Movements in commodity prices in the past 12 months will probably rank among the greatest roller-coasters of all time. From around $90 in January 2008, crude oil went to a high of $147 in July but is now hurtling all the way down to multi-year lows. At the time of writing this piece (20 January), benchmark crude oil fell below $34, close to its levels of five years ago (see Fig.1).

It does not stop there. The dire forecasts for the global economy in 2009 and the resultant slack in demand have even encouraged forecasts for a drop all the way down to even $10 or $11 a barrel – levels last seen more than 10 years ago in June 1998.

As for other commodities, suffice it to say that crude oil has been an excellent representative of the entire commodity class. Therefore, our refe-rence to crude oil in the rest of the article will well apply to other commodities also.

Price rise criticised but not price fall

The almost secular and massive rise in crude oil prices from early 2000 and particularly, the sharp run up in prices between 2006 and mid-2008 attracted a lot of attention and criticism – from policy makers and oil consumers – as purely due to speculation and, therefore, to be condemned and, if possible, banned.

Such critics did not spare the time to understand that speculation does not exist in a vacuum nor arises by itself but is built only on a specific foundation of fundamentals. Where speculators perceive that demand is running ahead of the available and potential supply, they are going to bet that prices would rise. They themselves are not the proximate cause of the rise. Actually, in so betting that prices would rise, they help in bringing an enhanced level of supply into the market – a supply which otherwise may not have come fully into the market on account of weak prices.

Equally, where speculators perceive that demand will fall far short of the available and potential supply, they will bet on falling prices. Again, they are not the proximate cause of the fall in prices. The action of speculators provides oil consumers with better price levels to hedge their requirements as such consumers would otherwise have kept away from the market on account of the high prices.

Where prices have been bid up to high levels – as happened in recent years 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 six months shows the speculative forces acting in reverse gear now.

Crude oil prices have crashed close to 75 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 market crisis has seriously depressed the overall 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 significant contraction occurring in overall demand and, therefore, have been furiously selling oil for forward maturities.

Speculative activity at this juncture has, therefore, presented better oppor-tunities for consumer hedgers (e.g. countries such as India, which have high dependence on imported oil) to hedge their forward requirements of oil.

Same speculation causes the fall in crude prices...

Understandably, the equally or even more massive fall in prices in the last six months has not elicited any kind of criticism from those consti-tuencies which railed against the price rise – even though it is possibly the same and much reviled ‘speculation’ which is responsible for the near 75 per cent price fall from the high of $147.

While their silence as consumers is understandable, it would also be a win-win situation for everyone if such silence finally leads to a realisation of the useful economic role which speculation plays in the commodity markets – rather in all kinds of goods and services markets.

For, it is the same speculation which has driven prices to multi-year lows which is required now to ensure that there is not an ‘undershooting’ or an exaggerated fall in prices. In other words, speculation is required to bring about better balancing of the forces of fundamental demand and supply – a balancing which could ensure that the prices which finally come out of the market are beneficial to both consumers as well as producers.

Consequences of such undershooting...

It has been estimated that oil prices lower than $50 could seriously undermine the budget balance and welfare spending in key oil-producing nations in West Asia. It should not take much imagination for a policy maker to understand that a serious economic contraction in West Asia – a volatile political zone – could have larger geo-political ramifications.

Also importantly, the newer oil finds and the investments going into such finds demand that oil prices stay sustainably above $50 for those investments to pay off. It has been reported, for instance, that Royal Dutch Shell has postponed a decision to expand its Athabasca oil-sands project in Canada. ConocoPhillips recently decided to halt bidding for a planned 400,000 barrel-a-day export refinery in Saudi Arabia because of falling prices. Quite simply, until prices improve, oil companies are delaying investments and shutting plants, threatening to reduce supply further.

Some early signals of the consequences of such delayed and moth-balled oil sector investments have been available in recent weeks in the form of an ‘upward sloping’ forward oil price curve.

The forward oil price curve normally slopes downwards – ie. near term prices are higher than farther term prices – to account for the near term stringency in supply but which is expected to ease off in the longer term. When the oil curve slopes upward, it means that the market is factoring the probability of a supply stringency even for the longer term (see Fig.2).

Speculation cannot be ‘generally destabilising’

At this juncture, it seems particularly apt to quote American economist, Milton Friedman, on the role of speculation in financial and commodity markets.

Replying to those critics who said that speculation is generally destabilising, Friedman said: “people who argue that speculation is generally destabilising seldom realise that this is largely equivalent to saying that speculators lose money, since speculation can be destabilising in general only if speculators on the average sell when the asset – be it a commodity, currency or equity – is low in price and buy when it is high.”

That is, destabilisation can occur only when speculators accentuate a price fall or a price rise by selling when prices are falling and buying when prices are rising. If they do that, how will speculators make money at all?
That is Friedman’s question and no convincing answers have been provided in the 50 years since Friedman posed it.