By L. Randall Wray, a Professor of Economics at the University of Missouri-Kansas City and Senior Scholar at the Levy Economics Institute of Bard College. Cross posted from EconoMonitor
Sorry, this is a day late (but hopefully not a dollar short).
Back in fall of 2008 I wrote a piece examining what was then the biggest bubble in human history: http://www.levyinstitute.org/pubs/ppb_96.pdf.
Say what? You thought that was tulip bulb mania? Or, maybe the NASDAQ hi-tech hysteria?
No, folks, those were child’s play. From 2004 to 2008 we experienced the biggest commodities bubble the world had ever seen. If you looked to the top 25 traded commodities, you found prices had doubled over the period. For the top 8, the price inflation was much more spectacular. As I wrote:
“According to an analysis by market strategist Frank Veneroso, over the course of the 20th century, there were only 13 instances in which the price of a single commodity rose by 500 percent or more. For example, the price of sugar rose 641 percent in 1920, and in the same year, the price of cotton rose 538 percent. In 1947, there was a commodities boom across three commodities: pork bellies (1,053 percent), soybean oil (797 percent), and soybeans (558 percent). During theHunt brothers episode, in 1980, silver prices were driven up by 3,813 percent. Now, if we look at the current commodities boom, there are already eight commodities whose price rise had reached 500 percent or more by the end of June: heating oil (1,313 percent), nickel (1,273 percent), crude oil (1,205 percent), lead (870 percent), copper (606 percent), zinc (616 percent), tin (510 percent), and wheat (500 percent). Many other agricultural, energy, and metals commodities have also had large price hikes, albeit below that threshold (for the 25 commodities typically included in the indexes, the average price rise since 2003 has been 203 percent). There is no evidence of any other commodities price boom to match the current one in terms of scope.”
Now here’s the amazing thing about that bubble. The staff of Senator Joe Lieberman and Representative Bart Stupak wanted to know whether the bubble was just due to “supply and demand”. Relying on the expertise of Frank Veneroso and Mike Masters (two experts on the commodities market), I was able to conclude beyond any doubt that it was a speculative bubble driven by a “buy and hold” strategy adopted by managers of pension funds. Hearings were held in Congress, with guys like Mike Masters testifying as well as representatives from the airlines and other industries.
The pension funds panicked, realizing that their members would hold them responsible for exploding prices of gasoline at the pump. Pension funds withdrew one-third of their funds and oil prices fell from about $150 per barrel to $50. If you want to read the detailed analysis, go to my paper cited above—it has to do with commodities indexes, strategies pushed by your favorite blood sucking vampire squid (Goldman Sachs), and futures contracts. It gets wonky. To make a long story short, the bubble ended in fall of 2008.
But then the crisis wiped out real estate markets and the economy. Managed money needed another bubble. They whipped up irrational fears of hyperinflation that supposedly would be caused by Helicopter Ben’s QE1, QE2, and the newly announced QE3. Better run to good “inflation hedges” like gold and other commodities. That did the trick. The commodities speculative bubble resumed.
And boy, oh boy, what a boom. An April report by expert Jeremy Grantham looks at the last decade’s bubble in commodities; Frank Veneroso expands upon that in a more recent report. Here’s the elevator speech summary. Take the top 33 commodities that are globally traded—everything from gold and oil to to rubber, flaxseed, jute, plywood, and something called diammonium phosphate. Over the past 110 years, an index price of these 33 commodities has declined at an annual rate of 1.2% per year. (Sure there are variations across the commodities—this is the average. And so much for inflation hedges. Commodities prices fell—they did not keep up with inflation. If you liked negative returns, commodities were a good bet.) Although demand for these 33 commodities has increased a lot over the century, new production techniques plus successful exploration has resulted in a declining price trend.
Further—and this is a bit surprising—deviations from the trend follow a normal distribution (you learned about this in high school; it is a bell curve with nice properties; chief among these is the finding that about 68% of outcomes fall within one standard deviation; about 95% fall within two standard deviations (once a generation); and you’ve got just about a snowball’s chance in hell of finding outcomes that are three or four standard deviations from the mean).
But what is more surprising is that over the past decade, the price rises you find for these 33 commodities are just about beyond the realm of possibility—2, 3, and 4 standard deviations away from trend. It is a boom without any precedent. Quite simply, nothing even close has ever happened before, in any market, including hi tech bubbles and real estate bubbles.
By now you’ve all read about black swans with fat tails—a reference to supposedly “unexpected” and highly improbable default rates on subprime mortgages and other toxic waste assets. (Way out the normal distribution’s “tail”.) As an insider quipped, you had once in 100,000 year events happening every day. But that is misleading. These were junk assets that from the get-go had nearly 100% probabilities of default—NINJA loans and so on. The models were flawed, indeed, fraudulent. That was all a scam. Those weren’t black swans with fat tails—they were Hindenburg blimps filled with explosive hydrogen just waiting for someone to light a cigarette.
By contrast, in the case of commodities, this is real stuff (not IOUs of deadbeats with no prospects). Barrels of oil that someone really wants. Corn to turn into pig and steer fat, or fuel for Midwest automobiles. Or gold to be hoarded by the University of Texas. There really is a demand for it; and someone produces it.
Yes, commodity bubbles happen, but eventually reality sets in and brings the price back down to reality. You don’t get 3, 4, and 5 standard deviation events. A four standard deviation price rise falls outside 99.994% of all outcomes—one in 100,000 years; a five standard deviation price rise is about one in 2 million years. That pretty much covers the time since our ancestors beat things with big sticks.
But wait a minute. The standard deviation of price rises for iron (5), coal, copper, corn and silver (4), sorghum, palladium, and rubber (3.5), flaxseed, palm oil, soybeans, coconut oil, and nickel (3), and so on down through jute, cotton, uranium, tin, zinc, potosh and wool (2) are so unlikely that they quite simply could not have happened. Individually. Together, the likelihood that we’ve got an unlikely boom in almost all of the 33 commodities? All at the same time? Impossible. Cannot happen. Not in the lifetime of our sun, let alone our planet.
But it did.
Why? China. Peak oil. Supply disruptions. Some markets cornered by speculators. Market manipulation by oligopolistic suppliers.
Yes, OK, those have played some small role. But remember, we are in the worst global slowdown since the 1930s. I will not go through all the data, but demand for most commodities is actually slumping. For many there is substantial excess supply. And China wants to slow. China is still largely a socialist society. China basically does what it wants to do. China will slow.
And yet the prices rise far beyond anything that has ever happened before. Beyond anything that can happen.
Why? Financialization. Just as homes became financialized (in many ways, including serving as the collateral for “ATM” cash-out home equity loans), commodities became thoroughly financialized. (So did healthcare and death, with peasant insurance and death settlements—topics for another day.)
Here’s the reason. Believe it or not, commodities markets are tiny; except for soy, oil, and corn they are smaller than tiny. Managed money is huge—tens of trillions of dollars floating around the world looking for high returns. US pension funds alone are three-fourths of US GDP–$10 trillion give or take. If you put even a fraction of managed money into commodities index funds, you blow up the prices.
The weapon of choice is the futures contracts—essentially you buy commodities for future delivery (a couple of months from now). When they mature, you do not take delivery but instead sell the contract to someone who actually wants the commodity, and roll into another futures contract. This is what pension funds, and so on, have been doing. If prices rise, you always win on the roll (sell for more than you paid).
The typical argument is that this cannot affect prices since for every buyer (long position in the contract) there must be a seller (short position). The balance between these two keeps prices in line with “fundamentals”.
In normal times, yes, more or less. But here’s the deal. What if I supply diammonium phosphate (whatever the heck that is) and you are speculating that the price will rise. You and every other pension fund and client of Goldman Sachs. I want to lock in the expected price rise, so I am a happy seller of future commodities. If prices go down, I do not get hurt—I locked in the price rise and have the right to sell the commodity at the higher price. And so even as prices leave all fundamentals, the producers continue to sell futures contracts to lock in higher prices.
I win, you win, we all win with price appreciation.
Now, to be sure, the whole thing is going to blow up, in what Frank Veneroso calls a commodities nuclear winter. As prices rise, consumption of the commodities falls (as we are already observing) both through substitution and through conservation. At the same time, additional supplies come on line. Real world suppliers feel the imperative to slash prices to have some actual real world sales. They cannot forever live in never-never land with rising prices and collapsing sales.
There are many shoes that will drop, bringing back the Global Financial Crisis with a vengeance. Commodities crash, default by a Euro periphery nation, failure of a Euro bank, or the closure of Bank of America or Citi. All of these are likely events, less than one standard deviation from the mean; probably all of them will happen within the next year.
No matter what the triggering event is, that commodities nuclear winter will happen.
Sooner than later.
Eh, commodities nuclear winter doesn’t sound like a good thing, but, wouldn’t commodity price collapse be a good thing for the average consumer ? I mean prices would be affordable again. Perhaps we’re talking something perverse though, like all the commodities being bought up (since they become so cheap) and everybody being without any material things or food.
Yeah, I also find that a weird conclusion.. Why would something bad happen when that bubble deflates?
The only thing I can think would be yet another huge blow against pension funds. Just like the collapse in real estate and private equity in 2008-09 put huge dents in the balance sheet of Calpers, for example.
If anyone can explain to me why we can’t:
(1) modify banks so that they are utilities, and also
(2) modify pension funds so that they have a division that employs their own realtors (base salary + commission), underwriters who would have a solid working knowledge of the properties (and property owners) they are underwriting, and a mortgage servicing division so that payments go straight to the pension fund to meet it’s obligations, I’d love to know why this simpler model is impossible.
After all, it might ease the pressure on pension fund to create commodity bubbles.
Yeah, but the article states these are small markets relative to global wealth, so if they go bust, it should be no big deal then. So the author is a little inconsistent there.
I agree with other commenters that peak oil is a big wildcard, as it is a heavy driver of cost per unit of commodities. Has the author seen the cost per unit changes over the last decade for all these commodities? I doubt there is even one that has not gone up at least 100%. That shows oil and monetary based inflation worldwide’s affect.
So even when the bubble pops, prices can’t go back to year 2k. Not even close.
Agreed. The bubbles in everything else are probably going to pop quite dramatically…. and oil prices will STILL be following a secular trend of rising. Presumably all the other industries will start switching away from oil.
As far as why the commodity prices ramped so quickly (1000+% increases), I had a weird thought. Perhaps this correlates with population growth (an exponential function), and add to that parts of the world industrializing and becoming part of the market for those commodities. The more users for a set amount of commodities, the prices should rise in a like fashion.
Didnt he cover that in the first 3 paragraphs? Didnt “rapegurney” Joe Lieberman woner aloud the same thing? The author “definitvely” demonstraed how it is not supply and demand but speculation.
During the 80s, didn’t many farmers run into financial problems? That’s what’s “bad”.
But, after billionaires, farm owners (not farm workers) are the next most coddled, with (a) large exemptions on inheritance tax that advantage them over landless laborers and (b) protectionism that advantages them over knowledge workers. If they misspent their gains as well, then…I’ll feel sorry for them but not enough to want to help them even more.
This is true for major agribusinesses that produce industrial meat and corn and soybeans, but it’s emphatically not so for the small growers, organic farmers, family farmers, etc.
The regulatory and subsidy structures are set up to privilege ADM, not Farmer Bob.
Can we financialize worker wages?
Make it a commodity and let the pension funds speculate and drive it up to 5 standard deviation away from trend.
Actually, workers are already a commodity. What we do is we will financialize their wages in the form of futures contracts.
Here is to the coming bubble in worker wages!
god what a great comment! And it would not only be fair, finally, it would actually put everything back in balance, no? At least demand-wise.
I think professor is a little bit too simplistic. Let be take a devils advocate position:
First of all the applicability of normal distribution to the analysis of prices is not a sure thing. If this is a “new normal” then all this talk about three or four standard deviations is pseudoscientific junk that reveals compete misunderstanding of mathematics.
Second peak oil is not the product of imagination. You generally should expect prices rise “in a long run” as cost of extraction goes up and consumption in developing countries increases. The same is true for many other commodities. It seems that our professor is unaware about this important factor.
Third the behavior of many governments undermine the confidence in fiat currencies. And amount of money printed (by shadow banking system) is such that they can’t be productively invested they spill into everything: stocks, commodities, bonds, etc. That might partially explain a gold run. Speculation definitely takes place but is it a dominant force is far from clear. May be situation is not black and white: in some commodities it is a decisive force and in others it is just a factor, may be important one.
Forth the confidence in dollar I think is close to all time low so it not clear to what extent converting currencies to gold is an irrational choice. It well might be a bubble, but this thing will be obvious only in retrospect. High deviation is a good heuristic suggesting bubble but this is just a hereristic. Time series are tricky things from the mathematical standpoint and excessive believe in “standard deviation” nonsense here does not help.
Also prices on some commodities did drop. For example uranium dropped after Fukushima nuclear crisis.
“New normal”? Is that like the “great moderation”?
Well, let’s be fair here. Things do change. Malthus was, for the most part, correct about looking backward at history and determining what appeared to be hard and fast population constraints. Then everything changed, and what he postulated didn’t seem so correct anymore.
The lesson, as always, you don’t know what you think you know.
The other obvious admonition, as always, past performance is not a perfect predictor of future results.
Things change. All the evidence in the world is not enough to predict the future with accuracy.
Oh, certainly things change (though I’m less convinced that trends change). But I would be especially wary of “new normal” arguments in times in which everything else is being financialized as well, whereas dear Kievite here seems more than happy to ignore that fact.
Don’t count Malthus out. Consider:
– Famine visits some countries fairly frequently.
– Most Americans — in the “richest nation on earth” — can’t afford Whole Foods and instead eat a lot of non-food processed and packaged to look like food.
In between these two extremes, how do things look?
That’s not really Malthus. Malthus was about real shortages of the physical commodities, not bubbly overspeculation.
This is kind-of the *opposite* problem. Absent real constraints on production, pricing gets weird.
I’ve been troubled for several years by the thought that Malthus was not wrong; it’s just taking several hundred years to reach equilibrium.
Individual outcomes may vary. That’s what the infomercial says, and that is what happens, here at the micro-economic level. The Trend is what counts at the Macro level. I remember my Dad trying vainly to explain how the good old fashioned slide rule could come so close to optimal results. It was a fairly imprecise tool, but the secret was in how it worked, not its’ own ‘personal’ precision. The averages, and how they balanced each other out, were the key. When you’re looking at the Macro level, it is the balances you are reading. The poor sod looking for work out on “the Street” doesn’t come into it at all.
So, I predict a huge rise in communitarianism as this disaster unfolds. It feels like that good old Chineese chastisement, “The Death of a Thousand Trades.”
It’s important to note that the primary driver of the holding capacity of the planet is the cost of energy. There is an extremely strong correlation with population growth and energy costs. Other techologies have affected population growth, but again most of those are reliant on low cost forms of energy.
So consideration of a new normal due to a change in energy costs is a reasonable counterargument to this article.
I don’t buy y the ‘peak oil’ theory, as we have ‘run out of oil” seven times overt the past 150 years…this time is no different.
For more info on this, see Daniel Yergin’s latest on the history of oil, ‘The Quest’, discussed here:
How much would oil really cost if there were profound and lasting peace throughout the middle east?
The price of oil is mostly set by politics, and only a little by physical necessity.
Peak oil is here, and oil prices are reflecting that. The real price of oil compared to the price of alternative energy sources has gone straight up since the 1920s, looking at the long trend.
But the fact is that we aren’t facing a hard energy limit; energy continues to get cheaper. Solar is getting cheaper at a spectacular rate, and batteries are too; electric motors are ridiculously efficient, and we have as much sunlight as we could ever want. So the elimination of oil will *not* be a general energy supply crunch.
And the fall-off in prices after 2008 was just a reaction to demand? And the subsequent rise was due to increased global demand?
One thing that you always notice about the ‘new normal’ rhetoric that people delude themselves with amidst bubbles is this: it’s never even remotely thought through against very simple macroeconomic fundamentals and trends.
Lemmings. Cliff. Jump. And don’t come crying to me when your portfolio falls apart at the seams and the kids’ college payments look increasingly large.
Speaking of fat tails, college tuitions should be placed in the same category as the bubble commodities.
I must agree. Most college grads I’ve known throughout the years were indeed ‘puffed up.’
e knows what will happen; however, I’ll stick with the old normal bell curve as a decent guide for commodities. Disclosure: out and short.
First of all the applicability of normal distribution to the analysis of prices is not a sure thing
agreed. Mandelbrot proved that with his research (which was not economic but which explains economics exceedingly well, far better than economic research).
one can easily see nonlinear changes in price based on exponentional growth and/or exponential use of resources.
however: one problem with the nonlinear growth argument is that some of these commodities are being used LESS over time, and yet price continues to go up.
Clearly, there is speculation in the commodities markets affecting price in a major way.
what most of us are unsure about is how much is due to speculation (or in this case Pension Funds/Financialization of commodities) and how much due to supply/demand and economic fundamentals.
We heard the “Peak oil” explanation for sky high oil prices a few years ago. Although I ardently believe we are near peak oil production and also believe that we will have a reduction in extractable cheap oil going forward, it still does not and did not explain $150/bb oil in the mid 2000’s. thus the crash down to $35 or so and a bounce back to $100. This volatility is not supply/demand driven.
A financial winter in commodities could hurt us all depending on who takes the losses.
Pension funds taking major losses will hurt us all
Also: commodity suppliers could be bankrupted and go out of business if we overcorrect, which would cause shortages, not to mention producers who may go out of business leaving nobody to refine the commodity into an end product.
in sum: it could throw us right into severe depression.
Financialization is THE weapon of mass destruction. wielded again and again, it makes locusts seem tame.
John Cochrane at Bloomberg discusses the speculation vs. fundamentals question. Ultimately he concludes that investors are changing their implicit discount rate … but we don’t know why! Fat lot of good that does.
Here is his lede:
Indeed. Peak oil is real, but the massive volatility is the sign that we’re watching a bubble.
‘You don’t get 3, 4, and 5 standard deviation events. A four standard deviation price rise falls outside 99.994% of all outcomes—one in 100,000 years; a five standard deviation price rise is about one in 2 million years. That pretty much covers the time since our ancestors beat things with big sticks.’
This statement assumes that a Gaussian normal distribution applies to price changes in commodity markets. But to echo Kievite, it doesn’t.
Fat tails are an inconvenient reality. Two stock crashes occurred in the 20th century, which were multi-sigma events (not sure whether I have enough fingers to count that high). Similarly, the extraordinary price rise in commodities is a multi-sigma event.
Bell curve math can be useful for identifying bubbles, but one can’t take the ‘once in a million years’ frequency forecasts literally. Try ‘once in fifty years.’
You’d think our central planners might be interested in identifying bubbles. But Greenspan put his head up his rectum and claimed that they are only identifiable in hindsight.
Now we have Benny Bubbles, the Fed’s Greatest Fool, doing his very best to gin up a fresh bubble or three.
When you have a printing press at your disposal, bubbles are easy!
But Greenspan put his head up his rectum and claimed that they are only identifiable in hindsight. Jim Haygood
Greenspan also said that bubbles were necessary for progress. He also said that legal tender laws were necessary without gold neglecting to say that they are needed with gold too in order to give it value beyond its commodity value.
Thank you for pointing out the glaringly obvious fault in this post. Had the author not gone out of his way to reference Taleb’s ‘Black Swan’ and ‘Fat Tail risk’ the author’s supreme faith in Gausian bell curves may have been excusable, but the whole point of Taleb’s book was that economists and finance types who specialize in forecasting and risk management foolishly depend on pretty but brittle models, and Gausian bell curves are the worst of the worst as far as predicting incredibly complex financial markets which are anything but rational.
Commodities may be overblown but counting standard deviations from a
a flawed model constructed from a narrow and inadequate data set proves nothing.
I think you are correct about this piece being over simpilistic. The conclusions seems to be mostly drawn from technical analysis of historical data. The cost of energy plays a huge factor in the cost of producing many commodities. With increased demand and extraction costs running north of $40 per barrel for new production, using historical data as a basis for calculating standard deviations on oil prices is questionable.
In some commodities there has been extensive industry consolidation. For example, over 70% of iron ore is controlled by BHP Billiton, Rio Tinto and Vale. This group has pushed through jaw-dropping price increases with steel demand growing only about 3% per year. Iron ore costs are the biggest drivers in a steel price that has increased 50% over 18 months. Inflated iron ore prices are not caused by speculation or major changes in supply/demand dynamics – this is simply old fashioned price fixing.
But if we commoditize wages, feed workers food instead of diesel, lay off a lot of big horrific excavating machines, and get back to a state of actual circulation of “money” then all problems solved. And it would be very ergodicious.
Don’t we need to make up for the difference between what is needed for acceptable human living standards and the marginalization of human labor? What other way?
The monopolization of the iron ore industry has had the salutary effect of driving a strong scrap steel market as well as a strong market in “minimills” which recycle old iron and steel into new steel, using relatively little iron ore.
The price-fixing power of the iron ore cartel is, in other words, incomplete.
Here is a pretty good post by Professor Hamilton, who is a peak oil disciple. He focuses on fundamental decline in supply of oil as the major reason for the rise of oil price: http://www.econbrowser.com/archives/2011/08/fundamentals_sp.html
Honestly, now any time something goes up in price it’s deemed a bubble–the word has become so over used that it no longer has any meaning. The guy who wrote this article might want to so his homework and not pick arbitrary dates since commodities have been a great investment since 1999–a 12 yr bubble?! and most commodities have surpassed the prices after 2008 that they were at before!
Definitely commodities can get over heated and are impacted by inflation but these are not the sole forces of a true bubble–when I think of a bubble it is a wildly over priced asset in relation to the underlying fundamentals that cause a significant change in the society at large’s economic behavior: like every one quiting their jobs for the real estate market.
Commodity markets were never meant to offer “investments”, and it is only since 1991 that this constraint has been progressively loosened (thanks to Goldman and Bush 1/Clinton). Ever since then, there have been money inflows into the new index funds that were set up; but it is only in 2002 or so that the prices exploded.
So that’s what happens when there’s a lot of fraud: everyone stops caring.
It is of course your right to have intuitions; however, I do not find yours particularly rigorous. And anyway, if you look at how much the commodity producers get, I can assure you that there is a mismatch between prices and “fundamentals”.
Nice comment Foppe. Way to cut through the baloney.
Why 110 years? The horizon should be 40 years, i.e. since the USD decoupled from gold (from 1971).
since the USD decoupled from gold (from 1971). SS
What the heck is gold? And what does it have to do with money?
Our current money system is stupid and immoral but going back to shiny rocks would be no improvement. Gold is merely a previous banker scheme to loot.
The article compares price trends across 110 years. And the fact remains that till 1971, the value of the dollar was linked to a certain weight of gold. How can you use the price of something linked to a commodity directly and say that the price did not change? It is an essentially moronic argument and that was what I was trying to highlight. I have no opinion on the feasibility of a gold standard as I have not lived through it nor has my country even been on a gold standard since our independence.
It was rather a Dollar standard than a gold standard, US promised to exchange $35 for a ounce of gold. A promise to other central banks. The gold market was highly regulated. 1968 US declared that it wouldn’t unconditionally exchange gold for dollar. US foreign deficits made dollar to pole up in especially European central bank vaults. De Gaulle didn’t like it and wanted gold in exchange, also others in Europe was worried, American “printing” dollars and buying European industries. Then suddenly like lightning from the clear sky oil prices sky rocketed and European central banks dollar piles was emptied out in no time. The Americans played the Europeans like fools.
One interesting thing which I cannot cite (sorry again). It might have been Gore Vidal. Anyway, toward the end of the Vietnam war we had amassed a huge pile of gold. Marcos (Sterling Seagraves histories) was our willing smelter. He put his indicia on it and that made it fungible and the Saudi princes accepted it as payment for oil. And as Vietnam wound down and we faced the fact that we had to go off the gold standard, the Saudis agreed to take dollars for oil. That caused the 1973 shock in oil prices. But it still doesn’t answer the question, Why is gold valuable at all? My answer: It isn’t. We just cajoled the Saudis.
Why is gold valuable at all? My answer: It isn’t. Susan the Other
Indeed! And it is a very severe indictment of our money system that that “barbarous relic” is still around.
Asset-backed money is a brilliant invention but the way it is currently implemented is dishonest and unstable.
How much speculation on commodities or indeed on anything would be possible without loans from the government backed counterfeiting cartel, the banking system? How does anyone buy on margin without so-called “credit”? How can bubbles be blown without (money-from-thin) air?
You can get credit from someone other than a bank. You can buy on margin as much as you like if the seller’s willing to supply your credit.
Just drop in on a car dealership sometime.
You can buy on margin as much as you like if the seller’s willing to supply your credit. Tiercelet
That would be fine. But banks, because of their government enforced private money monopoly, and other privileges such as a lender of last resort,the Fed, extend credit in OTHER people’s good and services. They are thus counterfeiters of credit.
Just drop in on a car dealership sometime. Tiercelet
I suspect the car dealerships have a line of credit with a bank somewhere in order to do this.
What about gold?
I read a lot – both camps make a good argument. The real question is when we have our financial collapse, what do you want to be holding?
I don’t trust the Bernank, China, the IMF or the ECB – they are all gaming the system for their benefit – not mine. You need something outside their realm of influence to manipulate – physical be it gold, land or whatever else they can’t steal without at least giving you a chance.
What a farce of a world we live in.
When we have our financial collapse, I want to be holding lots and lots of canned food in a well-secured rural shelter with a secure basement and good water access.
If prices collapse, prices collapse. Buying bubble gold is no better a bet than buying bubble real estate. We’re far more likely to be in a situation where you can’t find buyers for whatever private commodity you’ve chosen as a store of value than we are to experience hyperinflation of any kind.
When we have our financial collapse, I want to be holding lots and lots of canned food in a well-secured rural shelter with a secure basement and good water access.
When we have a financial collapse I want to be surrounded by people I know and trust. Yours is a fantasy of independence.
I have been writing about excessive speculation in oil markets since 2007. In these discussions, I also like to cite this report from 2006 that I later came across.
In oil, excess “financialized” speculation took off in 2004. You can look at the year over year price trends and compare them to supply and demand or external events (wars, threats of war, hurricanes, political instability). Normal speculation should prices rise in anticipation of these and then return to baseline as their effects dissipate or fail to materialize. But from 2004 onwards to the big spike in 2008, this doesn’t happen. Instead prices increased 30%, 40%, 50% a year. There wasn’t any reason for these price rises other than excess speculation.
Excess speculation in oil tracks well with the housing bubble. That is the housing bubble was not the only bubble going.
The pattern was, however, different back then. Today oil prices generally track with the stock market. If stocks are up, oil is up, and vice versa. After the housing bubble burst in August 2007, it was the opposite. If the stock market was down, there was a flight to commodities like oil. If the stock market went up, then prices fell on oil futures. This was not a flight to safety by the way but from one speculative opportunity to another.
The setup for this kind of speculation in oil dates back to a 1993 CFTC rule change that let noncommercial traders (investment banks like Barclays, Morgan Stanley, and Goldman Sachs through its subsidiary J Aron) into the oil markets. Then in 2000 there was the Enron exception that basically allowed deregulated (i.e. opaque) over the counter futures trading. You also had built in 20 to 1 leverage with margins at 5% and you had hundreds of paper barrels of oil for every real physical barrel in the market. I mean seriously in such an environment what would have been shocking is if there wasn’t massive financialized speculation going on.
Despite this there are still a lot of market traditionalists who say it must be supply and demand. This is really more of a religious point of view because there really isn’t any evidence to back it up. The same is true of peak oil. Peak oil will at some point have an enormous effect on price. It just hasn’t had one so far. This is because the peak has a flattened top to it, in part because you can bring future production forward although this should steepen the rate of decline of production in the future.
Current conditions remind me a lot of the period between the housing bubble burst in August 2007 and the meltdown in 2008 with us being closer to the latter than the former. Another crash will kill off oil speculation because crashes tend to do that across the board, both to cover losses and to seek safer havens.
Despite this there are still a lot of market traditionalists who say it must be supply and demand. Hugh
Yes, the argument being that it is difficult to hoard sufficient amount of commodities to drive up the price. But it occurs to me that futures contracts bought with bank “credit” backed by the rising price of the contracts themselves constitute a positive feedback loop that does not require any storage ability.
Producers go for the easy oil first, so if you’ve got a plateau in global production, it occurs with an increasing cost-per-barrel.
Also, a global production plateau implies decreasing amount of oil available for export to net importers like the US, as producing countries use more of their own oil as time goes on.
From the fall of soviet to 2004 the former Soviets oil consumption did decline more than Chinas oil consumption increased. And it wasn’t caused by the former Soviet got environment conscious and did go green, it was a massive deindustrialization turning many of them to simple raw material exporters. In biblical terms “hewers of wood and drawers of water”.
What a hell of a post:) I can understand the distress. As many do. I’m no rich guy and relying partly on my savings to feed the family…
I understand as well you want to have a liberal view on markets, money and al. But please stop uttering this kind of unarticulated post on that subject.
Even an old-guard 1966 Labour UK member of parliament would have a better grasp of the stuff.
Look at your dollars, pounds or whatever, look at the obscene rates on savings with a decent neutral eye. That nothing but a sinking beast. Both in terms of purchasing power and in terms of trust. Savers and pension funds managers are no rentiers.
We are on in 1880 any more. People just try to protect a part of their sinking purchasing power. And most do not!
That the dollar is not sinking alone should not be a matter of satisfaction. The whole Bretton Woods is sinking.
Dumb money is trying to get out of the security trap whilst speculators in the “finance industry” (what a joke calling these crooks an industry) reap 40% of corporate profits looting the system with asymmetric cash provision.
Regards from one of your Austrian friend.
Savers and pension funds managers are no rentiers. Daniel de Paris
Technically they are but through no fault of their own. The government enforced private money monopoly forces every one into usury and/or speculation and/or hoarding.
And we wonder why we have economic problems?
I assume when you measure price increaes, this is in US Dollar terms. Since the Dollar has depreciated massively during the commodity rally, would a basket of currencies not be a better idea.
As a professional commodities trader I couldn’t agree more w/ this piece. The problem is that this is not an investable thesis. Unfortunately there is no CDS like product that allows you to bet against commodity prices and with high realized underlying volatility, if you’re wrong on timing you’re going to get carted. I suppose you could buy long dated way otm puts but I feel like you pay too much in time value for those to work. Timing on this trade will be critical. I think we’re getting close and if we see another liquidity crisis in the financial sector that may be the catalyst for the end of this game.
I have to disagree –
The mortgage market was sucessfully gamed when traders knew that it would crash – a la Magnatar and GS
As far as shorting goes if the goal is to short why not companies such as farm implements manufacturers, mining equipment suppliers, mines and so on ?
A crash in commodities will almost certainly impact these industries.
So Randall, thanks for doing the grunt work to demonstrate the distortion; it’s about time someone got this down in black and white in pixels of dead trees. Yes, and one or a group of commodities might have a serious trend divergence for any one of a number of reasons, particularly over a timeframe as short as a decade, and appreciably less. But _all_ commodities radically _ABOVE_ trend? No way in a universe of hells does that happen without a huge market distortion involving either source control (not demonstrable) or speculative capital flows. Give that we have huge, artificial leverage and essentially unlimited derviative issuance, here we jolly well are. When this baby goes KA-BOOM it’ll be the financial equivalent of a five-mile cometary body hitting the flat-earth markets.
> As a professional commodities trader I couldn’t agree more w/ this piece. The problem is that this is not an investable thesis. Unfortunately there is no CDS like product that allows you to bet against commodity prices and with high realized underlying volatility, if you’re wrong on timing you’re going to get carted.
Give me a break, you can bet against any commodity on the futures market with 95% margin. Just open a short position.
I agree with Innocent Bystander.
I also read the Grantham report when was published and this article clearly misrepresents that reports conclusions. Mistakes like that damage the credibility of the rest of the article.
Rule #1 of citation: if you are going to cite to something, you better be sure it stands for the proposition you are referencing it for.
I thought CDS were invented to level out the volatility in commodities trades.
This is one of the worst pieces I have ever read on Naked Capitalism. For example:
> An April report by expert Jeremy Grantham looks at the last decade’s bubble in commodities;
In fact JG said in his report, which I read at the time, that this time it really is different because the rise of the former third world and the depletion of oil means prices are going up and will stay up. We are out of the bounds of normal fluctuations. This is a change, not a bubble.
> Further—and this is a bit surprising—deviations from the trend follow a normal distribution
This is so wrong it is beyond wrong. I’ve spend a lot of time looking at commodity price history and it is nothing like a normal distribution. Mandelbrot did a lot of work on this and showed conclusively that this is not the case. The argument in academia is what type of non-normal distribution is it – A truncated levy distribution? A Student distribution of the log returns? But no-one is saying it’s a normal distribution.
> we are in the worst global slowdown since the 1930s
This is getting embarrassing. According to the IMF the world economy is growing at about 6%. The rich countries are having some problems but the industrializing countries are booming. Just ask anyone working in the coal mining industry in Australia – they cannot dig it up fast enough.
Oh well I suppose it is about the point in the cycle where we start blaming “evil speculators”. This crisis is, of course, nothing to do with people borrowing money they don’t want to pay back, or governments printing money so they can spend more than they have, or lax regulation and repeal of long-standing regulation, crony capitalism etc. It must be the evil speculators.
In a world where what and whether you eat is dependent on what the looting classes decide to do on any given day, it’s important to be able to grow your own food. (Growing your own food and buying local also gets you out of Big Ag’s e. coli-infested and petroleum-based food chain.)
So, it’s really appalling that the city of Memphis is trying to shut down a local gardener’s garden — especially because the gardener is a schoolteacher who’s also educating his kids with it.
There is no bubble if you consider the relative to paper printed. Expect global markets tanking another -40-50% – see the chart for the Rosecast Bradley sideograph:
Then the Fed will print another trillion of dollars (according to Goldman there is a $1 trillion whole in banking capitalisation that is not yet priced in).
With paper printyed, won’t this push the commodities up?
>> Over the past 110 years, an index price of these 33 commodities has declined at an annual rate of 1.2% per year.
For 70 of the past 110 years, US oil production was rising. Up until 2005, global oil production was rising.
>> Although demand for these 33 commodities has increased a lot over the century, new production techniques plus successful exploration has resulted in a declining price trend.
Successful exploration of easy-to-reach geography! Hawaii and Alaska weren’t even “states” until 60 years ago. So, what’s next? Want to extract tar sands? Drill under the Arctic? Re-fill the Oglala Aquifer?
>> Believe it or not, commodities markets are tiny; except for soy, oil, and corn they are smaller than tiny. Managed money is huge—tens of trillions of dollars floating around the world looking for high returns.
So, what happens when that money decides that so much else is a Ponzi scheme and that they’re underinvested in real things?
Also, are you attributing the 2008 general market collapse to the sell-off of oil by pension funds?
Yves & co., I’d just like to point out that commodities are related to the real supply of necessaries. The recent Russian wheat crop failure sent food commodities soaring. You have all seen the pictures of what the drought did to Texas agriculture. There was no feed grain, and farmers slaughtered their livestock because they could not afford to feed them. Cheap steaks!–for a while.
The drought is spreading northward. For the last two summers the Midwest, the world’s greatest grower of corn and soybeans, has gotten no rain in July and August, and in July, ten days of temperatures over 100 degrees. (This prevents the ears from filling, if you want the details.) Every time the Department of Agriculture estimates this year’s crop, they lower the yield. My own farmer, who is now in the field, reports yields of between 140-160 bushels/acre, in land that should yield 200+ bu/acre. Everything is tied together. I am not an economist, but I can tell you that global warming is seriously affecting food supplies, and that causes prices to rise in a way that is NOT a bubble.
Insider trading advice: every time corn futures go down, I call my brokers in Chicago and ask, “Is this a buying opportunity?” When they say “yes,” I buy, and I’m ahead $4000 for this year. I know that’s peanuts, but I’m learning the game. If my crops are diminishing, and my farmland is losing value, I have to try to make it up on the CME (Chicago Mercantile Exchange, where commodities are traded).
Corn prices are down today because of “harvest pressure,” which means harvested corn is going into the pipeline. Supply up, price down. No farmer who doesn’t need the cash, and who has his own storage, is going to sell corn until the price goes back up. It used to be that a really good price was $3.50/bu. An amazing price was $4. An unimaginable price was $5. Overnight trading closed at $6.66. We are probably going to wait for $8.
We are in a terrible situation, and we have been put there by fools.
If the global financial crisis comes back?
Serious discount to all of your babbling for not recognizing it never ended.
F. Beard says:
“Despite this there are still a lot of market traditionalists who say it must be supply and demand. Hugh
Yes, the argument being that it is difficult to hoard sufficient amount of commodities to drive up the price. But it occurs to me that futures contracts bought with bank “credit” backed by the rising price of the contracts themselves constitute a positive feedback loop that does not require any storage ability.”
And there you have it bubble boom-and-bust due to George Soros’s theory of Reflexivity. Rising house prices caused by more money being created from thin air simply because the mortages as assets on the lender’s book are going up in value. Duh! Could that be because more money is being made available to pump up the price of those particular assets/commodities?
And there you have it bubble boom-and-bust due to George Soros’s theory of Reflexivity. Schofield
Yes, I should have mentioned Soros’s theory of Reflexivity.
Thx, Professor Wray, for this great, illuminative and entertaining post.
You showed convincingly that all participants in a commodity futures game are winning as long as there is no fundamental demand destruction (“I win, you win, we all win with price appreciation”), thereby suggesting an environment in which bubbles might occur.
Let us also keep in mind that suppliers of physical commodities are winning big with price appreciation on futures markets if the physical price follows the futures price. This price discovery mechanism was explained for oil in an excellent post by JD at ‘Peak Oil Debunked’, and Yves Smith commented here. It is obvious that this interrelation gives large suppliers a big and permanent incentive to drive up futures prices, themselves or with the help of 3rd parties.
One facet I find fascinating and underexplored is the sociotechnical structure enabling the construction of a monopoly-like price setting mechanism. One part of this structure is the instantaneous distribution and processing of information to all actors, another their silent alignment to set a single maximum price, very much like a monopolist or an oligopol would have done it. Such a structure seems to be in place in other markets too when price is discovered by derivative trading, e.g. when credit default swaps determine bond prices.
If we come to agree on the description of certain financial markets as inducers of monopoly-like price setting, this should have a significant impact on the question how to regulate. The topic itself has considerable importance, as revenue maximizing commodity prices far from the cost of production cause global pauperization. And the question how to regulate credit and other derivatives will probably be a topic for several years.
As James Hamilton has a recent post on commodity prices and arrives at somewhat different conclusions, I would greatly appreciate Randy Wray’s, Yves Smith’ or esteemed readers comments on his take, seconding Dennis above.
‘You showed convincingly that all participants in a commodity futures game are winning as long as there is no fundamental demand destruction (“I win, you win, we all win with price appreciation”), thereby suggesting an environment in which bubbles might occur.’
Actually this is not so. For every futures contract long position, there’s a short position on the other side.
Probably Randy Wray meant that rising prices give producers the opportunity to hedge at attractive prices. Nevertheless, hedging has a cost — everyone cannot win in a zero-sum game.
Jim: Randy Wray stated the case clearly in which both hedger (short) and speculator (long) profit when prices appreciate, and even discussed your typical counter argument (for every buyer there must be a seller).
Bubbles and financialized speculation destroy price discovery. They produce an artificially juiced price not based on the underlying fundamentals. That’s a different process.
Hugh: you are certainly right that we should not call it price ‘discovery’ if prices are set in a sociotechnological structure which behaves like a monopolist, and is fueled by ‘financialized speculation’.
I referred to the question if price is primarily discovered (or set) on the market for the underlying or the derivative product. See for this usage of the term ‘price discovery’ e.g. the recent interesting paper by Virginie Coudert and Mathieu Gex of Banque de France: “Credit default swap and bond markets: which leads the other?”
What does that mean for Gold and Silver, a commodity. A lot of people in these circles are big on them. Are you saying it is time to sell them?
This analysis completely ignores the fact of ongoing depletion of the world’s largest oil fields. Sure “new supplies come on line,” but perhaps not as fast as the old supplies are going off-line. There is a struggle to maintain supply in the face of this ongoing depletion and strong demand from Chindia. Supply is achieved through ever more expensive and more difficult sources as time goes on; each barrel of oil requires more energy to produce. This means rising prices for the same commodity. I also challenge the author’s assertion that global demand for energy and commodities is falling. Demand is falling in the US, perhaps we have reached peak demand for oil in about 2005-6, but growth in hydrocarbon demand in Asia seems to make up for that decline.
Professor Wray wrote: “Over the past 110 years, an index price of these 33 commodities has declined at an annual rate of 1.2% per year. (Sure there are variations across the commodities—this is the average. And so much for inflation hedges. Commodities prices fell—they did not keep up with inflation. If you liked negative returns, commodities were a good bet.) Although demand for these 33 commodities has increased a lot over the century, new production techniques plus successful exploration has resulted in a declining price trend.”
That was all about cheap energy, cheap oil. Where’s your cheap energy now?
Where’s your cheap energy now? robert57
Locked up in thorium and natural uranium till we are wise enough to use it.
Where’s the cheap energy?
Shining down on us from the fusion reactor located six light-minutes away.
“> Further—and this is a bit surprising—deviations from the trend follow a normal distribution
This is so wrong it is beyond wrong. I’ve spend a lot of time looking at commodity price history and it is nothing like a normal distribution. Mandelbrot did a lot of work on this and showed conclusively that this is not the case. The argument in academia is what type of non-normal distribution is it – A truncated levy distribution? A Student distribution of the log returns? But no-one is saying it’s a normal distribution.”
Yes! Thank you,
I commented on this once already, but but if the author would have bothered to skim even just a little bit of Taleb’s “Black Swan” he would have known this. Pretty embarrassing.
annual U.S. average domestic crude oil prices inflation adjusted 1971 – 2010
Anyone read this book The Asylum:The Renegades Who Hijacked the World’s Oil Market, by Leah Mcgrath Goodman? Quoting the blurb:
(It sounds a bit sensationalist and light on details..)
Wray’s is a bad, dumb post.
If something has no intrisic value–i.e. gold–yet is always valued, what is the importance of intrisic value?
This article fails to describe the larger picture. All of this was preordained since the 1950s.
Capitalism works because we don’t all want the same thing at the same time. I trade you stuff I don’t want so much for stuff I do. You likewise. We both profit from the marginal difference in value between the two. But, what happens when everyone wants the same thing at the same time? Capitalism breaks down and can become harmful to most who participate in it.
I assert we are in this predicament because we have among us a large subpopulation of people who are all trying to do more or less the same thing at the same time. For the last decade or two, they have been working hard through their prime earning years, generating cash and attempting to save for retirement. When they stop working, they will stop generating wealth, and instead turn into net wealth consumers.
Don’t blame the fund managers. Blame the people who gave them the money. The fund managers are just looking for places to stash the stuff. It is their job.
Alas, as much as any generation may try, the Boomers can’t actually save up for their own retirement. Most real wealth does not have a shelf life of 40 or 50 years. Like generations before, they must build up a savings in the fiat currency of their choice and then try to draw on the present productivity of later generations to keep them in comfort. Since that productivity may reasonably be expected to be less by virtue of the ensuing generations’ reduced numbers and demand for it high, the Boomer generation must inevitably surrender to relative poverty compared to their parents.
Call it generational ergodicity, if you will.
While there was undoubtedly a bubble in commodities, one partially reflated by Bernanke, much of the author’s argument just doesn’t fly.
There is a great big difference between “supply” in the sense of the absolute total in the ground (or what can be grown if we grew everything we conceivably could), what portion of that total is “supply” in that it can be produced at an economically (or environmentally/politically) acceptable price, and the current and near-term “supply” of any given product.
There is absolutely no doubt we are going to run into trouble with the second sort of “supply” problem and within a couple decades UNLESS there is a RADICAL transformation in production and consumption patterns for which, as of now, there is no evidence whatever, OR a prolonged Depression, which merely postpones the problem for a few years – why else right now are there so many huge companies who don’t need to play games scrambling to drill/explore/develop the most hostile places on the planet? They know what their own properties are producing – or NO LONGER producing. They’re buying up others’ production of everything possible because it’s so much cheaper than generating new production. There is an enormous scramble for agricultural land all over the globe, but particularly Africa and other impoverished countries orchestrated by the World Bank. The Pentagon sees potential for serious resource conflict as early as 2020. There are 5 billion people who quite naturally believe they ought to live like the average American does now. It’s not going to happen because the resources simply are not there.
The bubble wasn’t built on nothing. The pricing was simply premature (to the great benefit of speculators everywhere) – what would happen if we charged for water NOW what it’s going to cost billions of people in 2030? What it ought to do is sound a very loud alarm about the imperative of adapting to far less consumption.
Gold does not act like the other commodities – it isn’t consumed and the demand for it is driven purely by sentiment because almost none of it is used industrially.
In fact, as the price of gold rises, the demand for it seems to go up. Conversely, when the price of gold is low, scarcely anyone is interested in it and so demand is low.
Also, it is very difficult to increase gold production, as major gold finds are becoming rarer.
The professor would do well to deal with the price dynamics of these commodities individually.
The Whole Market is a Bubble Ripping off Non Investors and generations to come to pay off the losers with welfare via Leverage inflating dividend payments, while they stab me in the back with illegal labor. iilii
Fascinating and informative read. I believe the information to be substancially correct, but I think I disagree with the conclusion. The reason I disagree is that there was not any mention of the value of the COMMON DENOMINATOR…. ie the currency these markets are bought and sold in.
I would argue that the falling value of constantly inflating fiat money is the underlying cause of the swelling prices. I would also predict that except for the occasional temporary reprieve due to the stalling tactics of the Fed via QE infinity; trying to prop up all the ZOMBIE players in the commodities markets…. eventually the prices denominated in fiat will be infinity and the currency will die. Leaving commodities to real price discovery. As for commodities sold in fiat, the Fed is trying to keep some prices up while suppressing prices of others ie Gold and Silver. Total control ZOMBIE markets being kept alive by transfusion of increasingly watered down fiat plasma. Soon the long dead Zombies will lay down and admit to their death.
I have to say this is one of the most interesting
and informative threads I’ve ever read on this
site, and that’s saying a lot, as I always become
smarter as the result of reading here.
Many thanks to Yves and all of you smart people.
hm, in general one should have a problem with scientific method such as the one deployed by Eckaus: “I know A, B, C could be a cause for Y. I have determined that in one instance ABC were not the reason for a change in Y thus only D must a reason as I dont know any other letters”.
you also somehow decided to imply that marginal cost of oil today is $14.5/bbl which is a total …. Please check the reference. Eckaus took a claim by an executive from Canadian Natural Resources (publish in Bulletin) that that will be the cost in his project. (if every company were to achieve what it promised to investors…).
on the other hand simply because you logic makes no sense to me i am not going to deny that some financial speculation is not driving spot prices but in oil duopoly market the fact that regional middle east budgets only balance at about $80/bbl is a much bigger factor of why oil is where it is.
Well huge quantity of money chasing a few real goods… Hummm Is the price which goes up or the money and liquidity which is overly abundant? So if the money goes elsewhere another bubble or a credit crunch to kill money? Or do we expect even more money to be thrown at the problem to “solve it”. By the way if you check stats for 17 oils seeds and fats from malaysia palm oil board, the world increase in fat in the last past 10 years is increased 52% in physical quantity, not in monkey money unit of distortion but in mass, adjusted to inflation sales per share of the S&P is just 12% over the same period. I am happy to own oil seed plants and tea plantation through shares I have a family to feed!
Malthus is not wrong : the growth rate is a geometric function. Ponder the following assuming 45 kg of mass per human being and assuming the population growth of the 20th century, in 1200 years the mass of humanity is more than the mass of all oceans and seas of the planet. I just demonstrated the idiocy of standard deviation. Geometric projection can not work on a finite planet. We are likely to face constraints before the mass of humanity is superior to the mass of oceans. Cheap oil is an obvious one, was there any new giant field of low cost extraction announced in the last past10 years?