Reining In Commodities Speculators

News is out today that the U.S. Commodity Futures Trading Commission is considering placing limits on commodities trading. Regulators want to stop speculation in the commodities market. Presumably, their purpose is to prevent commodities from having as much price volatility and also to prevent bubbles. While their fear is understood, I believe that the outcome of imposing these restraints will not be as positive as they anticipate.

First, here's some detail from the Wall Street Journal:

U.S. Commodity Futures Trading Commission Chairman Gary Gensler said Tuesday the agency will hold hearings this summer to consider imposing position limits for "all commodities of finite supply." The agency will also review whether swap dealers, index traders and exchange-traded fund managers should be allowed to get around those limits through special hedge exemptions.

Why Just Energy?

These proposed restraints are clearly targeting energy prices. That's what they mean by "commodities of finite supply." But are why regulators only concerned with energy? Is speculation in gold and corn okay? Other commodities affect consumers too. If you asked me what makes energy so different, I would expect that answer to be that energy companies have more powerful lobbyists.

Who Would Control Prices?

As mentioned, one of the explicit purposes of these proposed measures would be to prevent traders from affecting energy prices. So let's say the new regulations successfully accomplish that goal. Who would be controlling energy prices? Suppliers.

This is particularly noteworthy when it comes to oil. Ironically, regulators would be giving more power to OPEC to set prices, rather than rely on the market-driven forces that traders react to. When the price of oil reached its highs last year, it came down so far and so fast mostly because traders were in the driver's seat. If OPEC had its way, oil prices would likely be higher now and would have taken longer to decline. That, of course, would have made our recession even worse.

Inefficient Markets

And that's a good lead-in to my next point. Setting controls on commodity trading will make markets for those goods less efficient. By having thousands of traders actively engaged in the commodities market with little restraint, prices can move quickly. With restraints in place, prices will become stickier. That means when the economy changes, commodity prices will change more slowly, intensifying whatever part of the economic cycle we find ourselves in.

Inefficient markets also redistribute profits to insiders. Again, in this case that mostly means suppliers, but it also means a handful of large, well-connected investors who have the power and influence to skirt these limits.

Countless commodities traders have had the opportunity to seize some of the profits that would have been made by oil and gas companies by reacting quickly to market shocks. Those profits are then passed onto the investors who actually own stakes in the commodities. With new trader constraints, those profits will largely fall back into the hands of suppliers and a few big investment banks.

Some might argue that is a more desirable outcome, especially the lobbyists for energy firms. Of course, they probably had a hand in encouraging this proposed regulation. Instead, I would prefer the profits -- and power -- to be more spread out amongst the broader investor community, and consequently the general public.

Only Energy Commodities?

Finally, I worry about a slippery slope. What if regulators were so happy with their newfound ability to control prices in the energy market that they decided to extend it to other markets? I would expect constraints in markets for other commodities to follow, especially agriculture. Once farming lobbyists get wind of the benefits these limits provided to energy companies, they'll be on board.

But what if regulators went even further? For example, maybe stocks should have more trading limits. After all, some might argue that it would be a good thing to reduce speculation and volatility. Of course, with that reduction of speculation and volatility, the stock market would also face all of the negative consequences I just explained for energy, including an inefficient market and insider advantage. I hope those attending this summer's hearings realize the full consequences that these limits could ultimately impose on the market.