Speculation is a centuries-old business practice that can both generate profit and lead to market turmoil. Now that the housing bubble has popped, a new specter is on the horizon. This one involves cocoa and iron ore.
Cocoa is trading at its highest price in decades
Speculation is no modern-day invention. In fact, betting on rising or falling prices and stock values is centuries old.
In futures trading, for example, a price for wheat is set at the point when it's just being planted, or airlines might buy a certain amount fuel of standardized quantity and quality at a specified future date at a price agreed today, the so-called futures price. Such deals, extremely common today, are also called hedging as they attempt to reduce one's exposure to unwanted risk by eliminating price or currency fluctuations.
But sometimes speculators get carried away and financial turmoil can be the result.
That was the case in the Netherlands back in 1637, when the potential for huge profits set off a run on tulip bulbs.
Tulip mania was a speculative bubble over bulbs in the 17th century
The price of some single tulip bulbs was set at 10 times the annual income of a skilled craftsman. Florists sold bulbs they didn't have in what is now considered the first recorded speculative bubble.
And as with all bubbles, it burst. Bulb prices fell by some 95 percent, wiping out the fortunes of many traders caught up in the mania. The consequence was an economic downturn that lasted for years.
But speculators appear to have learned nothing from the long history of bubbles. The causes of the latest global economic crisis can be traced to a gigantic disconnect with reality: namely, that US housing prices would rise forever.
Investment banks and hedge fund managers pulled in fat profits until the bubble, naturally, went "pop." The mess was left to taxpayers to clean up.
While these wounds are still smarting, a new bubble has already begun forming - this one in commodities.
For the love of chocolate?
On its website, hedge fund Armajaro talks about itself as a fighter against global poverty and as helping the United Nations meet its Millennium Goals. The fund specializes in commodities, especially cocoa, coffee and sugar - raw materials that often come from countries mired in poverty.
However, it is questionable whether it is altruism and a deep-felt concern for humanity that drives the London-based fund.
Hedge fund Armajaro is buying up cocoa beans and pushing up the price
The Financial Times Deutschland reported that earlier this week that Armajaro secured a huge supply of cocoa beans on the London International Financial Futures and Options Exchange (LIFFE): 240,100 tons, or seven percent of world production.
The market reaction was swift, pushing the price of cocoa to its highest level in 33 years. The fund managers hope to benefit from a further rise in prices and eventually sell the now-hoarded commodity at an even higher price.
In 2006, rising food prices - caused by speculation - sparked unrest in several poor countries. Now prices for cereals, rice or corn are climbing again.
One reason is growing demand; another is the weather. The summer heat wave in Europe has raised fears about the possibility of a major crop failure - and that has driven prices up. If speculators get involved at a time like this, they can act as a catalyst.
Iron ore gamble
Recently the head of Germany's largest steel group, ThyssenKrupp, complained about iron ore suppliers in an interview with the news magazine Spiegel. Ekkehard Schulz lamented the fact that the system of annual contracts that set the price of iron ore for 12 months was replaced by a system of quarterly contracts earlier this year
Ekkehard Schulz of ThyssenKrupp says short-term pricing encourages speculation
That means the price is determined by the extremely volatile spot market - and the consequences can be disastrous. The price of one ton of iron ore has doubled within a year.
In addition, Schulz said that investment banks, in search of what appear to be lucrative new profit opportunities, are preparing to enter the iron ore market. They have hired commodity specialists, bought trading houses and rented warehouse space in major ports to store iron ore in large quantities.
The recipe is the same as the one used by those in the cocoa business - buy until supplies are scarce and the price goes up. Then the product is sold for a tidy profit.
While speculation can be sensible and an effective way to set prices, overindulgence can have serious downsides, for example, decoupling the commodity from real consumption levels. Right now, the amount of nickel being shipped is 30 times higher than what is actually needed.
But the temptation to indulge in exaggerated speculation is hard to resist, since who can resist the Siren song of a windfall. Along the way, though, large bubbles often form, which prove devastating for the majority when they finally do burst.
Hedge funds, apparently, are little concerned. Until the great popping sound, they don't care so much since they've already earned a pretty penny.
Author: Henrik Boehme (jam)
Editor: Sam Edmonds