Rectifying Misconceptions about Steel Futures and Their Utility – Part Two

We are pleased to welcome a two-part series from guest contributor Spencer O. Johnson, who has worked at INTL-FCStone as the primary risk management associate for steel since December 2009. (Read Part One here.)

The most common of all misconceptions about futures markets is that they increase, or even promote, market volatility. The first response to this issue might be that crying volatility hardly seems unique. Even without an active futures market, volatility in the price of steel has been increasing at unbelievable rates. In fact, steel is already as volatile and in some cases more volatile than many of the metals that do have active futures markets (aluminum, lead, etc.). The reason for this has nothing to do with futures and everything to do with the way raw materials are now priced. A producer can no longer receive an annual price for key inputs like iron ore or coking coal and that means the volatility of those markets is now regularly priced into steel when in years prior, annual pricing made this concern far less relevant in terms of week-to-week volatility.

So, many readers will wonder, will futures add to this problem or alleviate it? Well, considering the historical precedent, the consensus opinion is that futures actually function in a way that alleviates volatility by having speculators take the opposite side of trades with industrial clients. Perhaps the best academic analysis of this issue is done by Dr. David S. Jacks, a professor and Economics and Faculty Research Fellow at the National Bureau of Economic Research. Jacks has tracked the historical relationship between futures and volatility in a number of key commodity markets and has concluded that futures markets are more often associated with lower commodity price volatility than higher volatility. As the author of “Populists versus Theorists: Futures Markets and Volatility of Prices, he notes in his opening discussion on speculation, “in few other areas do popular views and those of most economists more widely diverge.

Jacks uses a number of more complex economic and mathematical models to make his point, but of more interest to most will be the use of several historical examples of outright bans on futures trading, which further support the fact that futures tend to smooth out volatility, even during times when fundamental concerns might otherwise drive volatility higher. The first such historical example may seem dated, but may actually serve to illustrate the point best because of the clear demarcation in price action between an active futures market, and a market without any financial instruments for price risk management. Due to volatility in food prices, populist sentiment at the turn of the century forced a ban on wheat futures trading in Berlin. The ban was followed by wild swings in the price of wheat and, as you can see in the graph below, the volatility in the market was dramatically reduced during times when futures trading was permitted.

Berlin Wheat Futures, Before, During and After Ban on Trading

Source: “Populists versus Theorists: Futures Markets and Volatility of Prices by David S. Jacks

In fact, volatility became such an issue without an active futures market that Berlin rescinded the ban and returned to allowing futures speculation. This is not a mere coincidence in fact, far from it. All 16 of the commodities tracked in Jacks’ study confirm the trend of dampening volatility in a world of active futures markets.

What about domestic examples? Well, the US government has only once in its history created a ban on futures trading in a commodity — that was in 1958 when Congress passed the “Onion Futures Act, which banned onion futures trading in response to frequent claims of extreme volatility being caused by speculative traders. But average monthly price swings (see graph below) during times when futures were legal actually appear slightly lower than after futures were banned, which would seem to offer more evidence to support the fact that even in a largely un-storable seasonal commodity that should be naturally volatile, that price was slightly less volatile or at worst, no more volatile during the time when speculators were allowed to place wagers on the price of onions.

Onion Futures Before and After Ban on Trading

Source: “Populists versus Theorists: Futures Markets and Volatility of Prices by David S. Jacks

So historical examples that allow us to compare markets before, during and after futures trading provide a necessary glimpse into the fact that speculation in futures probably smooths volatility or at worst, does not increase it in any measurable fashion. But even if we were to take critics of futures markets and grant them the fact that futures do, in some instances, increase volatility, the futures market is itself the remedy for that volatility. Regardless of the movement in flat price, a consumer of steel who is properly hedged does not concern himself with flat price volatility because it is the very act of hedging that insulates the consumer from that volatility in the first place. If a consumer knows they will need to purchase 10,000 tons of steel this December, buying December futures at the current market price will allow that consumer to profit from increases in the price of steel, thus offsetting the higher price that consumer will pay for the physical steel they will eventually buy. It is precisely in this sense that futures criticism that supposes some speculative interests will hijack steel prices, creating some wild casino-style roller coaster in prices, is historically inaccurate and fundamentally misunderstands the value futures bring to commodity markets.

–Spencer O. Johnson

MetalMiner and its sister site, Spend Matters, along with Nucor, will host a live simulcast, International Trade Breaking Point on March 1, 2011. If your company sources products from overseas, you will not want to miss this half-day event:

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