Politicians frequently demonize speculators with proposed limits on speculation.  How foolish.

Let me explain.

Speculators are not the problem.  Speculators do not rule the markets.  Speculators are not big evil entities with all the money in the world that make prices bend at their whim.  And most importantly: Speculators do not cause cash (spot) prices to go up and down.

It may correctly be said, however, that supply and demand, or expectations of supply and demand, cause speculators to act – which effects futures prices – which effects cash prices.  But saying that speculators cause cash prices to move up and down is simply incorrect, for it confuses correlation and causation.

For most commodity producers, the discussion goes about like this:

“Speculators are just pushing the price down.  They always do that this time of the year when loans are due.  We had a good price back a few months ago right before harvest, but they are just out to get us.  They are every year.  Speculators are just greedy.”

First of all, on the notion of greed, it is certainly not exclusive to speculators (or oil companies or banks, etc.)  Economist Walter Williams has this to say:

“This winter, Texas ranchers may have to fight the cold of night, perhaps blizzards, to run down, feed and care for stray cattle. They make the personal sacrifice of caring for their animals to ensure that New Yorkers can enjoy beef. Last summer, Idaho potato farmers toiled in blazing sun, in dust and dirt, and maybe being bitten by insects to ensure that New Yorkers had potatoes to go with their beef.

Here’s my question: Do you think that Texas ranchers and Idaho potato farmers make these personal sacrifices because they love or care about the well-being of New Yorkers? The fact is whether they like New Yorkers or not, they make sure that New Yorkers are supplied with beef and potatoes every day of the week. Why? It’s because ranchers and farmers want more for themselves…This is precisely what Adam Smith, the father of economics, meant when he said in his classic “An Inquiry Into the Nature and Causes of the Wealth of Nations” (1776), “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” By the way, how much beef and potatoes do you think New Yorkers would enjoy if it all depended upon the politically correct notions of human love and kindness? Personally, I’d grieve for New Yorkers.”

On futures prices themselves, the thinking from everyone is that increased buying activity in the futures market causes futures prices, and then cash prices, to go higher.  Conversely, increased selling activity in the futures market causes futures prices, and then cash prices, to go lower.  And since much futures buying and selling is done by speculators, people think:  Speculators cause futures prices and cash prices to rise and fall.

To begin, take cotton as an example.  Cotton is publicly traded in the futures market where the equivalent of forward contracts on cotton can be bought and sold on an exchange.

Now, pretend I am a cotton grower and you and I enter into a contract where you agree to buy 1 pound of cotton from me for $1 per pound in 6 months time (this is essentially the definition of a forward contract).

Did our private decision – and the signing of the contract itself – cause the price that cotton sells for today to go up?  What if we had decided to exchange 1 million pounds instead of 1 pound?  What if millions of others joined us?  What if all of those contracts were, instead of being private, visible and tradable on an established exchange?

If signing pieces of paper, in the form of forward contracts, does not cause cash prices to rise and fall, why does telling other people (i.e. making those signatures public) change it?

The answer is:  It doesn’t.

While signatures do not cause prices to move up and down, changes in supply and demand (or expectations of changing supply and demand) can cause futures prices (and forward prices) to move up and down.

Do those changes affect cash prices?  You bet!

But that effect is not caused by the changing futures or forward prices.  That effect is caused by supply and demand affecting cash prices – as well as futures prices (and then forward prices).

Sometimes futures prices are affected more by changing supply and demand and sometimes cash prices are affected more by changing supply and demand – i.e. the ever-changing basis.

In general, what causes people to think that futures prices cause cash prices is the simple truth that futures prices and cash prices are correlated.  People see futures prices go up.  Cash prices follow.  Therefore:  Futures prices cause cash prices.

First, this is an example of the fallacy of post hoc ergo propter hoc.  It means “after, therefore, because of.”  If you sneeze and then I trip, your sneeze (most likely) did not cause me to trip.  Reporters are terrible about this.

“The S&P 500 is down 200 points.  Hmmm.  What else happened today?  Interest rates remained unchanged.  New headline:  ‘Fed Inaction Pushes Stock Lower’.”  Well, maybe.  But, probably not.

Back to the issue of speculators, this line of thinking is also done in the reverse:  “When speculators buy futures, futures prices, and cash prices, tend to increase.  When speculators sell futures, futures prices, and cash prices, tend to decrease.  Therefore, Getting rid of speculators will stop price fluctuations in the market.”

In statistics, this relationship between cash prices and futures prices would be called a spurious relationship.

So, since cash prices and futures prices are correlated, there are three possibilities:

1        Cash prices cause futures prices

2        Futures prices cause cash prices

3        Something else causes both cash prices and futures prices

What is the answer?

Number 3 is.

And let me blow your socks off with this one, with something that any economist can tell you.  What is the thing that causes both cash prices and futures prices?  In fact, the same thing that determines all prices?   I said it earlier.  The answer is:  Supply and demand.

Supply and demand causes both cash and futures prices.

Economist Robert Murphy agrees and empirically shows it in the case of oil prices.

In fact, not only do speculators not hurt the market by distorting prices – they help the market immensely.  Speculators add liquidity to sometimes thinly traded markets and take on the risk that hedgers are trying to offset, which is the essential function of a futures market.  Also, speculators help to stabilize prices.

Economist Walter Block says it like this:

“In times of plenty, when food prices are unusually low, the speculator buys. He takes some of the food off the market, thus causing prices to rise. In the lean years that follow, this stored food goes on the market, thus causing prices to fall. Of course, food will be costly during a famine, and the speculator will sell it for more than his original purchase price. But food will not be as costly as it would have been without his activity. (It should be remembered that the speculator does not cause food shortages; they are usually the result of crop failures and other natural or man-made disasters.)
The effect of the speculator on food prices is to level them off. In times of plenty, when food prices are low, the speculator by buying up and storing food causes them to rise. In times of famine, when food prices are high, the speculator sells off and causes prices to fall. The effect on him is to earn profits. This is not villainous; on the contrary, the speculator performs a valuable service.”

In summary, speculators buying and selling futures contracts does not cause cash prices to increase and decrease.

While it is easy to look for someone to blame when prices go up, maybe higher than we think they should, or when prices go down, maybe lower than we think they should – let us be guided by reason and thoughtful analysis rather than sometimes rhetoric and emotion.

First published by Cotton Grower Magazine under the title, Speculation 101-A Primer In The Cotton Market