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The Speculators' Role

There is much debate as to the speculator's role in the commodity markets. You likely witnessed Congressional testimony and other hearings regarding the matter. For those of us with the luxury of being within the industry and understanding the nature of the marketplace, it was nothing short of scary to see our elected leaders making such uninformed assumptions and eventually decisions about what are intended to be free markets.

The commodity markets are built on speculation; without it there would be no market. The futures markets were formed to facilitate the transfer of risk from producers and users to unrelated third parties hoping to profit from price changes; I cover this in detail in Chapter 1, "A Crash Course in Commodities." Nevertheless, many would argue that in 2007 and 2008 the speculators contributed to artificially inflated commodity prices to unsustainable levels.

"If the models are telling you to sell, sell, sell, but only buyers are out there, don't be a jerk. Buy!"

William Silber (NYU)

There seems to be some evidence suggesting that this is the case. After all, commodities boomed as anxious investors poured money into the alternative asset class in search of higher returns. How much capital made its way into commodities is unknown, but some have estimated $30 billion in the first quarter of 2008. (Don't forget about the leverage.) Additionally, what was once an investment arena utilized only by the über-rich and risk hungry investors, began to see money inflows from average retail investors and even pension funds. However, as investors began redeeming funds from their commodity holdings, it was as if someone had pulled the floor from underneath the markets. In my opinion, speculators didn't cause the bubble, but unfamiliar and inexperienced speculators might share some of the blame for the size of it.

Without support from basic supply-and-demand fundamentals, a market cannot sustain pricing in the end. Thus, if and when speculation does move prices beyond what the equilibrium price might be, it eventually has to correct itself. The problem is that there is no telling how far and how long prices can remain distorted; unfortunately, many traders were introduced to this the hard way. This is a phenomenon that is not exclusive to commodities; I am sure that you remember the tech bubble in the 1990s in which similar market actions took place.

Perhaps the single largest contributing factor to the speculator's role in the commodity bubble was the increasing popularity of the Electronic Traded Fund. Before the existence of commodity related ETFs retail investors were largely excluded from the asset class due to fears of the futures markets in terms of leverage, margin calls, and perceived risk.

During the 2007/2008 commodity frenzy, investment firms issued several new commodity-based ETFs. This should have been a warning sign as fund companies are notorious for providing sector-specific products near the bursting of a bubble. This makes sense; by the time that a firm identifies the trend, assembles the fund, and gets approval from the Securities and Exchange Commission (SEC), the sector might have exhausted its popularity.

Keep in mind that the magnificent rally and retreat was highly correlated with available leverage. Many of the gains made on the way up were backed by leverage as opposed to actual capital. As traders and fund managers de-levered, the markets suffered dramatically.

The role of speculators in the commodity rally was exacerbated by the toll that margin calls took on the markets. As the commodity boom began to fizzle, exchanges and brokerage firms began issuing margin calls to those that entered long positions at the tail end of the rally. As positions were liquidated to satisfy margin calls, prices dropped sharply, and new margin calls were issued. It isn't difficult to identify the snowballing effect of such events and how they could quickly alter the mentality of the market and, more important, prices.

It is critical that you realize that from a trading standpoint, it doesn't necessarily matter whether the market is driven by fundamentals, technicals, speculators, or hedgers. What does matter is that prices move, and it is up to you to be on the right side of it or at least get out of its way. Markets are unforgiving, regardless of how strongly that you feel that prices are overvalued due to irrational speculation; they might remain so for much longer and much farther than you can financially and psychologically afford to be involved.

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