Folklore And Myths Of Commodity Markets

Tuesday, 19 May 2015

Original Joomla Article

To quote the Economist: "The image of the market-rigging commodity speculator of modern folklore lies somewhere between moustache-twirling pantomime villain and James Bond's evil nemesis ("When I press this button the price of molybdenum will treble, the world will be destroyed and I will be rich, rich, rich!")."

Among the many myths about futures, there is belief that futures markets operate in an antiquated fashion and that they have ignored the advances in technology of the last fifty years. Thus, it is generally concluded that the futures market system of trade execution by 'outcry' is nothing more than a throwback to ancient times and a capricious gambit of the establishment to maintain a system which benefits insiders.

Many of the myths and much of the folklore about commodity markets comprise sales people and marketers trying to dispel the myths about how risky commodity markets are.

  • "In reality, commodities are no more volatile than stocks as an asset class if you remove the leverage factor. Leverage is the biggest problem when investing in commodities. Normally, you only have to put up about 3 to 15 percent of the total value of a futures contract in futures margin. That is far less than the 50 percent that is required for stocks. Many new commodity traders don’t know how to handle their newfound gift of incredible leverage."
  • "You really don’t need to worry about taking delivery of commodities. Only the commercial players are involved in taking and making delivery on commodities. As long as you close your futures contract before the first notice day, which usually occurs a few weeks before the contract expires, you should have absolutely no worries about this. If for some reason you forget about the first notice day, your broker will certainly catch it and contact you."

So don’t count your coffee beans as they are unlikely to arrive!

By contrast others dwell on the evils of commodity investment and trading.

“Many people do lose when trading commodities. However, the losers are usually ill prepared investors who jump into the commodity markets and lose within six month, never to return again. Others get addicted to the markets, while trying again and again to make a killing with the same strategies and just keep losing."

"It may be good news that commodity investing is a zero sum game but it means for every dollar lost, someone gains a dollar. When you have to factor in transaction costs, so each person loses a little more than a dollar and the other party gains a little less than a dollar."

"Who makes all the money? It is normally the professional commodity traders and money managers that consistently make money year after year. Amateur commodity traders who make money tend to trade for a long time. In that time, this trader has probably taken money from hundreds of commodity investors along the way."

A myth appears from time to time, when Commodity Markets are booming that ordinary investors need to have some direct exposure to commodities like oil, copper and wheat through the futures market, the 'diversification theory'. It makes no sense. 'Diversification' does not mean you have to squander some of your pension investment on dangerous bets at poor odds just because some other people are.

Commodities are far more dangerous (high risk) investments than stocks, shares, or property. The prices are incredibly volatile. They can spend years, even decades, in depressed markets. In the 1980s and 1990s, many fell by two-thirds or more. An ounce of gold or a pound of copper, unlike stocks and bonds, doesn’t even pay interest or dividends as you go along.

Oil trading has provided some very pertinent contemporary myths about commodity trading:

"OPEC is finished. Maybe, but the Gulf Cooperation Council is not. The 4 GCC members pump more than half of all OPEC production. They also have very low lifting costs and enormous cash reserves. Additionally, they have stamina and are going to maintain OPECs position of no cuts. Russia or Venezuela filling reduced quotas. This time around the GCC is not going to let that happen. Look for Saudi Arabia to pick up market share."

Shale wells have a productive life of only a few years. Shale lacks permeability. This means it has tight formation and requires “fracking” to free up the oil and gas trapped in its pore space. Fracking creates and sustains permeability and permeability is the pathway to the wellbore. Like any tight formation, oil and gas production is front loaded, meaning that most production will come right after stimulation. This results in excellent up front results but production falls very quickly by much as 75% in year one and settling into something less for the next 10 or 20 years. This is called the tail and the tail is profitable, but only if the initial flush pays for most of the well.

Ending Oil sanctions with Iran will lower oil prices: "Up to a point Lord Copper". It will take Iran a year or two to add anything meaningful to the global market but the fear of a nuclear Iran will create enough tension to offset the supply addition. Worries over a nuclear Iran, whether real or perceived, will create enough fear in the markets to more than counter balance the additional million barrels a day of supply that may come on.

By way of a corollary, the Secretary of State of one of the Indian States has condemned the commoditisation of folklore. F.C. Chegareddy said that under the impact of globalisation, folklore was vanishing slowly. Efforts to save folklore in the name of a jungle resort, ‘hallig sogadu’ had become commercialised so that folklore had been reduced to the state of a commodity. He said that marketing would not help save folklore. "Folklore can prosper only if it becomes a part and parcel of life."

I am not sure there is much to be said after that!

This article is part of Robert McDowall's series on Folklore & Finance.