So far we have assumed that buyers are interested in consuming or using the goods itself and are valuing it in terms of the satisfaction that it will bring them, or the use to which the goods can be put. However that is not necessarily the case. The buyer may be a speculator who is only interested in buying the goods because he knows he can sell it on to someone else for a higher price and make a profit on the difference.
Speculators have no intention of actually consuming or using the goods, and indeed may have borrowed money to make the purchase with the intention of using the proceeds of the sale to pay back the loan. Such a plan is highly risky as it depends on finding a buyer who believes, or can be persuaded, that the goods is worth more than the speculator paid for it. The nature of the goods is not particularly relevant, although it does need to be something that can easily be traded without undue delay or cost otherwise the speculator could end up having to pay for and take possession of the goods itself, which is the last thing he wants.
This is where futures contracts come in. Agricultural commodities such as wheat, coffee and rice are vital ingredients for a wide range of products. However their supply is seasonal and unpredictable. An unexpected frost can decimate a crop, causing severe shortages which result in a hefty price rise. This can be good news for those farmers whose crops survive as they can sell at a higher price, but it is bad news for the importer who has to either absorb the unexpected increase or pass it on.
Such unpredictability makes it difficult for either party to plan ahead so it has become common practice for them to enter into a contract in which the farmer agrees to sell the importer a certain quantity of the commodity for a specified price once it is ready, perhaps in three months time, regardless of what the market price may then be. This does mean that the farmer could lose out in the event of bad weather as he might have got a higher price if he’d not entered into the agreement. On the other hand, the farmer gains if a particularly clement summer means a glut in the market, causing the price to drop. Either way, both parties have at least negotiated a price that allows them to stay in business and plan for the future. The use of such contracts, which act to reduce each party’s risk in the market, is known as ‘hedging’.
Such agreements were being made at the beginning of the 18th century in the Rice Exchange at Dojima in Japan, where they were called ‘nobemai’ (Sansom, p.126). They are now known as ‘futures contracts’ or just ‘futures’, and are an ideal vehicle for the speculator because the contracts have a value in themselves, which means they can be traded. For example, a futures trader could buy a contract obliging him to purchase a unit of coffee (equivalent to 37,500 lbs) in three months time at a price of $1 per lb, making a total cost of $37,500. A month later, the price of coffee rises to $1.1 per lb and the contract is now worth $41,250. At this point the trader can sell it and pocket a profit of $3,750 without having had anything to do with the underlying commodity.
Alternatively, the trader could enter into an agreement obliging him to deliver a unit of coffee in three months time for $1 per lb, at which point he would receive $37,500 in payment. A month later and the price of coffee falls to 90 cents per lb. The trader can now buy a contract giving him the unit he needs to fulfil the deal for just $33,750, which again gives him a profit of $3,750.
What makes futures contracts particularly attractive is that the purchaser does not have to commit the full value of the contract up front. Instead a trader must maintain a ‘margin’ with the exchange to ensure that he can meet his obligations through the duration of the contract. Margins are typically between 5 and 15 per cent of the contract’s full value which means the trade is highly leveraged. If the margin is 10 per cent, for example, then a 10 per cent swing in the price of the underlying commodity could mean you double your money – or lose it all if the swing is in the wrong direction.
A futures contract is an example of a ‘derivative’, so called because its value derives from the value of something else. Other examples include the ‘option’, which is similar to a futures contract except that it gives you the option rather than the obligation to buy or sell the underlying asset. There is also the ‘swap’, which is an agreement to swap the income derived from one asset (rent, interest or loan repayments, for example) with the income derived from another. It is even possible to combine derivatives, perhaps buying an option to purchase a futures contract at a particular price on a certain date, or an option to buy a swap by a certain date (in which case it becomes a ‘swaption’). The valuation of such derivatives is an arcane art that few have mastered, which is another reason why speculators find them so attractive as it makes it easier for them to ‘talk up’ their value.
How much influence the speculator has on the ‘spot’ price of the underlying commodity is the subject of much debate. However price is intimately connected to demand so any substantial purchases, whether made by genuine consumers or by speculators, naturally lead to price increases. This is precisely the result the speculator wants and indeed can create, both through his own actions and by persuading others to take similar ‘positions’ in the market. Michael Lewis describes the actions of Lewie Ranieri, a bond trader working at Salomon Brothers during the 1980s:
Lewie would say he thought the market was going up, and buy a hundred million [dollars-worth of] bonds. The market would start going down. So Lewie would buy two billion more bonds, and of course the market would then go up. After he had driven the market up, Lewie would turn to me and say, ‘See I told you it was going to go up.’” (Lewis, p.147)
Such behaviour, fuelled by the highly competitive and insular atmosphere of the trading floor, can cause spectacular increases in price over very short periods of time. As the price rises, other speculators jump on board, creating more demand and driving the price higher. They may well realise that the price at which they are buying is already considerably greater than the market for the underlying commodity actually merits, but as long as they are confident that they can find someone else foolish enough to pay even more for the contract, they need not be concerned.
Of course eventually the bubble bursts. If the traders cannot sell for more than they bought then they face significant losses, and the act of selling increases supply which drives the price back down. Those who got in early will have already secured their profits. The latecomers have no choice but to accept their losses, which could mean bankruptcy – particularly if they are highly leveraged. The whole thing bears more than a passing resemblance to the game of ‘pass the parcel’.
The bubble occurs because the response of a speculator to a rise in price is the opposite to that we would expect of a conventional consumer. As we saw in the previous chapter, an increase in the price of a commodity signals a shortage in the market, either because demand has increased or because supply has dropped. Ordinary consumers are put off by the price increase and so turn to cheaper alternatives to fulfil their needs. Producers are attracted by the opportunity for bigger profits and so increase production. As a result, the price falls back to a new equilibrium.
However the speculator sees the rise in price as an investment opportunity. Knowing that an increase in demand will cause the price to go up even further, his reaction is to buy as much as he can. The rise in price will attract more producers, however it may be many months before the results of their efforts are brought to market, by which time the bubble has burst. Indeed the speed at which prices fall in the aftermath may be exacerbated by the increase in supply.
It is for these reasons that futures markets have been highly regulated. It is common practice for exchanges to limit the size of contract that one person can hold, and to limit the amount that the price of a derivative can change in one day. However the US government relaxed regulations in 2000, partly in response to pressure from companies such as Enron who saw an opportunity for a quick profit.
Gambling on oil
What makes such bubbles particularly dangerous is that many of the commodities underlying such derivatives are vital to the livelihood and even survival of large numbers of people. Futures contracts can be traded in agricultural products such as wheat, corn, oats and livestock. Contracts can be bought or sold for the supply of metals such as gold, silver, copper and lead, but perhaps the most significant are those that concern oil as these affect the cost of any goods that needs to be transported any distance – which is almost everything in our global economy.
Airlines and other companies involved in transport have long hedged their risk by trading in futures contracts on fuel. The price of crude oil has been rising steadily from around $20 a barrel (approximately 159 litres) in 2000 to around $60 a barrel in 2007. It then started rising very sharply, reaching a peak of $147 in July 2008 before falling rapidly to around $50 by the beginning of 2009. Many argue that the rapid rise was down to the increase in demand from China and India, coupled with friction in the Middle East which was seen as a potential threat to supply; while the rapid fall reflects the impact of the banking crisis that coincidentally followed. However there are others that suggest that the rapid rise and fall could have been fuelled by a speculative bubble.
In a statement to a US government Committee on Energy and Commerce, Douglas Steenland of Northwest Airlines pointed out that worldwide demand for oil increased by only around two per cent through the period in which the spike occurred, while in early June 2008, for every barrel actually consumed, 22 were being traded on the New York and London futures exchanges. He continues:
According to numerous experts, the fundamental difference between the oil market today and the market of a few years ago is the increase in speculative investment in the futures market by financial institutions such as pension funds, investment banks and hedge funds.” (Steenland, 2008)
Or as Stephen Schork, who publishes The Schork Report on energy markets, put it:
Factors other than supply and demand are now impacting the price. We now have to factor in how the speculators are going to affect the market, because they have different priorities in managing their portfolios.” (Davis, 2007)
In his testimony to a US Senate Committee, hedge fund manager Michael Masters pointed out that such institutions increased their investment in commodities from around $13 billion at the end of 2003 to some $260 billion by March 2008. Given that the total value of open contracts in those same markets in 2008 was $700 billion, it is clear that speculators were responsible for a significant portion of the demand. During those same five years the commodities concerned rose in price by an average of 183 per cent. Masters continues:
Rising prices attract more Index Speculators, whose tendency is to increase their allocation as prices rise. So their profit-motivated demand for futures is the inverse of what you would expect from price-sensitive consumer behaviour.” (Masters, 2008)
The consequences of such a price rise can be devastating. As Steenland pointed out, eight US airlines were forced out of business as a result of the increase. Masters concludes his testimony by warning:
There are hundreds of billions of investment dollars poised to enter the commodities futures markets at this very moment. If immediate action is not taken, food and energy prices will rise higher still. This could have catastrophic economic effects on millions of already stressed U.S. consumers. It literally could mean starvation for millions of the world’s poor.”
Early 2008 saw riots in Egypt, Haiti, Cameroon and even Italy as people protested against the rise in the price of basic foodstuffs such as bread, pasta and cooking oil, while the United Nations World Food Program claimed it was facing a $500 million shortfall in funding as a result (Corcoran, 2008). There can be no doubt that an increase in demand from China and India, and the subsequent recession caused by the 2008 banking crisis, played a part in the precipitous rise and even more rapid fall in the prices of basic commodities such as wheat, rice and oil. How much responsibility derivative speculators must take for the scale and the severity of this bubble is open to debate, but it does serve to demonstrate that the link between demand, supply and price is not as clear cut as libertarians would have us believe.