Save Our Speculators!

The speculative smackdown continues.

As we pointed out a few weeks back, the growth of many commodity funds such as U.S. Natural Gas Fund (UNG) and iPath Natural Gas ETN (GAZ) has occurred at a time when prices for the commodity they track have plummeted. Despite massive new investment in recent months, natural gas has now dropped to the lowest level in more than seven years.

U.S. Natural Gas Fund (UNG) - 2 years

That hasn't stopped regulators from disrupting free trade. Earlier this week, PowerShares DB Crude Oil Double Long ETN, a popular note that provides twice the daily return of oil prices, announced it was liquidating altogether as a result of more stringent government regulations specifically designed to limit speculation. The honest, law-abiding investors who had included the fund as part of their strategy are now out of luck. Are speculators responsible for volatility in energy prices? If the government outlawed futures trading or speculation on energy altogether, would prices settle into a low, calm and politically palatable range?

Putting aside the moral argument -- that energy, be it natural gas, oil, coal or gasoline, is privately owned, and that an individual or group of individuals has every legal right to buy or sell as much as they please -- the fact is that speculative futures markets don't create volatility, they reduce it.

That's not an assumption on my part, but demonstrated by the hard data surrounding another important commodity: onions.

In the late 1950s, farmers blamed falling onion prices on speculators at the Chicago Mercantile Exchange, where, at the time, an onion contract was actively traded. Isn't it funny how speculators are to blame whether prices are sinking or soaring?

In response to complaints from the powerful lobby, Republican Congressman Gerald Ford, who would go on to be our 38th president, pushed through the Onion Futures Act. So in 1958, futures trading in onions was banned, because "speculative activity in the futures market causes such severe and unwarranted fluctuations in the price of cash onions" that "a complete prohibition of union futures trading" was needed "in order to assure the orderly flow of onions in interstate commerce." Still on the books to this day, it remains the only ban on trading of a specific commodity in United States history.

In the years that followed numerous studies demonstrated onion prices were actually more volatile after the ban was passed than during the period in which onion futures were traded.

Source: David S. Jacks, "Populists Versus Theorists: Futures Markets and the Volatility of Prices"

Recent history confirms the pattern. According to the Wall Street Journal, onion prices climbed more than 430% from October 2006 through April 2007, before crashing 92% by October. During this volatile period for all commodities, onion prices were demonstrably more volatile than corn, wheat or oil, despite the lack of a futures market.

It's a point that was reinforced by none other than Joseph Dial, a commissioner for the Commodities Futures Trading Commission (CFTC), who, in 1997, observed that economists "found more cash market volatility in onion prices before and after the period of futures trading than there was while the onion futures market was operating. In other words, futures markets don't cause volatility -- they respond to and decrease volatility."

Prices rise and fall based on supply and demand, regardless of whether politicians ban futures trading. As the assault on speculators, such as we've already seen with U.S. Natural Gas Fund and PowerShares DB Crude Oil Double Long ETN (DXO) continues, investors will simply migrate to unlisted products or offshore exchanges, which helps no one. Outlawing speculation altogether, as was done in the case of onions, won't eliminate volatility, but exacerbate it. When will Washington learn?