236 years ago, Adam Smith wrote that agitation towards the trading of commodities resembled “popular terrors and suspicion of witchcraft”. Even though most people probably have given up the thought that there is any witchcraft involved in commodity trading, there still seems to be a struggle between those who argue that speculation is indeed driving up commodity prices and those who argue it does not. Dennis Kelleher, the President of Better Markets, a non-for-profit reform group, contends that excessive speculation has sent the price of gasoline up: “It is Wall Street, not Iran, raising the price of gas”. A study conducted by Better Markets asserts that the $400 billion poured into commodity index funds by Wall Street have distorted the market and have driven prices up. Mr. Kelleher thus argues that these index funds should be prohibited.

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These commodity futures markets were obviously not designed for speculation, but rather to allow farmers to sell the wheat they planned to grow at current prices. Hence, when the farmers planted their crops, they would therefore know pricing and the buyers would know how much they would buy for in the future. Other than wheat, many other markets have also developed.  Since there are not always enough buyers to meet the availability of sales, and vice versa, speculators are allowed to participate on a restricted basis. However, Kelleher argues that these markets function properly only if speculators are restricted to approximately 30% of the clientele base. In reality, the percentage of speculators is significantly higher and creates an incentive for higher prices.  Kelleher further argues that even Goldman Sachs, the firm which created the index funds, admitted that it is distorting the market. There is a broad agreement that excessive speculation is causing commodity prices to go up.

In The New York Times article “Commodity Prices – Wonkish”, Nobel Economics Prize Laureate Paul Krugman argues along similar lines, but adds the aspect of storage. He provides a simple model showing how speculation can send prices up, using ice cream as the commodity. Ice cream cannot be stored and therefore price is determined by supply and demand. If however, the commodity can be stored, people who expect an increase in price would take some amount off today’s market. By doing this, they raise the current value and expect to be able to sell later at a higher price. In order to illustrate this, he gives the example of how speculation could be driven by the news. Krugman references the headline, “The White House fires an admiral know to oppose bombing Iran” and asserts that this might drive up the expected future oil price and raise current market values.

There are also people arguing that speculators simply do not drive up prices. Craig Pirrog, finance professor and director of the Global Energy Management Institute at the University of Houston affirms that it is basic fundamentals – supply and demand for commodities themselves – not excessive speculations that drive the prices up. To explain this, he gives the examples of the markets for natural gas and oil. At the time when the Better Market Claims Index Trading raised the price of oil extravagantly, the price of natural gas plunged to almost historic lows. He contends that dealers treat these two markets exactly the same; however, the fundamentals (i.e. the supply and demand) of these commodities have differed significantly, ergo, it is the fundamentals, not index trading that have sent the prices up.

Fawley and Juvenal argue in a publication of the Federal Reserve Bank of St. Louis that it is important to understand the source, that is if there is one, of fluctuating commodity prices in order to establish a proper policy response. Some countries such as India have already begun to regulate commodity futures markets whereas, for example, the United States is currently debating the issue. Regardless of whether you believe that speculation is the source of rising commodity prices or not, most people agree that properly functioning commodity futures market are vital to our the real economy; after all, people who do not want to hold the risk of future price movements can sell to willing parties. Moreover, the OECD’s report “The Impact of Index and Swap Funds in Commodity Markets” is a reminder of the importance Index Funds maintain as a source of liquidity and of risk absorption for these markets.

To summarise, there seems to be no clear-cut answer for the question of who to blame for the fluctuation of commodity prices. The struggle between those who argue that prices are subject to heavy speculation and those who firmly defend commodity trading continues. Perhaps we will have to wait another 263 years until we know the answer.

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