The True Story Behind Plunging Commodity Prices

If you’ve paid any attention to the financial media lately, it has been hard to miss the wild ride that silver prices have been taking.

Prices of the shiny precious metal have dropped like a stone in recent weeks, with the U.S. quoted iShares Silver Trust (NYSE: SLV), the key silver exchange-traded fund, falling last week as much as 30% from its highs just the previous week.

Other commodities have been rocked, including the big one: oil. Crude oil prices have gyrated wildly in recent days, with oil now trading below US$100 a barrel.

Precious metals prices in particular have looked bubbly to many of us for a while now, having been on a sharp rise since inflation worrywarts started piling into them during the financial crisis of 2008.

But even the most dubious investing bubbles require some impetus to pop. And in this case, the trigger might have been a surprising one: margin requirements.

An obscure trigger for a major drop

Why are margin requirements a big deal? Commodities such as silver and oil are rarely traded in physical form.

Instead, investors buy and sell futures, contracts that provide for the delivery of the commodity on a set future date at a set price.

Many of those buying futures are hedging, locking in prices for commodities they expect to need in the future. Think airlines buying fuel, automakers buying steel, or food producers buying wheat. Locking in prices well in advance helps companies like these plan production and manage their own expenses more carefully.

But not everyone buying or selling futures contracts intends to take delivery of the underlying commodity. Futures markets have long drawn speculators, investors who — for instance — think that the price of gold or oil or pork bellies (yes, really) is likely to rise and want to align their portfolios accordingly.

This is not a bad thing — arguably, speculators help the market function properly over the long term. But because futures markets can move swiftly, U.S. based CME Group, the company that owns the Nymex futures exchange, requires that futures traders post deposits large enough to cover most of the losses that would be expected on a really bad day, a sort of prepayment on the possible downside of the next day’s trading.

These deposits are called “margin requirements,” and CME adjusts them over time based on a commodity’s price and volatility.

Obviously, the greater the volatility, the greater the potential one-day losses, and so the greater the deposit needed to give assurance to the CME. These adjustments aren’t uncommon — the CME has done well over 50 so far this year — but if the requirements become particularly large, smaller traders (typically speculators) can be abruptly forced out of the market.

And that, some say, is what happened to silver: The CME announced an increase in margin requirements, and the selling started. Increased volatility in turn led to further margin increases. Likewise, oil was rocked by volatility after a similar announcement, although somewhat less dramatically.

The difference? If I had to guess, I’d say the silver market had a larger proportion of smaller speculators.

Now, to be clear: Major speculators, institutions in the George Soros weight class, are unlikely to worry too much about margin requirements. It’s the smaller shops and individuals who may have decided that trading these futures had become too expensive.

But what does all this mean for investors in shares and ETFs that are affected by oil and silver prices?

Margin prices aren’t the real problem with silver

In a brilliantly timed article on April 29, my Foolish colleague Alex Dumortier argued compellingly that a collapse in the price of silver was likely to happen sooner or later, and that a number of popular investments were likely to be adversely affected.

While the recent drop hasn’t been as large as the one Alex eventually expects, plenty of damage has been done: In the U.S., investors holding shares of silver miners Coeur d’Alene Mines, Silver Wheaton, or Pan American Silver have seen gut-wrenching drops recently, with Coeur d’Alene down more than 25% over the last month.

Oil stocks have had a somewhat gentler ride, but it generally hasn’t been up. In the U.S., ExxonMobil dropped more than 5% in the past seven trading sessions. Still, the fundamental case for oil — supply is finite, demand’s growing — seems to be a lot stronger than the case for silver, where the case for high prices has come to depend on one’s belief in some rather scary possibilities for the global economy.

Long story short, if an exchange’s routine hike in margin requirements can really trigger a 20%-plus drop in a commodity’s price, that may not be the best sector to be investing.

This article, written by John Rosevear, was originally published on Bruce Jackson has updated it.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss a very important event! Chief Investment Advisor Scott Phillips and his team at Motley Fool Share Advisor are about to reveal their latest official stock recommendation. The premium “buy alert” will be unveiled to members and you can be among the first to act on the tip.

Don’t let this opportunity pass you by – this is your chance to get in early!

Simply enter your email now to find out how you can get instant access.

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our Financial Services Guide (FSG) for more information.