Commodity Chaos
Recent news has been ablaze with news of commodity price volatility.
Prices for gold, silver, and oil have all taken a sharp drop after rising significantly over an extended period of time.
These rapid price fluctuations demonstrate the effect to which commodity prices are being driven by leveraged futures contracts and speculation concerning future price movements.
The situation that has emerged in major commodity markets is one where upward movements have resulted in more people purchasing futures contracts to profit from future price increases, but any weakness in prices is met by a rapid rash of selling by investors who are looking to limit their losses The implicit problem that is uncovered by this recent price volatility is that returns from commodity investment singularly flow from price increases.
Naturally, the only way that prices rise is if an imbalance of buyers vs.
sellers pushes up the price at which people buy.
If this trend continues for too long, a 'bubble' results where people buy simply because they believe others will continue to buy and drive up the price.
During bubble markets, many investors will begin to make leveraged investments on anticipated price movements through instruments such as futures contracts.
A futures contract is where two parties agree to exchange a specified asset of standardized quantity and quality for a price agreed today but with delivery occurring at a specified future date, the delivery date.
People who correctly predict upward price movements when using futures contracts can make a lot of money very quickly by selling the contract before its delivery date for a profit.
Conversely, if prices move counter to what an investor anticipates, a lot of money can be lost very quickly.
The ability to buy/sell contracts for future delivery allow investors and speculators to employ a tremendous degree of financial leverage.
This leverage increases the perceived returns of asset bubbles since increases in prices are seen as pure profit to futures traders who simply flip a contract and make money.
This phenomenon then attracts more people seeking easy money until prices are driven so high that nobody can be found to take physical delivery of the product in question at the inflated prices.
At this point, the investors who have no desire to take physical delivery of commodities must sell quickly to cover their position.
If many investors end up liquidating their positions simultaneously, price crashes can occur.
In recent months, "speculators" have been a popular political target for attempting to draw attention away from turmoil in the Middle East, a continued ban on US offshore drilling, and money printing by the Federal Reserve as drivers of increased energy prices.
However, it is important to note that speculators can only capture profits if somebody else buys the other side of their contract.
In other words, they can only profit from the price of oil going up if people reasonably expect the price of oil to escalate in the future.
It would be very difficult to find people willing to pay increasingly higher delivery prices for oil if new exploration contracts were approved and drilling resumed on existing offshore wells.
The important thing to understand in regard to commodity price fluctuations is that they move in accordance with the number of people who are willing to purchase the commodity in question at a given price.
The advent of price collapses is nothing more than a by-product of chasing profits with leveraged futures contracts.
The same forces that compel people to pursue big money in commodity trading also compels people to sell their positions rapidly when prices decline, because of the high leverage they are using for their transaction.
Ultimately, price bubbles and price collapses are two different sides of the same coin.
All bubbles eventually end in a collapse, and collapses do not occur unless prices become disconnected from fundamentals.
In the end, market prices will always regress back to fundamentals over time.
It may take a series of gyrations, but the one principle that has born out throughout financial history is that no bubble can endure indefinitely.
Prices for gold, silver, and oil have all taken a sharp drop after rising significantly over an extended period of time.
These rapid price fluctuations demonstrate the effect to which commodity prices are being driven by leveraged futures contracts and speculation concerning future price movements.
The situation that has emerged in major commodity markets is one where upward movements have resulted in more people purchasing futures contracts to profit from future price increases, but any weakness in prices is met by a rapid rash of selling by investors who are looking to limit their losses The implicit problem that is uncovered by this recent price volatility is that returns from commodity investment singularly flow from price increases.
Naturally, the only way that prices rise is if an imbalance of buyers vs.
sellers pushes up the price at which people buy.
If this trend continues for too long, a 'bubble' results where people buy simply because they believe others will continue to buy and drive up the price.
During bubble markets, many investors will begin to make leveraged investments on anticipated price movements through instruments such as futures contracts.
A futures contract is where two parties agree to exchange a specified asset of standardized quantity and quality for a price agreed today but with delivery occurring at a specified future date, the delivery date.
People who correctly predict upward price movements when using futures contracts can make a lot of money very quickly by selling the contract before its delivery date for a profit.
Conversely, if prices move counter to what an investor anticipates, a lot of money can be lost very quickly.
The ability to buy/sell contracts for future delivery allow investors and speculators to employ a tremendous degree of financial leverage.
This leverage increases the perceived returns of asset bubbles since increases in prices are seen as pure profit to futures traders who simply flip a contract and make money.
This phenomenon then attracts more people seeking easy money until prices are driven so high that nobody can be found to take physical delivery of the product in question at the inflated prices.
At this point, the investors who have no desire to take physical delivery of commodities must sell quickly to cover their position.
If many investors end up liquidating their positions simultaneously, price crashes can occur.
In recent months, "speculators" have been a popular political target for attempting to draw attention away from turmoil in the Middle East, a continued ban on US offshore drilling, and money printing by the Federal Reserve as drivers of increased energy prices.
However, it is important to note that speculators can only capture profits if somebody else buys the other side of their contract.
In other words, they can only profit from the price of oil going up if people reasonably expect the price of oil to escalate in the future.
It would be very difficult to find people willing to pay increasingly higher delivery prices for oil if new exploration contracts were approved and drilling resumed on existing offshore wells.
The important thing to understand in regard to commodity price fluctuations is that they move in accordance with the number of people who are willing to purchase the commodity in question at a given price.
The advent of price collapses is nothing more than a by-product of chasing profits with leveraged futures contracts.
The same forces that compel people to pursue big money in commodity trading also compels people to sell their positions rapidly when prices decline, because of the high leverage they are using for their transaction.
Ultimately, price bubbles and price collapses are two different sides of the same coin.
All bubbles eventually end in a collapse, and collapses do not occur unless prices become disconnected from fundamentals.
In the end, market prices will always regress back to fundamentals over time.
It may take a series of gyrations, but the one principle that has born out throughout financial history is that no bubble can endure indefinitely.
