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Timothy A. Wise

As Jayati Ghosh explained in her recent post on the “Frenzy in Food Markets,” high food prices are back and market fundamentals do not adequately explain the price rise. Still, a wide range of analysts and commentators, from Paul Krugman to the International Food Policy Research Institute, dismiss the argument that a significant part of the 2006-8 food price surge was due to speculation. They are more dismissive now, two years further removed from the bursting bubbles of the housing and financial crises.

As Krugman put it in one of several recent blog posts, “I was and remain skeptical about the speculation story in 2007-2008, because of the lack of evidence of inventory accumulation.”

Krugman and others are missing the point, or at least missing the distinction between price manipulation and excessive speculation. If a big market player hoards in a scarce market, that’s manipulation. But you don’t need manipulation to have non-commercial investors overwhelm commodities markets. And it is hard to deny the market fundamentals of our brave new “financialized” – and still-deregulated – commodities markets.

Let’s review the basics. Some $9 trillion in trades take place in commodity derivatives, with 80-90% in over the counter (OTC) trading, outside of public scrutiny. Five banks control 96% of derivatives activity, giving a few players decisive market power. The ratio of non-commercial speculators to commercial hedgers (those with a commercial interest in the traded commodity) is by some estimates 4:1, roughly a reverse of the shares ten years ago when speculators accounted for 20% of the activity. Then, such speculators indeed provided liquidity to the markets without overwhelming them. That is no longer the case.

Commodity index funds are where the market fundamentals of speculation seem unarguable, particularly in relation to agricultural commodities. Index funds, which are typically baskets of twenty or more commodities, were created by Goldman Sachs and other financial players as a hedge against declining returns in other sectors, based on the observed tendency of commodity prices to hold their value as other assets lost theirs. Index funds generally bet “long,” on rising prices, and they hold their investments for a longer time than the typical commercial hedger. This has a tendency to push prices up, which attracts more speculative capital, which adds to the volatility.

Overall, the number of derivatives contracts increased more than six-fold between 2002 and mid-2008, as these investment vehicles became a safe haven from the subprime crisis and financial meltdown. According to Masters and White, index fund purchases from 2003-7 already were higher than the futures market purchases of physical hedgers and traditional speculators combined. Then they doubled in the first half of 2008.

It would be bad enough if speculative capital simply overwhelmed commercial hedging interests in these markets. But the speculation is actually more institutionally entrenched than that. Index funds rarely hold more than 30% of their value in agricultural commodities. In fact, in July 2008 the ratio for the S&P Goldman Sachs Commodity Index, by far the largest index fund with 63% of the market, held 75% energy futures and 10% grains futures, with the rest in minerals.

So the movement of the index funds is driven by the price of oil, itself a highly speculative market with some 70% of futures investments coming from non-commercial speculators. Under such institutionalized structures, the price of oil drives the movement of the index funds and pushes up the prices of agricultural commodities, no matter what is happening to the fundamentals of supply and demand for soybeans or corn. Worse, the index funds are mandated to keep the value of their commodities in strict proportion, so that when the prices and value of energy products go up the funds have to buy more corn and soybean futures to maintain the mandated proportions. This represents yet another institutional impetus to buying agricultural futures regardless of the market fundamentals.

What part of this picture don’t the speculation-deniers see? Finance capital now dominates commercial hedging in futures markets, index funds have become huge investment vehicles in uncertain economic times, and the index funds move with oil and minerals prices, dragging food prices along with them.

Fortunately, France, as the new chair of the G20, has made the issue a priority for 2011, and in May we’ll see the first-ever meeting of G20 agriculture ministers. Meanwhile the U.S. Commodity Futures Trading Commission (CFTC) is now in the process of issuing its proposed rules re-regulating derivatives markets, implementing some of the more promising provisions of the Dodd-Frank financial reform bill. As CFTC chairman Gary Gensler stated, “I believe that increased speculation in energy and agricultural products has hurt farmers and consumers.”

We should certainly study and debate how much of the recent price volatility owes to excessive speculation and what should be done about it. But we should stop debating whether it’s a problem. The market fundamentals of commodity market speculation seem painfully clear.

For some good overviews of the issue, see:
Food Commodities Speculation and Food Price Crises, Olivier de Schutter
Commodities Market Speculation: The Risk to Food Security and Agriculture, IATP
The Great Hunger Lottery, Tim Jones, World Development Movement
How Institutional Investors are Driving up Food and Energy Prices, Masters and White
Index Funds and the 206-8 Run-up in Agricultural Commodities Prices, Ray and Shaeffer
The State of Agricultural Commodities Markets, FAO
Reflections on the Global Food Crisis, IFPRI

13 Responses to “Food Price Volatility: Market fundamentals and commodity speculation”

  1. Ilene Grabel says:

    Excellent analysis, Tim. And the list of resources on the subject is very helpful.

    It is good to see that the issue of food price inflation makes clear that we are still dealing with the wreckage of an out-of-control global financial casino. It is also stunning to see the “nothing wrong here” camp re-emerging in the debate on food price increases. If we substitute the words “housing prices” or “stock prices” into the latest statements of those denying the role of speculation in driving up food prices we have a nice flashback to the pre-208 environment.

  2. Timothy A. Wise says:

    Thanks for the comments. Krugman has come back to it on his blog several times, and he seems firm in the argument that with commodities it all comes down to physical supply and demand and hoarding. Here’s his post today:
    http://krugman.blogs.nytimes.com/2011/02/07/signatures-of-speculation/
    I posted the following comment, because I can’t believe he doesn’t think speculation has something to do with it:

    “Thanks for keeping the discussion of the issue active. I still find your position perplexing, but maybe it’s just contrarian. Of course it’s not all, or even primarily, speculation, but few are actually saying that. We’re saying that the “financialization” of commodities markets has made futures markets less reliable as predictors of future prices, based on market fundamentals. As prices are bid up, that has a wide range of effects on those dealing with the physical commodities. It’s no accident that some of those most vociferously calling for re-regulation are those actually involved in the physical hedging, groups like the Commodity Markets Oversight Coalition.
    Maybe the question we’d all like you to answer is not, why isn’t this all speculative? It is: What role did financial speculation play in the 2007-8 food price spikes? And, of course, the multi-billion-dollar policy question that it all implies: Should the CFTC limit such derivatives trading? Your position would suggest that you think not, that you agree with the argument that such financial capital just adds liquidity to the market without disrupting it. What do you say to the hedgers who think it’s making a mess of price discovery?”

  3. Timothy A. Wise says:

    Yves Smith has taken up the question on Naked Capitalism in a Feb 10 post:
    http://www.nakedcapitalism.com/

    Illuminating, but still leaves a lot of questions unanswered. I posted the following comment:

    Ultimately, this seems to be a question not about whether financial (as opposed to commercial) speculators entered commodities futures markets in a big way (agreed), nor whether they did so through largely deregulated financial instruments (they did), but about whether all that new money provides added liquidity to futures markets, with no ill effects. That seems to be Krugman’s argument, because in the end it’s all about the physical commodities. But doesn’t all that financialization make a mess of price discovery? After all, why are some of the most vocal groups that are demanding reregulation and strict derivatives reforms the commercial hedgers themselves? To listen to Krugman, they should be thrilled that Wall Street is throwing money into their markets. From what I can tell, they’re not. And that makes a whole lot of sense if futures markets actually affect the decisions of economic actors in the real world. Guess what: they do, from farmers deciding what to plant to governments deciding what to buy, like Mexico locking in a contract on corn futures now in fear of another price bubble. A “panic buy?” Maybe, maybe not. It all depends on how reliable the price signals are in the futures market. Financialization makes a mess of that.

  4. Thanks for this. I understand that speculation on oil prices pushes index funds prices up and then agricultural futures prices up. But what are the precise mecanisms by which the increasing price of futures translate into an increasing price of the commodities ?

    Why betting up the price of derivatives pushes up the price of the underlier ? And is the reverse true, i.e, are short sellers pushing prices of agricultural commodities down ?

  5. Timothy A. Wise says:

    see further discussion at later post:
    http://triplecrisis.com/commodity-speculation-krugman-leaves-questions-unanswered/
    and in the interview posted with Jayati Ghosh and Robert Pollin:
    http://triplecrisis.com/speculation-and-the-frenzy-in-food-markets/

  6. Airelon says:

    Several data points are just factually … incorrect with no supporting references.

    Disinformation at its finest

  7. Dear Timothy

    I am so happy to have found this article its estimates on what percentage of the food commodities market is truly “non-commercial”, i,e. purely speculative..and the eye opening stat that 95% of this is controled by and profiting only five banks.

    It seems the UN FAO and France at least are finally coming around to publicly acknowledging that the distinction between speculative and non speculative is important and was a significant factor in market oprice distortions in food hat pushed millions into chronic hunger. From barely mentioning the role of speculation in food prices at te 2009 Rome Summit on Food Security year later in September 2010 they are on board in acknowldeging the harmful role of speculation but only calling for “classifications” ; not any out right ban or limitation on purely speculative .

    Until I saw your article I had no idea that there might already be lots of reliable data on index fund classifications, pethaps even enough to do more than simply call for classiciations.

    At the above TED Conversation, us amateurs are trying to take a responsible look at the role of speculation in the food price trends that pushed millions into hunger and look at realistic immediate measures that will protect millions more falling into chronic hunger as food prices continue to climb and speculation on food continues to grow unabated.

    Just put out a call for data on commercial v non commercial food contrcats in global commities markets and would so appreciate your input there and the input of others who follow your excellent blog here ( I wil be doing that too)

    Many Thanks for your important and excellent work.

    Lindsay Newland Bowker
    Member NYS Banking Board 1986-1997/ Baking Consumer Advocate
    Stonington, Maine, U.S.A.

  8. [...] Regulate financial speculation in commodity markets – The financial sharks are circling as prices spike, hungry to play the volatility for their benefit. Regulations are still not in place to get them out of our food. Governments can act to reduce speculation-driven food price volatility. [...]

  9. It is good to see that the issue of food price inflation makes clear that we are still dealing with the wreckage of an out-of-control global financial casino. And fiscal Cliff is coming soon.

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  12. Interesting stuff but complicated none-the-less. Even despite my quite dated comment!

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