Congress is going crazy over commodities, and especially over oil. They are convinced that we have a commodities bubble, so that all they have to do is smash down their boogymen, "the speculators", and all will be hunky dory. They are convinced of this because those supply/demand curves in the first chapter of our Econ 101 textbook no longer seem to be working for commodities.
This article provides an overview of the state of the commodities markets -- follow the links for more explanation of the various topics.
Those supply/demand curves in the first chapter of your Econ 101 textbook assumed that goods are sold for some fix standard of value, a currency. But under floating currencies, which the world has had since the U.S. went off gold in 1970, there is no fixed standard of value. When trading commodities, supply and demand for the currencies they are traded for must now be taken into account. A long commodity position is also a short currency position, and vice versa. Furthermore, expectations about future supply and demand for currencies must be accounted for. Under floating currencies and a free market in commodities, commodity prices, especially for commodities like oil and gold where the stockpile (whether below or above ground) to production ratio is very high and storage costs low, are highly volatile – a small change in inflation expectations causes a very large change in commodity prices. The commodities themselves start to act like gold: to take on monetary functions such as a store of value or a hedge for currency-denominated debt. The logical emergence of money from barter is taking place every day as commodities come to serve these monetary functions better than floating currencies.
The critics complain that commodities markets, no longer reflecting Econ 101 supply and demand, are no longer providing reliable price signals. In fact commodity prices still are reflecting Econ 101 supply and demand, but this often tends to get buried in the noise of the much larger price changes caused by changes in inflation expectations. The fault lies with poorly managed floating currencies, not with attempts by currencies users to protect against the damage done by floating currencies, for example by hedging their dollar-denominated investment portfolios with long commodity positions. Trying to stop "speculation" will be like curing a fever by attacking the immune system. You may get rid of the fever, but you won't get rid of the flu, and the patient, no longer protected, may end up six feet under.
The evidence for all this, such as the great rise in the use of commodity derivatives and commodity index ETFs (exchange-traded funds) and ETNs (exchange-traded notes) by long-term investors such as pension funds, endowments, and sovereign wealth funds, in parallel the great recent rises in commodity prices, are lumped by critics under their derogatory label of "speculation." Another, and probably even larger, source of the oil run-up are decisions by producers to keep oil in the ground (where its storage costs are cheapest) rather than pump it only to sell it for depreciating dollars. Similarly, there has been a great deal of informal "hoarding" of food. Here the commodity is being stored by those who expect to consume, or who expect their customers to consume, the commodity in the future. The stockpile is a hedge against both the falling currencies and political risk that governments might hoard and ration the food. This “tacit speculation” too reflects an increase in inflation expectations. If or when inflation expectations decrease, we can expect (contrary to “peak oil” theory) oil pumping to greatly increase, as having dollars will once again become more valuable than having oil in the ground, and we can expect informal food stockpiles to be drawn down and food prices to drop.
These are all attempts to preserve wealth in the face of a highly uncertain, and probably falling, value of the future dollar and other floating currencies. In the era of floating currencies, not only are commodities a legitimate asset class, they are an essential asset class. Floating currencies add a very large and dominating amount of noise to commodity price signals when inflation expectations change, but there is no easy fix for this problem.
Attacks against commodity "speculation" are attacks against efforts to protect property and markets against highly uncertain currencies. Without this protection, economies will be in grave danger of wealth destruction. Instead of attacking "speculation", the great increase in trade of "paper barrels" or "video barrels" should be encouraged. The more commodities can be traded as bits instead of by shipping physical commodities, the lower the transaction costs that will be imposed on tradition physical delivery markets. The "rolling-over" of commodities futures -- when expiring futures are swapped for distant futures instead of taking delivery of the physical commodity -- should be formalized in long-term commodities securities that minimally disrupt traditional "commercial" commodity hedging operations.
We may be seeing only the first stages of a switch from floating currencies, which may be proving to be unworkable, to commodity-backed currencies. Floating currencies were and are a great historical experiment, and there is no guarantee that such experiments will work out in the long run. By serving monetary functions such as stores of value and hedges against currency-denominated debt, commodity index ETFs and ETNs are starting to serve as monetary substitutes. But the benefits so far have been limited to investors and other big players. Those saving for retirement or who will have to pay for their child's education are benefitting from the use of commodity long positions to stablize pension and endowment funds against falling currencies and protect them against future inflation. But we still have to take our wages in floating currencies, hold our checking and savings accounts in floating currencies, and pay or be paid our debts in floating currencies. Can commodity money move from Wall Street to Main Street?
There are, alas, great legal barriers to retail commodity money. While legal barriers often just increase costs by a few basis points for Wall Street, they usually prove insuperable for the man in the street. To remove these legal barriers, contracts in any part of the economy should be allowed to use commodity index ETFs or other standards of choice as payment terms. Negotiable instruments law in the U.S. must be changed to allow payments by check, money order, etc. in commodity standards to compete against government currencies on a level playing field. Legal tender laws requiring an option to pay debts in particular currencies should be eliminated in order to allow payment terms denominated in commodity indices to be as simple as payment terms denominated in dollars. These kinds of reforms will bring the benefits of stable commodity money from Wall Street to the man in the street.
If the Federal Reserve decided to use leading indicators (e.g. commodities) instead of trailing indicators (e.g. the Consumer Price Index, CPI) to fight inflation, or decided to go to a de facto commodity index or back to the gold standard, and stopped bad practices such as "printing" dollars to swap for dubious real estate securities, we would not need to otherwise use commodities for monetary purposes. If the Federal Reserve or the European Central Bank prove incable of providing a stable currency, commodity money will provide the long-term stability that our floating currencies since 1970 have usually not exhibited. The more governments try to fight the use of commodities for monetary purposes, the more painful the effects of poorly managed floating currencies will be, and the more painful the resulting transition from those floating currencies to commodity money will be.