Mike Norman, anchor, HardAssetsInvestor.com (Norman): Hello everybody, this is Mike Norman, your host here at the HardAssetsInvestor.com interview series. This is the second part of my interview with Professor James Doran, who teaches finance at Florida State University.

Professor Doran, let's talk a little bit about the explosion in the growth of the different types of instruments, derivative instruments that now are available to investors to gain some exposure to the commodities markets. We have exchange-traded funds. Futures obviously have been around for decades, if not longer, and other over-the-counter products. Explain some of the differences and where you see most of the large institutional investments … what sort of instruments they're leaning to.

James Doran, professor of Finance, Florida State University (Doran): The growth that you've seen in derivative-types instruments, especially in the futures markets and the options markets, and the volume of trading over the past five years, has grown in excess of 200% to 400% relative to the growth in volume of traditional equities. Along with that, we've had the establishment of many solid commodity-based ETFs. From the investors' standpoint, that offers a lot of opportunities, and this is very good thing because the ETFs offer the investor a chance to invest in a type of energy product or the energy sector without worrying about the transaction costs and the actual portfolio management that goes with typically buying individual equities.

Regarding the access to the futures markets, what a lot of the futures exchanges have done is they've taken away essentially the physical delivery that's associated with a futures product, and they've offered cash settlement products or half futures contracts. That allows for downside protection and downside risk control. Before entering into the futures markets, one better be fairly sophisticated. The chance for speculation and risk is very, very high in that.

Norman: This raises an interesting question, this elimination of the need for physical delivery. Some say if there were the physical delivery mechanism, if it were enforced, if you had to go through physical delivery, there would be less of a speculative influence. There is a raging debate out there right now as to how much, indeed, speculation has been contributing to price run-ups in certain markets.

Doran: Let's just take a look at the commodities markets in general, especially crude oil. What have we seen over the past year? And over the past few weeks we've seen oil prices hit a top around $140–$145/barrel, and now they're back down to about $103–$104/barrel in just a matter of several days [Editor's note: This interview was recorded prior to the U.S. House vote on the bailout plan, which caused oil to fall $10/barrel in a single day].

The speculation in these markets is quite rampant, that's for sure, and the use of futures contracts and so forth allows tremendous leverage and so forth. Now for investors, what are we talking about here? Are we talking about a long-term investor or are we talking about a short-term investor? Let us not chase the profits. That's the worst thing an investor can do, and the worst thing an investor can do is start to sell out when the market's dropped down. So even though commodities have lost a little bit recently, it's still the worst time for them to get out.

The commodity is a solid product, it's a hard asset. It's not an Internet stock, right? We understand the basic cash flows and the need for this and the demand for this. While there are speculators in the market, this is actually a good thing because it improves liquidity, it allows us to get actually better prices with lower transaction costs. We just have to overcome the short-term cycles that typically occur with rampant speculation.

Norman: So is this period that we're seeing now with the very heightened volatility reflective of this sort of new embrace of commodities, but as the markets develop from an institutional investor point, will the volatility sort of settle down?

Doran: Volatility will come back down but it'll still be high by the nature of the good itself. It has tremendous price fluctuations just given the nature of what the supply is like - weather and so forth - and so you're going to see higher volatility, but you will not see volatility on the order that we've seen recently. The volatility that we see today is in part contributed by this short-term speculation, and frankly, long-term investors will not get hurt as long as they stay put. Short-term speculators will.

Norman: Very quickly, I just want to ask, with the trillions of dollars potentially out there from large investors, does that not say that prices have to go up in the long term?

Doran: Prices will always go up in the long term. Why? Because companies in general and assets in general have positive MPV [market price validation] value to them, right? When prices go up and prices go down, what we've seen is a tremendous deviation from fundamentals, but prices do revert back to fundamentals; they have to.

Norman: All right, there you have it; prices going up in the long term, folks. Another reason why you've got to stay tuned right here to HardAssetsInvestor.com. My thanks to Professor Doran. This is Mike Norman; stay tuned here for more great interviews on this Web site. Take care.