Aug. 22, 2008

Speculation and Commodity Prices

When speculation is rampant, spot prices may also rise, but a rise in spot prices must imply some form of hoarding. In the absence of hoarding, spot commodity prices are determined by supply and demand, where demand refers to demand by the users of the commodities.

When intense speculation pushes up oil futures prices, suppliers who do not believe the prices can sustain may want to sell in the futures market. If they do not believe that the high prices will sustain, it makes sense to sell in the futures market while prices are still high. On the other hand, if further price rises are expected, then suppliers may want to withold some of their supplies now; at the same time some users may also want to buy more now and hold them in inventory. This will push up spot prices, and the final users of commodies will then suffer for having to pay higher prices.

Speculation without a surge in real demand however cannot sustain. Without a surge in real demand by users, speculative price increases must lead eventually to a price crash. Inventories have to be disposed off some day. Real demand must also fall with higher prices, adding pressures on inventory accumulation.

It is unfortunate that today commodities have become a vehicle for fighting inflation and a declining US dollar. That is to say, the prospect of higher inflation encourages hoarding and speculative demand for commodities. If commodities are priced in WCU2000 or WCU2005, however, real prices would not need to change as the effects of inflation and US dollar depreciation would be completely offset, leading to more stable commodity markets.

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