Free Markets and Food Markets: The Ugly

The food crisis is bad, and getting worse. The Washington Post calls it “the worst food crisis sine the 1970’s,” and both they and the New York Times have series on the jump in food prices. A lot of it has to do with rising demand worldwide, coupled with scarce supplies due to drought and the use of cropland for biofuel production. The role speculators on the commodity markets have played in driving up agricultural commodity prices has largely been unexamined.

An excellent article, Deadly Greed: The Role of Food Spectators in the Global Food Crisis, in the top German news-magazine, Der Spiegel, lays it all out clearly

But classic supply and demand theory offers only a partial explanation. Sudden price hikes since last January have been alarming. The UN estimates that at least $500 million (€312 million) in immediate aid will be needed by May 1 to avoid serious famines. Agricultural scientists at the world body’s Educational, Scientific and Cultural Organization (UNESCO) have presented a report on the world food crisis. And criticism is growing that hedge funds, index funds, pension funds and investment banks bear part of the blame

“What we normally have is a predictable group of sellers and buyers — mainly farmers and silo operators,” says Greg Warner [a two-decade veteran of the grain wholesaling business]. But the landscape has changed since the influx of large index funds. Fund managers seek to maximize their profits using futures contracts, and prices, says Warner, “keep climbing up and up.”

But some basic market rules seem to have stopped working. “The enormous influx of capital has resulted in the futures markets no longer reflecting supply and demand,” says Todd Kemp of the US National Grain and Feed Association. Ironically, investors have placed their wildest bets on staple foods. Information about supply bottlenecks and famines at the other end of the world is not noted on market quotations. [emphasis added]

A commodities dealer named Christoph Eibl soberly concludes that financial managers just want to “benefit from the scarcity of these commodities.” Eibl’s Stuttgart-based investment firm, Tiberius, manages €1 billion ($1.6 billion). His in-house experts estimate that hundreds of billions of dollars have flowed into the futures sector as a whole within the last five years, much of it for agricultural commodities. Eibl admits the whole thing demands an “ethical discussion.” Some futures traders argue that they don’t cause prices to rise in the real world because as a rule they never take delivery of a given crop — other parts of the economy control the actual street price. But futures prices affect real-world behavior (such as inventory hoarding), and Eibl says that buying futures in rice, for example, “eventually causes consumer prices to rise in developing countries like Haiti.”

In Haiti, people are eating dirt formed into patties because they can’t afford rice, scavenging for food in garbage dumps, and food riots forced the Prime Minister out of office.

The upshot is that more and more small investors are jumping on the commodities bandwagon. Many investors, not unlike hedge fund managers, seek diversification in their portfolios, partly through investment in agricultural commodities. From the standpoint of these investors, poor harvests that drive up prices are only good for their portfolios. Many investors either don’t care or are simply oblivious to the fact that by investing in the global casino, they could be gambling away the daily food supply of the world’s poorest people.

Financial giant ABN Amro has been especially adept at turning a profit in the current market. As a provider of commodities-investment products for private investors, ABN Amro last March became the first bank to offer certificates allowing small investors to place bets on rising rice prices on the Chicago Futures Exchange.

The bank’s marketing department has reacted with cold precision to headlines about famine around the world. Two weeks ago, when experts warned of an impending hunger crisis and the political instability associated with it, ABN Amro introduced a new ad campaign on its website. As India imposes a ban on rice exports, the ad said, world rice supplies have declined to a minimum: Now ABN Amro was making it possible, for the first time, to invest in Asia’s most important basic food product. In the space of only three weeks, investors raked returns of more than 20 percent. The number of futures contracts traded in Chicago has skyrocketed

A Sasketchwan grain elevator

Last week’s column by recent Pulitzer Prize-winner columnist Steven Pearlstein touches upon another effect of this speculation in commodities markets, aside from the astronomical rise in prices:

Speculators have always played a prominent role in commodities markets, but in the past year, they have literally overwhelmed them, causing a dramatic increase in trading volume, volatility and prices and disrupting many of the normal relationships between producers and end-users. [emphasis added]

There are various estimates of how much of this new investment money flowed into these vehicles in the past two years. Philip Verleger, an economist who closely studies commodity markets, estimates that the inflow was running at an average of $100 million a day during most of 2006 and 2007, rising to as much as $1 billion a day during the frenzied trading days of February and March. J.P. Morgan put the amount at between $150 billion and $270 billion. And the Bank for International Settlements estimates that the value of all the derivative contracts traded on the unregulated over-the-counter markets surged from about $3 trillion in the spring of 2005 to more than $8 trillion today.

Whatever the number, it’s hard to imagine that it wasn’t a significant factor in skyrocking prices that have created problems for many of the nonfinancial players who rely on the commodity futures markets for selling products, assuring adequate supplies and hedging against price fluctuations. Many farmers and grain elevators are reluctant to sell their product on futures markets out of fear they won’t have the cash to meet the ever-escalating margin calls, while giant users like Cargill are reportedly also cutting back on the their use of futures contracts to lock in supplies. [emphasis added]

Essentially, tons of new investors rushed into commodities markets, looking for the next sure thing. There is only a limited amount of wheat or soybeans contracts to buy, and so global commodity prices go up even more than they would have due to increased demand and diminished supply. This influx causes a lot of volatility and uncertainty in the markets, because no-one is sure what the market price, based on true supply and demand, should actually be. Hence, the commodities and futures markets no longer work for the people they were designed to serve: farmers and buyers who want to lock in a guaranteed price and protect themselves against price swings.

Another New York Times article, Price Volatility Adds to Worry on U.S. Farms, gives the details from the farmers’ perspectives.

Today’s crop prices are not just much higher, they also are much more volatile. For example, a widely used measure of volatility showed that traders in March expected wheat prices to swing up or down by more than 72 percent in the coming year, three times the average volatility for that month and the highest level since at least 1980. The price swing expected in March for soy beans was three times its monthly average, and the expected volatility in corn prices was twice its monthly average.

Fred Grieder has been farming for 30 years on 1,500 acres near Bloomington, in central Illinois. His crop insurance premiums rise with the volatility. So does the cost of trading in options, which is the financial tool he has used to hedge against falling prices. Some grain elevators are coping with the volatility and hedging problems by refusing to buy crops in advance, foreclosing the most common way farmers lock in prices.

“The system is really beginning to break down,” Mr. Grieder said. “When you see elevators start pulling their bids for your crop, that tells me we’ve got a real problem.”

Until recently, that system had worked well for generations. Since 1877, grain producers have been able to hedge the price of their wheat and corn crops on the Chicago Board of Trade through the use of futures contracts, which are agreements to buy or sell a specific amount of a commodity for a fixed price on some future date. Soybean futures contracts were introduced in 1936. More recently, the exchange has offered another tool: options on those futures contracts, which allow option holders to carry out the futures trade, but do not require that they do so. Trading in options is not as effective a hedge, farmers say, but it does not require them to put up as much cash as is required to trade futures. These tools have long provided a way to lock in the price of a crop as it is planted, eliminating the risk that prices will drop before it is harvested. With these hedging tools, grain elevators could afford to buy crops from farmers in advance, sometimes a year or more before the harvest.

For a clear description of what a futures contract is, look here. There is a more detailed explanation of how futures contracts and options actually work here, which has some nice examples.

But that was yesterday. It simply is not working that way today. Futures, for example, are less reliable. They work as a hedge only if they fall due at a price that roughly matches prices in the cash market, where the grain is actually sold. Increasingly — for disputed reasons — grain futures are expiring at prices well above the cash-market price.

When that happens, farmers or elevator owners wind up owing more on their futures hedge than the crops are worth in the cash market. Such anomalies create uncertainty about which price accurately reflects supply and demand — a critical issue, since the C.B.O.T. futures price is the benchmark for grain prices around the world.

“I can’t honestly sit here and tell you who is determining the price of grain,” said Christopher Hausman, a farmer in Pesotum, Ill. “I’ve lost confidence in the Chicago Board of Trade.”

At current levels of volatility, options trading becomes riskier, and therefore more expensive — too expensive for many farmers like Mr. Grieder, who now has to hedge with the recently less reliable futures contracts.

That exposes him to the risk of having to put up more cash — to maintain his price protection — whenever a weather threat, shipping disruption or a fresh surge of money from Wall Street suddenly pushes up grain prices. “If you’ve got 50,000 bushels hedged and the market moves up 20 cents, that would be a $10,000 day,” he said. “If you only had $10,000 in your margin account, you’d have to sit down and write a check. You can see $10,000 disappear overnight.”

I strongly recommend reading the more detailed explanation of commodities futures trading here. Essentially, the two major problems are uncertainty about the true price of a commodity and the increasing volatility of commodities markets cause by the huge influx of investors trading contracts. This is very interesting, and worrying and certainly looks like bad news for farmers. It seems like these tools, designed to protect the farmers, are now benefiting the speculators at the farmers’ expense.

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