Daryl Guppy

Seeking to remove speculation from commodity trading

By Daryl Guppy (China Daily)
Updated: 2010-12-20 13:14

The United States Commodity Futures Trading Commission (CFTC) last week announced new restrictions designed to remove some of the speculative element from commodity futures trading.

The proposals restrict the number of open positions held by a single individual or organization. The objective is to reduce speculative trading. This will affect large commodity trading funds and also on governments, such as India, that have been actively intervening in commodity markets.

Some traders believe these restrictions reduce the liquidity in the market and this has the unintended consequence of increasing volatility in an already volatile market. They argue that size and position restrictions make it more difficult for genuine hedgers to apply hedging strategies that are essential for the smooth operation of commodity markets. Increasing the required margin also makes it more difficult for smaller hedgers to protect their clients' positions.

The futures markets reflect a balance of supply and demand of the physical commodity, but they will often trade at a 5 to 15 percent risk premium above the estimated "fair" market price. A market moves into a speculative range when the futures price is more than 15 percent above the estimated fair value.

The proposed CFTC regulation changes will alter the operation of the commodity futures markets, but they are unlikely to prevent the development of speculative bubbles as traders and investors will find ways around them. After the collapse of the speculative commodity market in 1929 the CFTC was given the task of developing regulations to prevent further speculative bubbles.

They were largely successful in this objective until recent years. Without doubt the new regulations will inhibit the frequency of speculative bubbles in commodities and this signals a welcome return to greater demand-supply stability in pricing.

Speculative money shifts around commodity markets seeking the development of new trends. The oil market has remained largely free of the speculative activity seen in cotton, wheat, soft commodities, gold and some of the base metals.

However, the move above $88 in NYMEX oil in the last week signals an important change in the pricing and trend activity in this market and this may attract more speculative activity.

The move above resistance near $88 is important for several reasons.

Related readings:  China to step up supervision of futures market  China to set up prices, competition agencies to curb market manipulation  China's first speculation trial to start Speculation has limited impact on China's CPI  Investor speculation on gold will add risks

First, this is the first breakout above $88 since October 2007. This is a very significant price development. The $88 level was a significant support level for oil between November 2007 and February 2008. It was the lower edge of a consolidation band between $88 and $98.

Second, the price breakout is part of a rising trend. This upward trend started to develop in September. The position of the upward trend line was confirmed with the retreat and rebound from $81.50 in November. The upward trend line is significant because it defines a longer-term trend and not just a short-term rally.

The new upward trend is confirmed in two situations.

The first situation is a price retreat to the old resistance support level near $88. A rebound from this level is very bullish. The result is a very fast move toward the next resistance target.

The second situation is a price fall below $88 and a rebound from the value of the upward trend line, currently near $84. This price activity confirms the long-term upward trend pressure. The result is a slower upward price move toward the next resistance target.

The first target is near $98 and is also an historical support and resistance level for oil. This was a significant resistance level for oil in November 2007 to February 2008. The breakout above $98 in February 2008 was rapid and prices moved up very quickly to $110 and higher. The technical resistance level is $98. The psychological resistance level is $100. When the psychological $100 level is broken then the oil price moves up very rapidly and this is the danger in this market in 2011.

The changes in the trend of the US dollar are helping to push all commodity prices higher. Oil has been slow to feel this effect, but the move above $88 is a signal for speculators that upward-trending activity is developing in this market. An increase in speculative trading, and investment by commodity investment funds and exchange-traded commodity funds, has the potential to rapidly push oil prices toward the $100 level.

The author is well-known international financial technical analysis expert and appears regularly on CNBC Asia.