Iowa is flooded and there’s drought in California, but speculators are the real cause of soaring prices.

Massive floods in Iowa drown a good part of the corn crop, so corn prices hit record levels. Chinese industrial production rises 16 percent over last year, increasing demand for everything from oil to iron ore. Oil prices surge because the dollar falls or there is a fire on a Norwegian oil platform in the North Sea.

Everybody knows that food and energy prices are skyrocketing because the Chinese are eating more beef, it’s raining too much in the Midwest, it’s not raining enough in California and Australia, and Nigerian rebels are blowing up pipelines in the delta—whatever.

It’s simple economics: more demand + less supply = higher prices.
Apparently, at least one expert didn’t get the memo. Michael Masters, an Atlanta-based investor, says that financial speculators are a bigger part of the problem of high food and energy prices than any of the myriad of headline-grabbing usual suspects. “Institutional investors—pension funds, sovereign wealth funds, university endowments and others—are collectively driving prices higher,” he says.

And he has produced the numbers to back up his claim. Masters says that financial investors, who put $13 billion into commodity trading in 2003, are now investing more than $260 billion in the same commodities.
In our graphic feature, follow the rise of the commodity index and how much investors are pouring into the system.Not surprisingly, that dramatic inflow of investment dollars has helped push up the prices of the 25 most important commodities by an average of almost 200 percent during the same period. Higher commodity prices mean higher prices in the grocery stores and at the gasoline pump.

Masters doesn’t deny that the Chinese and Indians and droughts and floods all impact prices: “the question is not whether supply and demand are pushing prices up. The question is whether speculation is pushing prices up even higher—and whether ordinary Americans are suffering as a result. And the answer is that they are.”
The irony is that “ordinary Americans” also describes many of the investors. These aren’t the days of Duke & Duke in Trading Places, where only billionaires could play the commodity game. Several years ago, the Commodity Future Trading Commission (CFTC), which is supposed to regulate speculation to protect consumers, exempted investment banks from the limits that apply to commercial companies. The banks then invented so-called “index funds” which effectively let investors bet that commodity prices will rise.

Today, investors with as little as $1,000 can buy funds like Oppenheimer’s Commodity Strategic Total Return (up 38 percent since January 1) or PIMCO’s Commodity Real Return Strategy (up 26 percent).

Who benefits? Investors win if prices go up, but investment banks win whether prices go up or down. Like mortgage brokers and the game of subprime loans, the banks make money by encouraging their clients to speculate on ever-higher prices. That could even be part of the explanation for why former investment banker Paulson insists that speculation doesn’t cause higher prices.

Masters sees it differently. Speculators invest because prices are going higher—and the higher prices go, the more money speculators invest.

“Speculators flooded the markets with $55 billion in just the first 52 trading days of this year,” he told (PDF) the Senate Committee on Homeland Security and Governmental Affairs at the end of May. That means that speculators are effectively buying massive amounts of things like corn and oil as their investments purchase the right to future delivery of various commodities.

Investors have stockpiled the equivalent of 1.1 billion barrels of petroleum, 1.3 billion bushels of wheat and untold amounts of other goods. Of course, they never actually take delivery of the commodities. Instead, they trade their stockpiles for even more corn or oil in the future at higher prices.

For the past year, that has been a great (and partially self-fulfilling) bet. Typical commodity funds have increased 60 or 70 percent over the last 12 months, while stocks have dropped—9 percent as measured by the Dow Jones industrial average and more by other measures.

Speculators are betting that commodity prices—like house prices—will defy gravity forever. Odds are that will be a good bet for a long time…until it becomes a spectacularly bad bet.

The difference is that the run-up of housing prices didn’t hurt anyone, even though the crash badly damaged the economy. Excessively high commodity prices hurt every consumer every day.

This being an election year, Congress is starting to wonder if something should be done. Not surprisingly, the CFTC doesn’t think so. But the obvious “something” would be to (gradually) remove the investment bank exemption, letting some of the air out of overheated commodity markets.

Masters thinks politicians should act soon: “if ordinary citizens understood that speculation is causing them economic pain, they would demand an end to it.”
Watch FLYP’s video in which we delve into the reasons behind the soaring commodity prices, and also watch George Soros give testimony to Congress on the subject.