Why the Futures Market Matters to Everyone Part 3

I wasn’t originally planning to do a Part 3 for this topic, but I’m going to anyway. What I’d like to do here is further explore the ‘artificial demand’ I spoke of previously. Unlike in my previous posts, I won’t limit the concept of artificial demand to simply financially-driven artificial demand because there’s one other source I’d like to discuss.

Earlier, I briefly talked about financial sources of artificial demand via the futures markets and Exchange Traded Funds (ETFs). I also mentioned how many ETFs have options attached to them. Futures and options are also known as derivatives because their existence is derived from something else (stock, commodity, ETF, etc.). We also have two types of ETFs. Some of them create their commodity exposure by stockpiling the commodity in question and others create their exposure through futures. Thus, it’s fair to say the former are derivatives and the latter are derivatives of derivatives or second-order derivatives.

This is what they mean when discussing derivatives in a financial context. It’s not exactly the rate of change (or rate of change of the rate of change in the case of second-order derivatives) that you learned of in calculus class. What is applicable from the calculus definition about the financial definition is how it’s possible for the derivative and original to decouple from each other. It’s also even possible for the derivative to drive the original in a ‘tail wags the dog’ sort of way. We see both of these in the financial markets quite often.

A side note on options. With stocks and ETFs, you can often gain much more exposure for much less money. In other words, they’re highly leveraged. We’ll use stock options to illustrate this real quickly. To buy 100 shares of United Technologies (UTX – full disclosure, I am long UTX), it costs about $9,000 based on a ~$90 share price. To buy a June $85 call option, which is the right, but not obligation, to buy 100 shares of UTX stock before the third Friday in June at $85, I only need to pony up $3.40/share, or $340. So, I can get the equivalent, albeit time-limited, exposure to UTX using options for about 4% of the cost of buying the shares outright. Obviously, a longer-dated call would cost more. A January 2013 $85 call costs $11.35/share or $1,135, but you’d get an extra 18+ months. It’s a contango curve. I’m not going deep into stock/option strategies here; just providing an example of the powerful leverage.

So, how do we reduce the impact of derivatives? We need global coordination to limit margin on these instruments, position size limits, and we need to differentiate between the producer/consumer class (those who use futures for business purposes) and the financial class (those who use futures for speculation only). Dan Dicker provides some more surgical solutions in his book versus these broader tools. Again, I’m not saying speculators shouldn’t be allowed to speculate, but when their actions have such broad impact as they clearly do, we need to try to insulate their impacts from the rest of the world. Note that we’ve seen some exchanges like the CME (Chicago Mercantile Exchange) tighten margin requirements on both oil and silver. This is a good thing.

One last side note. It wouldn’t be a bad idea to explore returning the exchanges like the CME to non-profit status. I think the conflict of interest is too powerful because they profit from higher volumes rather than orderly markets.

Ok, enough about the financial end. Let’s look at one other source of artificial demand for commodities, particularly corn. As you know, corn isn’t just used for corn-based foods, but it’s also used to feed livestock. You’ve no doubt seen the signs at gas stations that say, “Up to x% ethanol in this fuel,” or something like that. Usually it’s around 10%. Guess what. We use about 40% of our corn crop to provide about 10% of our gasoline. How’s that for self-inflicted artificial demand?

The sad truth is there’s a strong lobby to increase our ethanol use. That’s such a terrible idea that I don’t even know where to start. First, ethanol is very hard on engines, even when they’re designed for it. It basically rots the engine from the inside. Second, ethanol produces less thermal energy than gasoline, so by adding ethanol to gasoline, we’re reducing the overall thermal output of the mixture. That’s exactly what you don’t want to do if you want to increase your car’s miles per gallon. Third, by using corn in our gas tanks in addition to our food, we’re driving up the price of corn. Assuming a constant supply, when demand increases, price increases. So, we’re paying more at the grocery store and at the gas pump. Fundamental supply and demand still is a driver of the futures market in addition to speculation. Fourth, using corn to fuel humans and livestock instead of cars simply makes more sense to me, seeing as how we have millions, if not billions, of people worldwide who are starving, undernourished, malnourished, etc.

I left out the details of the corrosion and thermodynamics from the first two reasons because that’s engineering nerd stuff, however if anyone’s curious, I’ll gladly go into greater detail. :-) I discussed the futures market mechanics extensively already, and the fourth reason is pretty straight-forward, methinks.

Also, on a related note, farm subsidies are a terrible waste of taxpayer dollars and should be discontinued. Why should we pay farmers not to grow crops? That’ll save us a few billion dollars per year.

If our leaders got a little smarter about how they’re imposing artificial demand, thereby driving prices higher and hurting a lot of people, these prices would drop. That’s in the collective best interest, but our leaders aren’t seeing it.