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Who's Behind High Prices

By Robert J. Samuelson
Tuesday, July 1, 2008

Tired of high gasoline prices and rising food costs? Well, here's a solution. Let's shoot the speculators. A chorus of politicians, including John McCain and Barack Obama, blames these financial slimeballs for piling into commodities markets and pushing prices to artificial and unconscionable levels. Gosh, if only it were that simple. Speculator-bashing is another exercise in scapegoating and grandstanding. Leading politicians either don't understand what's happening or don't want to acknowledge their own complicity.

Granted, raw materials prices have exploded across the board. From 2002 to 2007, oil rose 177 percent, corn 70 percent, copper 360 percent and aluminum 95 percent. But that's just the point. Did "speculators" really cause all those increases? If so, why did some prices go up more than others? And what about steel? It rose 117 percent -- and has increased further in 2008 -- even though it isn't traded on commodities futures markets.

A better explanation is basic supply and demand. Despite the U.S. slowdown, the world economy has boomed. Since 2002, annual growth has averaged 4.6 percent, the highest sustained rate since the 1960s, says economist Michael Mussa of the Peterson Institute. By their nature, raw materials (food, energy, minerals) sustain the broader economy. They're not just frills. When unexpectedly high demand strains existing production, prices rise sharply as buyers scramble for scarce supplies. That's what happened.

"No one foresaw that China would grow at a 10 percent annual rate for over a decade. Commodity producers just didn't invest enough," says analyst Joel Crane of Deutsche Bank. In industry after industry, global buying has bumped up against production limits. In 1999, surplus world oil capacity totaled 5 million barrels a day (mbd) on global consumption of 76 mbd, reckons the U.S. Energy Information Administration. Now, the surplus is about 2 million barrels per day -- and much of that is high-sulfur oil not prized by refiners -- on consumption of 86 mbd.

Or take nonferrous metals, such as copper and aluminum. "You had a long period of underinvestment in these industries," says economist John Mothersole of Global Insight. For some metals, the collapse of the Soviet Union threw added production -- previously destined for tanks, planes and ships -- onto world markets. Prices plunged as surpluses grew. But Mothersole says "the accelerating growth in India and China eliminated the overhang." China now accounts for up to 80 percent of the world's annual increased use of some metals.

Commodity price increases vary because markets vary. Rice isn't zinc. No surprise. But "speculators" played little role in these price run-ups. Who are these offensive souls? Well, they often don't fit the stereotype of sleazy high rollers: Many manage pension funds or university and foundation endowments.

Their trading might drive up prices if they were investing in stocks or real estate. But commodity investing is different. Investors generally don't buy the physical goods, whether oil or corn. Instead, they trade "futures contracts," which are bets on what prices will be in, say, six months. For every trader betting on higher prices, another is betting on lower prices. These trades are matched. In the stock market, all investors (buyers and sellers) can profit in a rising market, and all can lose in a falling market. In futures markets, one trader's gain is another's loss.

Futures contracts enable commercial consumers and producers of commodities to hedge. Airlines can lock in fuel prices by buying oil futures; farmers can lock in selling prices for their grain by selling grain futures. The markets work because numerous financial players -- "speculators" in it for the money -- can take the other side of hedgers' trades. But the frantic trading doesn't directly affect the physical supplies of raw materials. In theory, high futures prices might reduce physical supplies by inspiring hoarding. But that's not happening now. Inventories are modest. World wheat stocks, compared with consumption, are near historic lows.

Recently, the giant mining company Rio Tinto disclosed an average 85 percent price increase in iron ore for its Chinese customers. That affirmed that physical supply and demand -- not financial shenanigans -- is setting prices: Iron ore isn't traded on futures markets. The crucial question is whether these price increases will continue or ease as demand abates and investments in new capacity expand supply. Prices for some commodities (lead, nickel) have receded. Could oil be next?

Politicians promise to tighten regulation of futures markets, but futures markets aren't the main problem. Scarcities are. Government subsidies for corn-based ethanol have increased food prices by diverting more grain into biofuels. A third of this year's U.S. corn crop could go to ethanol. Restrictions on oil drilling in the United States have limited global production and put upward pressure on prices. If politicians wish to point fingers of blame, they should start with themselves.

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