You are correct, I got ahead of myself on the housing analogy — that was primarily intended to be in terms of the replay of unquantified rising demand / limited supply arguments.

Let me try my take on your Exxon oil example… I think the key difference between our assessments is whether you assume that there is enough consumption demand for the commodity even at the higher price point in order for physical delivery to be taken by consumption-oriented parties — i.e., in your example, are there enough consumers of the oil even at $100 a barrel to buy up all the futures even as they are coming due for physical delivery? My guess would be that in most commodity markets the answer has been “yes” (although in some markets the buyer may stockpile rather than consume), but it sounds like your assumption has been “no”. If “no” is correct, then I do see the problems you describe, and perhaps that is how some commodity markets will peak and crash.

But if we go with the “yes” assumption, then what speculators are doing is just bidding up the price of things above the level implied by consumption demand alone (relative to supply).

Someone tell me if this is off base.

And by the way — Yves — thank you for this blog, it is one of my favorites!

The option of physical delivery is meant to provide for an arbitrage mechanism between the cash and futures markets.

However, it appears that futures prices are having a significant impact on cash price formation. My understanding is that it the case at least in the oil market. Similarly, gold prices appear almost entirely futures market driven. I know people in the jewelry business in the US and it has never been worse (and it’s not due to the price of gold. Pearls, diamonds, estate pieces are very hard to sell in the trade, as they call it).

In fact, that happens in a lot of derivative markets. As the derivatives become more liquid, traders prefer the derivative to the cash market. Then price formation moves to the derivative market. This has happened with bonds versus credit default swaps.

Your analogy to housing is apt, but critically different in one way. Essentially, housing speculators are taking physical delivery of the house, with the expectation that they can sell it later for a higher price. Along the way, they incur carrying costs (e.g. interest, taxes, maintenance, etc.) similar to carrying costs for storing physical commodities. Thus, since housing speculators can and usually do take physical delivery of their “commodity”, they can continue the speculative bubble even though they’re not really “consuming” the commodity (i.e. living in it).

OTOH, the vast majority of commodity speculators are unable to take physical delivery of their commodity. That means at the end of the day, the only open contracts left will be with people who can actually utilize the commodity (plus some small number of people who have the ability to take delivery and speculate with the actual commodity in hand). The speculators should by and large be squeezed out.

For example, say that Exxon has a million barrels of oil to sell in March. And say that at $80/bl there is demand for the whole mil barrels, but at $100/bl, there is only demand for 900k barrels (I realize that both demand and supply for oil is relatively inelastic, especially month-to-month, so pricing is intrinsically volatile since it’s set on the margins, but plenty of analysts are saying that the equilibrium price of oil should be ~$80/bl). That means that Exxon should sell as much of their supply to consumers at $100/bl, and sell futures contracts for the remainder 100k barrels to speculators willing to buy contracts at $100. Then, they just sit and wait until expiration, and dump their excess supply to the speculator on the other side of the contract. The speculator OTOH becomes increasingly frantic to get out of his contract to avoid physical delivery, but none of the other speculators want to take physical delivery either, so the price keeps coming down until an actual oil consumer bites (which in the above example, would be at $80).

Isn’t this the way futures are supposed to work? I thought the physical delivery part is supposed to keep speculators on a short leash. If that isn’t happening, then the only likely explanation I can come up with is that there is no excess supply, and consumers are willing to pay $100 with no reduction in demand.

With some commodities there is some possibility of storage. I doubt that tulips could have bubbled as they did, if they could not be stored. In fact tulips became very easy to store, as one little bulb held a great deal of value. So I suppose that once those commodities leave touch with true pricing, the more they bubble, the easier it is for further bubbling, as storage becomes easier per dollar value stored.

I have no experience related to commodity investing, and initially had the same question as you due to the physical delivery aspect to commodity futures. However, thinking through it, I think it makes sense — I’m guessing investment funds that are long commodity futures have to roll them over each time they come due (that is, if they aren’t choosing to stockpile the actual commodities). For example they would sell the futures for April (to actual commodity users) in order to buy new futures due in May. Assuming the prices between April and May futures are highly correlated, demand for that commodity’s futures as a whole doesn’t drop. Someone tell me if I’m wrong…

And as long as the gap between demand for the futures (speculative or real) and supply of the futures keeps growing, prices will rise as increasing numbers of potential buyers bid up the price of the contracts. Just like condo flippers did with housing! In fact it seems like many of the same arguments are being used as to why commodities aren’t in a bubble as were used for housing — just because the of the trends of increasing demand and limits to supply, it doesn’t mean prices can’t get way ahead of themselves! And when the deleveraging and destruction of credit-based money accelerates and no one new is left on the demand side, prices could plunge…

It even seems to me that the idea that there must be unused stockpiles for it to be a bubble isn’t accurate.

Now, if only I knew a way as an individual US investor to short commodities… (I did see that one fund company opened a bunch of commodity short funds in Europe a few weeks ago). Outside of short term climate and geopolitical risks, it seems safer than equity shorts (since the US government at least would have more incentive to artificially support equity prices than commodity prices).

What this should translate to in the commodities market is a drastic decline in the price of futures when you get close to the expiration date, as speculators scramble to dump their contracts to avoid taking physical delivery of a commodity they can’t sell, while producers keep their positions open in order to unload their goods at an inflated price. According to my logic, then, the price should reach equilibrium at the time of the expiration of the contract, unless you’re willing to speculate by physically storing your commodity and selling it at a later date (something that has increasing costs in perishable commodities like agriculture).

So except for a few players who can speculate with the physical goods themselves, everyone else who’s just speculating on the financial markets should get squeezed out at the time of contract expiration. So why isn’t this happening?

Good point about Brazilian farmers. Lost in all this discussion about commodities is the margin squeeze on the foreign producers of ag commodities. With a rising currency relative to the dollars, but consigned to selling their product in $$$, they are at a disadvantage compared to the American producers, and probably watching their margins shrink.

As for high oil inventories, I don’t know what to believe. I don’t really think they know what the inventories truly are, as I constantly hear differing opinions almost everyday.

Lastly, are commodities in a bubble? yes, but so is everything else. At least commodities have real demand pressure, unlike shares in ABK to anyone with half a brain cell floating between their ears

Money fleeing housing combined with the new liquidity to make a financial asset of the basic stuff of the economy. It is cruel that speculation in food is hurting the poor.

What is amazing is more people do not see it happening. What is scary is not only the current burden of energy and food prices that are high only because of speculation, but the crunch that will hit farmers and other producers hard when the bubble bursts.

Give it a critical think.

It seems like there’s not enough employment needs to keep a level of employment that doesn’t create riots and civil wars.

We hear companies have record cash on the balance sheet juxtaposed against rising unemployment (weak ADP) and spiking bankruptcies – a precurser of what is to come considering the turn in nonresidential investment and retail carnage. Bernanke gets it considering his increasingly urgent language. His only problem is in trying to solve the problem within the exising global construct. My owns sense is that China and the global central banks – per brad Sester – continuing buying to protect an incumbant system that if they can nurse it through will revert to mean. To wit, I would disgagree with bill gross that the US is a going concern in the traditional sense. Unless there is a fundamental restructuring you end up in the same culdesac, like autos. So yes the US isn’t going to die, but neiher does Rome look the same as it did in its heydey.

John McCain’s and for that matter conservative reflexive defense of free trade is anachronistic thinking. The democrats are on to something in thinking throuhg new ideas although the tax breaks to incent investment is a little too cute. Again no attempt to address underlying structural issues. Mish has been big on discussing overcapacity in the retail, construction etc, but there is also a growing overcapacity in the financial services business. That does not bode well for the “trade” policy makers agreed to decades ago. When does manufacturing become the new service.

The dollar is a lagging indicator of the policy decisions that offshored US standard of living in exchange for geopolitical and special interest goals.