The Phaserl


How Prices Get Set

by Theodore Butler, Silver Seek:

In the quest to explain something that may be complex into something easily understood, please allow me to reference a recent issue most in the US are now familiar with – the shocking rise in price for EpiPens, produced by the Mylan drug company. An EpiPen is a life-saving medicine in injectable form for those suffering a food allergy attack. Since many of the victims are children unknowingly ingesting what to them is poison, Epipens are prevalent in schools and have become a vital part of life for many families.

Shocking and persistent price increases of many hundreds of percent over the past several years for a drug that hasn’t changed much had finally reached the boiling point of public and political consciousness and all manner of discussion has erupted. This is not a matter, by any means, limited to Mylan, as there have been many recent cases of skyrocketing prices on a variety of drugs. Having gotten my interest, I was sure that when I looked into the matter, I would discover a case of unbridled greed on the part of Mylan. While I wasn’t disappointed by my preconceptions, I also came away with the opinion that it wasn’t quite as simple as that.

The whole pricing situation for drugs in the US is extremely complex and involves a wide array of characters, including insurance companies, pharmaceutical distributers and the US government itself, in the form of the FDA and Medicare/Medicaid. The more I looked, the more complex it seemed and that was also the conclusion from all those who seemed most informed. Then it dawned on me what the problem was – the price discovery mechanism for drugs in the US was flawed, just as it is for silver and other commodities.

I’m not going to discuss drug pricing because I’m not remotely qualified, but with all the experts on every side agreeing that how drug prices get set is kind of screwy, at least it establishes how prices can get distorted. Why should commodities be exempted? The price of everything in the world has a price discovery process, which is just a fancy way of saying how prices get set. From kids selling lemonade by the cup to the pricing of the biggest ships and planes and parcels of real estate, there is a price discovery mechanism for everything that has a price. All involve the desire by the seller to achieve the highest price possible, balanced by the buyer’s desire to pay the lowest price – but beyond that, complexity can soar.

In commodities, it is assumed that prices are set by the broad array of consumers and producers on either side, with no one producer or consumer dictating price. Commodity prices are assumed to be set by the myriad countless daily interactions between the world’s producers and consumers in a free market atmosphere. And where a big producer or consumer does exert undue price influence, we rely upon antitrust and antimonopoly law to balance things out. That’s how commodity prices are supposed to be set.

But something has occurred that has turned the world of commodity pricing on its head. The most shocking element is that while many see it, few recognize how the price discovery process for commodities has been completely upended. At least in the short to intermediate time frame (weeks and months), the usual interactions between the actual commodity producers and consumers of the world have come to matter little in establishing price. Let me be clear, I am saying that what used to set prices and is still thought by most to continue to set commodity prices, no longer sets price over the intermediate time frame. There has been a price setting revolution in some important world commodities.

All revolutions involve a sweeping out of the old and the ushering in of the new. If the price influence of the real commodity producers and consumers has been swept aside, as I claim, then a new force must have taken its place. That new force is the collective influence exerted on price by the traders in the managed money category of the disaggregated COT report and their counterparties (the commercials). So overpowering is the collective managed money/commercial buying and selling that it obliterates any price influence from real producers or consumers.

Not all world commodities have experienced a price discovery revolution, but many have, including not only silver and gold, but also copper, grains and crude oil, the world’s most important commodity. The common denominator of the price revolution for commodities is an active futures trading market in which the managed money traders operate. (For what it’s worth, most, if not all of the futures markets involved in the price setting revolution are owned by the CME Group, and that’s why I zero in on it).

In simple terms, the managed money traders have come to buy and sell futures contracts in such enormous collective amounts that their positions overshadow the amounts produced and consumed in the real world. Even though the managed money traders and commercials deal mostly in derivatives contracts and the prices of such contracts are supposed to be derived from the real world of commodities and not the other way around, size distorts what’s supposed to happen.

Under US commodity law, it is illegal for speculators to set or manipulate prices, yet it is easy to document that is precisely what is occurring. Before proving that speculators are setting prices, let me cut to the chase and explain how and why the regulators allow managed money traders and their commercial counterparties to set and manipulate prices. It has to do with speculative position limits and how those limits are determined.

The CFTC has managed to drag its heels for more than five years since the passage of Dodd-Frank and still there are no speculative position limits in gold and silver and other commodities, although long established position limits exist in some markets, notably the grains. It matters little, at this point, whether legitimate position limits ever arrive in gold or silver, because unless the CFTC changes the way it considers the managed money traders, such limits won’t limit the managed money traders at all. That’s because the agency considers position limits in terms of individual traders only and not in terms of the collective influence of many traders operating as one. Having a position limit, for example, of 5000 contracts sounds reasonable to prevent any one speculator from amassing too large of a position and influencing prices, but what if 100 different traders sought to establish the same 5000 contract long or short position at roughly the same time? In the normal scheme of things, how could a 500,000 contract position not be considered too large and influential on price?

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