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Wednesday, June 29, 2011

Curbing the exuberance in oil (& commodity) prices

The fluctuations in oil prices and commodities are creating a problem for global regulators. There is a way to make the volatility go away while allowing for liquidity. Oil prices dropped $6 as the reserves were released. If not speculation, what is this?

Reign of speculators
Physical delivery accounts for only ~3% of the trading that takes place. The rest of the trade is mere speculation or hedging. A lot of arguments are made about the 97% providing liquidity for the 3%. To me, that is too much liquidity. Its corollary, high liquidity means inflation, implies that prices are too high. My gut feel (no research backing) is that this figure should be ~20-30% if not more.

Compulsory delivery
Now if delivery is compulsory for these traders it will make it difficult for random speculators. But it is very difficult to create and enforce compulsory delivery mechanism. In some cases there is legitimate re-sale to other parties (high-seas sale). However, the principle can be deployed with adjustments. Let me explain this mechanism.

Hurdle costs
What we need is to get the investor to block a percentage of capital required for storage and an annual fee for maintenance and upkeep. This will create a hurdle costs for investors. If they are legitimate investors or genuine traders then there is no extra cost as they already have infrastructure for storage and delivery.

The capital requirement will have to be deployed for each commodity or at least specific types of commodities. e.g. grains may have a single warehouse but oil and grain will have separate investments and upkeep costs. 

Trading Caps within hurdle costs
Once the investor pays the capital for storage and maintenance, he creates a maximum allowed position that commodity or commodity group. Hedging may be allowed for 100% of the volume occupied. 

This is beneficial for producers too
Today, producers make investment looking at commodity prices and later the prices fall, it will create huge losses. Therefore, producers are reluctant to deploy capital till they are sure the high prices are result of fundamental factors rather than speculation. Hence, oil exploration that could be viable when crude is at $80 is not undertaken till crude goes above $100 and stays there for some time. In short, producers cannot trust the prices communicated by the markets. This leads to a build up of supply side pressures creating an inflationary spiral that abruptly breaks down.

In sum
Such limits should reduce the rampant speculation. This, I believe, will allow for real markets to clear at correct prices. It will ease the burden on consumers and will correctly determine the return on investment by producers.

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.