Why Subsidize Speculation in Commodities?

If you follow me on Twitter @ElliotTurn, you know that commodities have been a big point of interest of late.  I’ve been spending some time trying to distill whether the driver of the commodities bull market for the last decade has been US monetary policy or China’s rapid acceleration in growth.  The answer to that question has significant implications for several different types of investments today, and is really just an interesting and important point in understanding today’s macroeconomy.  But today, with commodities a hot-topic and tax day quickly approaching, I want to take a glimpse at commodities through a different lens entirely.  With oil prices rising quickly in the face of our largest build in crude oil inventories since 2008, there are obvious questions being raised about the impact of speculation in commodity markets (see here for a good look at the question).  After all, how can something go up in the face of an overabundance of supply?  Rather than try to answer the question of how much of a premium in commodity prices is driven by speculation, to this too, I want to take a different angle altogether.

Whether one agrees or disagrees with speculation being a factor in commodity markets, I think we can all agree that such activity should not be subsidizes no matter what.  Yet, that is exactly what our tax code does—it incentivizes speculation in commodities over speculation in any other market.  Even more, speculation in commodities is a great way to guarantee a lower tax rate than the general income tax, when compared to any other profession in America.  There is a hot debate over carried interest, yet this loophole is at least as egregious. 

Broadly speaking, we are in a state of heightened global macroeconomic volatility, and that alone does yield way to increased volatility in demand and pricing for resources; however, that does not explain some of the radical swings in commodities ranging from oil to palladium to gold in recent times.  Since the 2003 Bush Tax Cuts, long-term capital gains are taxed at a 15% rate, while short-term capital gains are taxed as general income, at a 35% rate.  These capital gains apply to most forms of investment income; however, they do not apply on gains in futures contracts–the principle way in which commodities are traded.  Futures contracts, as prescribed by Section 1256 of the tax code, are taxed with a blended rate of long and short-term gains: 60% long-term capital gains and 40% short-term.  The blended rate results in an effective tax rate of 23% on income derived from futures/commodity trading (check out this site for more information on trading taxes).

In essence, the tax code promotes short-term speculation in commodities markets, and it does so in several ways.  People who are speculating in commodity future markets are inherently short-run, and care far more about the discount on the short term capital gains tax rate than they do the increased cost of long-term commodity ownership.  Whereas a short-term equity speculator is taxed at the general income rate, a commodities/futures speculator is taxed at 23%.  The consequences of this are two-fold: first, there is an economic incentive for speculators to ply their craft in commodities markets as opposed to equity markets, and second, speculators desire volatility in the short-run in order to maximize their capacity to make money, such that there is a serious misalignment of incentives between speculative market participants and the purpose of commodity markets. 

The goal of commodity futures markets is to provide a venue through which buyers and sellers of raw materials can share some of the risks in price fluctuations and both can secure some sort of certainty for longer-term budgetary purposes.  Fundamental commodity market particpants are not necessarily trying to make money on each transaction, but rather their aim is to gain security in price on both sides of the equation in order to more efficiently plan and manage their business.  Because this is the existential purpose of commodity markets, it should be noted that volatility poses dangerous risks to the players who need smooth functioning in these markets most. 

Meanwhile, short-term transactions that result in realized gains in commodity markets are not done with the intention ever taking or giving delivery of the underlying goods themselves.  Rather, these transactions are done for the purpose of realizing a gain off of changes in price.  These transactions require inefficiencies between supplier and buyer PLUS volatility in order to generate a profit.  In seeking volatility, such transactions promote yet further volatility.  Because of this fact, volatility and market dislocations lead directly to more opportunities for speculative gains.  Pushing such actors into commodity markets creates a situation where volatility becomes a self-fulfilling prophecy for the benefit of a significant portion of market participants, but a detriment to society at large. 

Speculative traders do play an important role in that they provide liquidity for the true suppliers and consumers of commodities; however, there is no reason for the government to provide a direct subsidy in inducing speculators to prefer commodity rather than any other market.  And there’s really no reason that speculators who engage in these markets for a living should pay a lower tax rate than any other hard working American.

Since markets like these are zero-sum, where one actor must inherently make money at the expense of another, there is unquestionably at least some coefficient of a speculative cost in the price of commodities.  No one these days is seriously concerned about a lack of liquidity in commodity markets, if anything we as a society acknowledge the abundance of this liquidity between the proliferation of commodity-based ETFs.  While we can’t necessarily weed out all speculation from these markets, we can realign the incentive structure to be symmetrical with every other profession in our country.  This is a question to which both Democrats and Republicans should be able to find some common ground.

Links for Thought -- March 9, 2012

Cost of Gene Sequencing Falls, Raising Hopes for Medical Advances (NY Times) -- This is a narrative I will continue to follow from both a science and investment standpoint.  We are at a very real tipping point in terms of the impact the Human Genome Project will have on our lives.  Ultimately deflation in the price of mapping the genome will help drive down the cost of medical treatment.  Just wait (and also read my post on the Innovator's Dilemma to create your own mental model for how this will play out).  

Selling Shovels in a Gold Rush (Leigh Drogan) -- Leigh Drogan, founder of Estimize, offers great insight on how some of those who prosper most from the present tech boom will be the ones who facilitate the boom along the way.  This is precisely how Levi Strauss made himself one of the most successful beneficiaries of the California Gold Rush.  

Warren Buffett: All that Glitters Is Tungsten (Benzinga) -- What's rarer than Rare Earths? Tungsten.  The most successful investor in the world, Warren Buffett has now taken a stake in a major producer via Berkshire's ownership of Iscar.  Tungsten is my favorite commodity investment and one I have been following for some time, as it has unique traits compared to most ordinary commodities.  Good to see Mr. Buffett give his implicit endorsement!

New Math Will Drive a U.S. Manufacturing Comeback (HBR Blog) -- HBR lays out the math behind why the U.S. is experiencing a manufacturing renaissance, and why this trend will accelerate over the coming years.  This is a highly compelling argument, substantiated by a good look at the numbers.  If the prediction is in fact correct, it bodes amazingly well for the U.S. economy.

Consumer Price Index (CPI): Comprehensive In-depth Analysis (ValueWalk) -- The CPI is controversial to many, for a variety of reasons. Here Kim Palacios at ValueWalk takes an excellent look at some of the ways in which the CPI is not properly constructed for the modern economy.  Substitution, sharing, and auction-based pricing all have serious consequences for the broader economic price level.  

Speculation Blamed for Global Food Price Weirdness (Wired) -- Yes Futures are an important tool for commodity consumers and producers to hedge their exposure, but, these days several crucial commodities seem inundated with speculators who are accumulating long-term positions.  This is leading to a disconnect in the true supply and demand equilibrium.  Food is far too important arena to allow such gamesmanship to influence everyday prices.

The Illusion of Understanding Success (Why We Reason) -- This is a great write-up on JK Rowling, the wildly successful offer of the Harry Potter series.  Rowling was in a state of depression before a twist of fate sent her life on a rapid ascent to stardom.  Too often society builds after-the-fact narratives of success as if someone started on the bottom left of a chart and ended at the top right without any bumps along the way.  This is a theme Daniel Kahneman has spelled out nicely, and one I will take a deeper look at sometime soon.  In the meantime, give this one a read.

Who Has the Moral Highground in A's-Giants Dispute (Baseball Nation) -- The Oakland A's and the San Francisco Giants are in the middle of a territorial dispute.  Tied into this fight is some interesting baseball history and more general questions about fairness.