As I have diaried here, I am in the commodity market. I just had a fairly disturbing conversation with a company in the food business that I talk to. I had an offer from another company for a lot of product that this food company would normally buy. This contract was offered at almost 10% below the current market price for a year starting in June.
The interesting part is the customer had no interest in doing anything. This company said that they had taken a corporate position that they would neither buy or sell anything except on an "as needed" or "as ordered" basis. They felt the risk of dramatic price movement - in either direction - made forward purchasing or buying too risky. Why is this so important?
The futures markets were originally designed to allow producers and consumers of products to come together and transfer their risks amongst themselves. A farmer would like to know what price he or she could get on their production so they can plan ahead (farmers are incredible planners). Similarly, a steel company taking an order for a sale of steel three months from now wants to know the price of iron and fuel.
The inability of these markets to perform this function raised the risk for the producer and consumer (a steel company is a consumer or iron). The greater the risk of price movements, the more the producer will "pad" the price to make sure they make a profit on the sale.
The influx of speculation created a change - now, the person using these markets had to negotiate not only with the other side (a producer had to negotiate with the consumer) but now they also had to "negotiate" the price with the speculator. The risk that the speculator was influencing the price was a price risk adder and has impacted market prices for things the commodity was used for.
The came the last three weeks - the violent market reaction to the needs of hedge funds to liquidate positions has increased the risk of price movement. Don't forget, a hedge for input becomes a speculation on the output price if you have not already sold the output.
The example here is let's say I bought corn to make corn flakes. What happens if I bought corn for the next six months and my competitor did not. Well, if the price of corn drops 20% my competitor can drop their price 20% and kept their profit margin. I can not drop my price any (my input price is already set) without taking a loss. OOPs.
The crumbling of the usefulness of the commodity markets has an implication on more volatile consumer prices. It also is likely to cause an increase in underlying costs because risks can not be transfered as efficiently. The bubble of speculation will have a far reaching implication in many places - and none of the implications are good.