Debate has raged as to whether rising commodity prices owe more to the actions of speculators and less to an imbalance in supply and demand. Speculators have not come out well in this debate – not surprising in light of the food riots in developing nations and fuel protests in developed ones, writes Fidelity Investments’ MICHAEL GORDON.
But amid the often heated exchanges about responsibility for booming commodity prices, few stop to define what they mean by speculation. Perhaps it suits some of the participants not to have a clear definition. Yet if this debate is to have merit, we must agree on its terms.
Speculation can be defined by what it is not, namely, investment. What is the difference between speculation and investment? Speculation is no longer defined by the people who participate in it. Index buyers from investment banks, hedge funds, pension funds, even private investors are all involved in speculation.
The participation of private investors and pension funds in commodity speculation does not mean there is no case for putting their money into this sector. It could be argued that the purpose is to hedge inflation. In spite of the problem of the new buying helping to stoke inflation further by pushing the prices higher, it remains an obvious hedge. In that sense it may not necessarily be seen as speculation. But can it be seen as investment?
Speculation is increasingly the pursuit of those who do not have what could be termed a “natural” interest in commodity prices. Examples might include an investment bank holding corn or oil futures, or a pension fund buying a raw commodity index product.
Traditionally, when investment is “unnatural” it ends up being criticised. More often than not, this is after it goes sour. The UK Coal Board’s venture into fine art many years ago comes to mind. Let us not fall for the “I’m just passing it on” argument. For the investment banks that need underlying exposure so that they can package commodities into structured products to sell on to their customers, it can perhaps be seen as investment, just as investment in subprime mortgages was needed to create CDOs and asset backed securities.
Here is the difference. Investors deserve a risk premium for investing. Historically it has been demanded. Generally, too, a risk premium has accrued and been earned in the absence of a move in the price of the asset. In the case of equities, it is often measured in the form of the dividend and the growth of those dividends. In real estate, it is rental income and growth. In bonds, it is the coupon.
On the other hand, buying an asset where all you can achieve is the upward movement in prices seems more like speculation. Genuine investors are interested in asset classes that have a risk premium and offer a return, even if the price of the asset does not move upwards.
What is the economic benefit of an allocation of capital to a raw commodity? There is little doubt that providing investment capital for a going concern, and receiving ownership rights through equity or entitlement to an income payment through debt, help job creation, wealth generation and economic growth. The investor is providing the function true investment should: the provision of capital. Buying a commodity does not do the same.
So if the purchase of a non-income-producing commodity, or basket of commodities, does not provide a risk premium, should pension funds and institutional investors be involved? It is an old maxim that when metal prices soar, the companies making the shovels are the ones to make money. Share prices rise in anticipation of higher earnings, and that is where the risk premium comes into play.
The cotton futures contract a speculator has just purchased helps to increase the price and thus the revenue of the farmer. But the speculator is buying a product of the enterprise, not the enterprise itself. Compare this with an investment in the farm itself. Does it do the same good?
This is the root difference between speculation and investment. In many ways, it is the difference between buying shares in Woolworths and shopping there for groceries.
Michael Gordon is global head of institutional business at Fidelity Investments.