Why is speculation necessary in commodity and financial markets?

Speculation in commodities and financial markets enables better hedging decisions and financial outcomes for producers, consumers, borrowers and lenders. It is utopian to assume that the hedging and price preferences of producers and consumers in goods markets can be contemporaneously matched or can be similar in terms of expectations. Speculation bridges this gap in perceptions and timing. With better access to futures markets, Indian cotton farmers, may have been able to better utilise the significant price rise noted in the past year.

Rising input costs but inadequate returns from selling the product. This is the bugbear of agricultural operations. A recent report points out that farmers in Virudhunagar District of Tamil Nadu get only Rs.750 for selling 100 kg of rice whereas the foodgrain sells in the open market at upwards of Rs.25 a kilogram, with the difference accounted for in a major way by intermediation costs (or to put it less technically, middlemen commissions). With high labour and material costs, the economics of farming are turning significantly unattractive as farmers are not able to obtain remunerative prices linked to prevailing open market prices, point out many other reports.

Much the same conclusion was drawn by Basix, a leading Indian micro-finance institution which studied the problems faced by cotton farmers in Adilabad District of Andhra Pradesh. Basix found that farmers were using chemical pesticides indiscriminately, suffered from high input costs and finally were squeezed by low and fluctuating selling prices for their products. Basix has launched a multi-pronged action plan to improve the economics of cotton farming in Adilabad. Apart from educating farmers on more scientific and appropriate use of pesticides (and other material inputs), one of the key initiatives of Basix is to enable farmers to obtain better and more stable prices for their produce. Basix proposes to do this by introducing cotton futures markets to the farmers - so that they not only obtain up-to-date information on ruling market prices for cotton but can also, in course of time, use the futures market for hedging the price risk on their production.

Infrastructural requirements of national markets
These 2 cases highlight the key role which futures (or forward) markets in commodities can play in improving the economics of farming activities. In the backdrop of the policy ambiguity which surrounds this issue and the government ban on futures trading in some key agricultural commodities, the resolve expressed by institutions such as Basix to utilize market mechanisms to deliver better financial outcomes for farmers is refreshingly welcome.

To be sure, a considerable amount of infrastructure - both physical infrastructure such as warehouses and transport linkages as well as financial infrastructure to network farming communities on to a national market in agricultural produce - would have to be created as a part of this process. Significant amounts of time and financial resources may also have to be expended in educating farming communities about the benefits of forward contracting and of hedging the price risks they face.

Why it appears an alien utopian concept...
Of course, in a milieu where, as some commentators have pointed out, large sections of farmers in the country are not able to access even the MSP of the Government, futures markets and forward contracting do seem alien concepts. All these may also seem quite utopian in the Indian environment given that overall capital investment and that particularly in the agricultural sector has been on a long-term decline in the country for a number of reasons. Further, the costs of creating such infrastructure will be inevitably built into the prices finally realized by farmers and therefore, to that extent, farmers may still not have 100 per cent access to prevailing open market prices.

But, given that such costs in many cases will be in the nature of one-time and non-recurring expenditure, futures markets will likely provide increasing levels of incremental benefits to farmers. More importantly, the success of micro-finance, which is a private and market-based solution to the problem of rural poverty and livelihood protection / enhancement,illustrate that broadening the scope of such private / market-based solutions to cover commodities markets need not be a utopian idea or unrealistic goal at all.

Speculation, an integral element of markets  
To realise those benefits though, policy-makers should appreciate that speculation is an integral element of any market in goods and services - be it spot or forward - and so it will be in the case of agricultural and industrial commodities also. One can go so far as to say that a forward market will not exist if speculators are not allowed to operate.

Indian policymakers, for instance, may possibly allow futures trading in agricultural commodities such as rice, wheat or soya bean if it can be ensured that speculators will not operate in those markets. But, the result then will be sub-optimal outcomes for producers and consumers of various products and services as a crucial link in the price discovery process - the speculator - is absent. The ultimate result will be that producers and consumers will cease using the futures market leading to its irrelevance and non-existence.

How does the speculator play such an important role in the price discovery process? And why will his absence lead to sub-optimal outcomes for producers and consumers - who have a natural hedging requirement - of commodities?

Speculator bridges timing and perceptional differences
A prime reason for the existence of the speculator is the fact that in no market will the hedging requirements of producers and consumers be contemporaneously matched - that is, in terms of timing. Even if timing differences can be managed, more critical is the fact that the perceptions and expectations of producers and consumers as to the future price of a commodity will also fundamentally differ.

To understand the role of speculation in futures markets and how it helps the hedging decisions of producers / consumers, assume a market initially where there are only producers and consumers. The producer has a natural hedging requirement where he has to sell his product - say an upcoming agricultural harvest - at the best price possible. The consumer too has a natural hedging requirement where he has to procure his future consumption at the lowest price possible.

It is obvious here that there can and (in most cases) will be a fundamental perceptional difference between the producer and consumer as to the future price of the commodity. More critically, where the forward prices offered by the market (by the consumers) are lower than the price which is expected by the producer, the producer will be reluctant to hedge. It is possible that some of the producers may be reluctant but still will be forced to hedge as they may not be in a position to wait till the forward maturity to sell their produce. To that extent, there will be a number of producers who would not get the best prices possible - a sub-optimal outcome for them. There will also be a number of producers who decide not to hedge and thus will carry the price risk till the forward maturity. There will, therefore, be a hedging imbalance as far as the producers are concerned - some have hedged but at less than the possible best prices and some have not hedged at all.

On the contrary, the consumers will fully hedge their requirements as long as the forward prices quoting in the market are lower than the expected price for the commodity in the future. But they too will hold back from hedging if the forward prices in the market are higher than the prices they expect will prevail at the forward maturity. Therefore, there could be a hedging imbalance from the consumers' side also.

At any point in time, in the overall market for a commodity, the quantity of desired producer hedging and desired consumer hedging will vary, generating either a net producer hedging imbalance or a net consumer hedging imbalance.  
Introducing speculation...
Now introduce speculators into the market in this environment and we can see how this impacts the formation of the equilibrium futures price - that is the price where there is a much better balance between the hedging requirements of producers and consumers.

When the forward price of the commodity falls below the price expected to prevail in the future, there will be some speculators who feel that is a good bargain. Such speculators will commence buying the commodity for forward maturities. This demand and buying interest from the speculators will automatically drive the futures price of the commodity price up. As the futures prices move up, they will provide better levels for the producers - such of those producers who had held back in the initial stage since market prices did not match their expectations of the commodity's future price - to hedge their production. The magnitude of the producer hedging imbalance, therefore, can be brought down by the activities of speculators.

Similar will be the outcome when speculators act to reduce consumer hedging imbalance. If market futures prices are above that expected to prevail in the future, there will be a consumer hedging imbalance as consumers are reluctant to hedge at the higher prices. But there will be some speculators who can take the risk of betting that prices will be lower in the future and, therefore, will sell the commodity for forward maturities. Such selling by the speculators will tend to depress the futures prices of the commodity and bring it more in line with the price levels expected by the consumer hedgers. As the futures prices drop, an increasing amount of consumer hedging will be undertaken, progressively reducing the consumer hedging imbalance noticed in the initial stage.

The upshot of all these activities of the speculators - both those buying the commodity and those selling the commodity for forward maturities - is that hedging imbalances get reduced and producers / consumers get better hedging prices.

Why then the bad press for speculation?
Is that all there is to speculation? Is speculation such a do-gooder for the markets? Then why all the bad press and negative perception about speculation being the primary factor behind prices deviating far away from fundamentals?  
A careful perusal of the role of speculation described above would show that there is nothing inherently sinister about speculation. As a concept, speculation has a very significant economic function to play in forward markets for goods and services. Also it can be clearly seen that the springboard or foundation for speculative activity is the level and nature of fundamentals activity - that is, demand and supply for the commodity in question.

Where futures prices have been bid up to high levels - as happened recently in the case of crude oil - it is based on the perception and expectation of speculators that fundamental demand is so high that the prevailing futures prices (before being bid up) are underestimating the future expected spot price of the commodity. Bringing futures prices down in this scenario depends crucially on correcting the perception that fundamental demand cannot be brought down or restricted AND not on blaming speculative forces or banning them from the market.

The fact that global crude oil prices have declined dramatically in the past couple of months to $ 92 as at the time of writing this piece (16 September) - a fall of close to 40 per cent from their peak of $147 in mid July, amply bears this statement out. Crude oil prices have crashed 40 per cent because the market is now factoring a serious cut back in demand and consumption in the US and other advanced economies as the financial markets crisis extends its impact into the real economy. Speculators here have acted on the perception and expectation that futures prices were much higher than the prices expected to prevail at the forward maturities given the underlying changes coming through in overall demand and, therefore, have been furiously selling oil for forward maturities. Speculative activity at this juncture has, therefore, presented better opportunities for consumer hedgers (for instance, countries such as India which have high dependence on imported oil) to hedge their forward requirements of oil.
 
Negative externalities...
The negative externalities arise, though, when the institutional mechanisms necessary for the proper play of speculative activity are either absent or are inefficient. Institutional mechanisms here would cover a range of practical points such as position limits on market players, the level of margining required, the efficiency of the market supervisory and surveillance mechanism among others. There have been instances in the past where gaps in the institutional mechanism - for instance, the position limits violation which was noticed in silver futures contracts in the late 1970s and the large cash positions held by the Hunt brothers, known as the Hunts silver corner - led to large increases in the commodity's prices. These are occasions and instances which call for the institutional mechanism covering these markets to be strengthened. They certainly are not examples calling for the concepts of forward markets and speculation themselves to be cast in a negative light.