy, agricultural and metals are critically low everywhere," said Tracey Allen, commodities strategist at JPMorgan Chase & Co., which expects prices to remain high through 2023. “It doesn’t appear there’s a silver bullet," she said.

In the spring of 2020, as much of the world began pandemic lockdowns, commodities markets were in free fall. U.S. oil futures plunged into negative territory for the first time in April 2020, ending one session at negative $37.63 a barrel. Sellers were so desperate that some essentially paid buyers to take their barrels.

An early sign of the rally came that summer, when the lockdown prompted Americans to remodel all at once. Home builders all over the country were overwhelmed with buyers eager for backyards and home offices, and to take advantage of the lowest mortgage rates ever.

The normally sleepy futures market for lumber began a wild ride. Lumber futures nearly tripled that summer, then fell back, and then climbed to more than four times the typical price for two-by-fours by May 2021, before plunging down to prepandemic levels by summer. They took another run to the stratosphere through the winter.

Though it was the most profitable stretch for sawmills in modern times, the volatility made trading in lumber futures treacherous. Resolute Forest Products Inc., a big Montreal-based lumber and pulp producer, liquidated its futures positions after notching a $49 million trading loss during the spring quarter of 2021.

Resolute more than made up for the loss by selling a lot of actual lumber, a spokesman said, but the firm’s retreat from futures trading was a big loss for a market that was shedding participants. Lately, open interest, a measure of market participation, was roughly a quarter of what it was in May 2018, when lumber futures hit their prepandemic high.

On many days lumber futures move so sharply that trading locks up at daily-move limits that are intended to ensure order, leaving traders unable to trade. That slowed the flow of lumber when traders couldn’t unwind futures bets that were originally made to protect the value of warehouses full of wood. Rather than shipping the material to building sites, the lumber had to be held as a buffer against potential trading losses.

Other, larger commodity markets heated up in 2021 and began their own bouts of chaotic trading.

China and other importers stocked up, lifting prices for soybeans and corn. Inclement weather reduced harvests in South American growing regions. The northern prairies were parched by the La Niña weather pattern and put out poor crops of wheat and oats.

The natural-gas glut that had depressed U.S. prices for years evaporated last year when some of the hottest weather on record jolted demand for electricity to run air conditioners. Drought cut hydropower output in the West, creating even more demand for gas.

The fuel started heating season last fall at the highest price since before shale drillers flooded the market more than a decade ago. Inventories were low in Asia and Europe, touching off a global scramble for liquefied natural gas as winter approached and Russian troops massed at the Ukrainian border.

In late December the benchmark European gas price, set at a Dutch trading hub, shot up to more than 10 times what the price was a year earlier as LNG cargoes were bid up to replace Russian gas. As gas prices rose, so did power prices. Fertilizer plants, which consume large volumes of gas, curtailed production due to the expense.

The exchanges and banks that facilitate trading responded to fast-rising prices by boosting the size of the deposits they require from traders. Known as margin, the collateral protects the banks and exchanges from losses in the event that bad bets result in a default among traders.

Bourse-operator Intercontinental Exchange Inc., or ICE, has lifted the margin rate for trading in European natural-gas futures repeatedly, including six times this year. Even after lowering the rate late last month to reflect easing gas prices, buyers and sellers must still plunk down €70.70, or about $77, for the exchange to hold as collateral for each megawatt-hour worth of gas they want to trade, up from €3.87 a year ago, when front-month gas futures traded for one-fifth of what they cost now.

That’s an extreme case, but margins have been boosted across commodities markets by the exchanges and banks that manage trades. The increased margin costs cut into the funds traders can use in the markets, and many traders have unwound positions rather than pony up more cash.

The margin required to trade a single front-month contract for Brent crude, a global benchmark that covers 1,000 barrels, is $11,920, or $11.92 a barrel, according to ICE. That’s more than twice the margin cost a year ago, as the price for the barrel of oil itself moved from about $63 to roughly $115 when the latest margins were announced about three weeks ago.

Traders and analysts say the added costs and heightened risk of trading commodities has dried up market liquidity—the ability to transact at expected prices without causing big moves in prices or disorderly trading.

Open interest—the market participation measure—has declined 25% over the past year in the main U.S. oil-futures contract and is less than half what it was two years ago. Open interest in benchmark futures for U.S. natural gas and wheat have also declined by more than 20% over the past year.

JPMorgan’s Ms. Allen estimates that open interest across commodities markets measured by its value dropped by about $94 billion during the week that ended April 1, as investors and trading algorithms backed away from turbulent markets. “The number of contracts traded within these markets has declined quite sharply," she said.

Shankar Narayanan, head of research at Quantitative Brokers LLC, which uses algorithms to trade on behalf of hedge funds, banks and asset managers, said that traders wary of tipping their hands or making big ripples in illiquid markets are slicing up large trades into smaller transactions, which is making it difficult to ascertain prices. Wider gaps between offers to buy and sell have meant more volatility across nearly every commodity, Mr. Narayanan said.

The average size of buy and sell offers in U.S. crude futures, for example, has decreased by 81% from a year ago, to the lowest since 2008, Mr. Narayan has calculated. For U.S. natural-gas futures, the year-over-year decline in quote size has been 62%. Corn-future quotes have shrunk by 75%.

“There will be consequences from this inefficient futures market into the physical market," said Christophe Salmon, finance chief at commodity-trading firm Trafigura Group, speaking last month at the FT Commodities Global Summit in Lausanne, Switzerland. Firms like his rely on the futures market to manage the risk involved in moving commodities around the world, and less trading can mean fewer shipments and higher prices.

In the U.S., futures-market chaos has already boosted consumer prices. In late January, expiring natural-gas futures contracts shot up 46%, the biggest daily gain on record. Trading was paused a dozen times that afternoon as prices careened, tripping circuit breakers aimed at maintaining order.

The timing and sharpness of the move—and the few trades involved—suggest speculators trapped in wrong-way bets on the direction of prices raced to buy futures at the 11th hour to settle trades. Known as a short squeeze, the situation can produce sharp gains with little connection to market fundamentals.

Since many sales to residential gas customers are linked to futures prices, the sharply higher futures meant a big increase in what many Americans had to pay for heat and electricity in February, according to the American Public Gas Association, which represents hundreds of gas utilities.

“These higher fuel costs must be passed through to consumers," the group’s president, Dave Schryver, wrote in a letter to the Commodity Futures Trading Commission requesting an investigation of the spike. A spokeswoman for the CFTC declined to comment.

Energy costs especially are busting household budgets. The energy commodities category jumped 48% in March from a year earlier, according to the Bureau of Labor Statistics on Tuesday. Overall inflation rose 8.5%, the highest reading since December 1981. Global food prices jumped to an all-time high in March, according to the United Nations’ Food and Agriculture Organization.

Goldman Sachs Group Inc. economists estimate that the rise in commodity prices over the past year accounted for 1.9% of U.S. consumer spending, compared with a 1.8% slice when they vaulted ahead of the 2008 crash and 1.2% when the Gulf War doubled oil prices and drove the economy into the short-lived 1990-91 recession. Soaring commodity prices during the Arab oil embargo in the 1970s took a bigger bite out of American budgets.

While strong wage growth could help consumers keep up with rising costs, Goldman’s economists nonetheless expect commodity prices to limit economic growth this year.

Central bankers are responding by raising interest rates. Last month Fed officials approved their first interest-rate increase in more than three years, lifting their benchmark rate to a range between 0.25% and 0.5% and penciling in additional hikes this year.

Investors have fled risky investments and piled into those they expect to follow commodity prices higher and offset the erosive effect of inflation elsewhere in their portfolios.

Higher rates introduce opportunity cost and reduce the appeal of speculative investments, such as technology stocks, which have halted years of outperformance to lead a 15% decline in the Nasdaq Composite this year.

In the S&P 500 index, the top 21 performing stocks this year belong to companies involved in the production of energy, fertilizer or other commodities.

“Everyone is looking for hedging," said Louis Navellier, chief investment officer Navellier & Associates. The Reno, Nev., money manager has been buying shares of oil producers, such as ConocoPhillips and EOG Resources Inc., which have this year gained 39% and 40%, respectively, and fertilizer makers, including CF Industries Holdings Inc., up 55%.

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