Making Sense

Hot Commodities, Stuffed Markets, and Empty Bellies

What's behind higher food prices?

By Ben Collins


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Since 2003, prices of basic agricultural commodities such as corn, wheat, soybeans, and rice have skyrocketed worldwide, threatening to further impoverish hundreds of millions of the world's poor.

Shifts in fundamental supply and demand factors for food grains have undoubtedly contributed to higher food prices. Prominent among these shifts are the increasing diversion of food crops for biofuel production in the United States and Europe; sustained drought and water scarcity in Australia's wheat-growing regions; flooding in the U.S. grain belt; rising prices for oil and fertilizer worldwide; and the adoption of European and American meat-rich diets by the growing middle classes throughout Asia.

On top of these recent developments, long-term threats to worldwide agricultural output have eroded the world food system's resilience in the face of changing supply and demand. Although decades in the making, a loss of agricultural capacity worldwide caused by soil depletion, climate change, water scarcity, and urbanization has begun to take its toll on food production. Moreover, half a century of import restrictions and cheap agricultural exports by wealthy countries has devastated domestic food production capacity in poorer countries, forcing many countries that were once self-sufficient to rely on imported food from the world market.

At the same time, however, the growing presence of buy-and-hold investors in commodity markets has prompted heated debate among commodity traders, economists, and politicians over other possible causes of higher commodity prices apart from supply and demand shifts. Since 2001, the declining value of the U.S. dollar, low U.S. interest rates, weak stock market returns, and accelerating inflation have drawn investment dollars away from stocks and into non-traditional investments such as commodities. This flight to perceived safety in commodity markets turned into a stampede in 2007 and early 2008, as a credit-induced financial crisis in the United States compounded these existing stresses on global financial markets.

Rising commodity prices and financial speculation on food are not new phenomena. The 1970s saw a similar rise in commodity prices in the United States, and in the 1920s, U.S. investors formed commodity pools to bet on commodity price movements. But the quantity and liquidity of money flowing through today's global markets is unprecedented in human history. The current commodities boom could be a sign of looming agricultural scarcity, or it may prove to be a short-lived speculative bubble that will deflate over the next few months or years. But regardless of where agricultural commodity prices are headed, the boom has already begun to transform how food is financed, grown, and sold, and may dramatically change how people around the world eat (or don't).

Commodity investment goes retail

Commodity exchanges exist as a mechanism for the producers and consumers of grains, energy, and livestock to transfer risk to financial institutions and other traders. For example, wheat farmers might seek to reduce the risk of price fluctuations by selling a contract for the future delivery of their wheat crop on a commodity exchange. This futures contract will guarantee a price for the farmer selling the contract, enabling them to pay for their planting costs, and avoid the risk that the price of wheat may decrease between the date they sell the contract and the date they agree to deliver the wheat. Food giants such as Kraft and Nabisco, as well as smaller bakers and grain consumers, typically purchase commodity futures contracts to avoid the opposite risk—that the price of their raw materials may increase in the future. (Commodity markets also trade "spot" contracts, which entitle the purchaser to the immediate delivery of a commodity.)

Because producers and consumers seek to reduce risk, they function as so-called hedgers in commodity markets. In contrast, commercial trading firms and other speculators bet on the price of a commodity rising or falling, buying and selling futures contracts frequently in order to profit from short-term changes in their prices.

Since 2001, commodity funds have gained in popularity as a mechanism for institutions and individuals to profit from increases in commodity prices. These funds purchase commodity futures contracts in order to simulate ownership of a commodity. By periodically rolling over commodity futures contracts prior to their maturity date and reinvesting the proceeds in new contracts, the funds allow investors to gain investment returns equivalent to the change in price of a single commodity, or an "index" of several commodities (hence the name "index investor").

Investors in these commodity index funds include public pension funds, university endowments, and even individual investors, through mutual funds, for example. Although these investors are similar to traditional commodity speculators in that both seek to profit from changes in price, traditional speculators zero in on short-term price shifts, while index investors are almost exclusively long-term buyers betting on higher commodity prices in the future.

A Lexicon of Commodity Markets

  • Hedger—An individual or institution who buys or sells an asset to avoid the risk that the price of the asset may change over time. In agricultural commodity markets, hedgers are typically farmers and end-users of grains.
  • Speculator—An individual or institution who buys or sells an asset to profit from fluctuations in its price, but takes on the risk of an unfavorable change in the asset's price. In agricultural markets, speculators are typically large financial institutions, but since 2003 a growing number of "index investors" have speculated on the continued rise of commodity prices.
  • Futures—Tradable financial contracts used to buy or sell an asset at a certain date in the future, at a specified price.
  • Spot Contract/Spot Market—A contract for the immediate delivery of the commodity. Also called the "cash market" or "physical market," the spot markets determine the current price of a commodity.
  • Over-the-Counter—Any contract or security traded outside of a regulated exchange. Over-the-counter trading can take place directly between two traders, or on unregulated exchanges or informal dealer networks.
  • Position Limits—In commodity markets, the maximum number of futures contracts a trader or institution is allowed to hold for a given commodity.

—Tillman Clark and Ben Collins

Some observers have argued that index investors themselves may have pushed already-high prices of commodities even higher. Hedge fund manager Michael Masters testified to the U.S. Senate that the total holdings of commodity index investors on regulated U.S. exchanges have increased from $13 billion in 2003 to nearly $260 billion as of March 2008. And as of April 2008, index investors owned approximately 35% of all corn futures contracts on regulated exchanges in the United States, 42% of all soybean contracts, and 64% of all wheat contracts, compared to minimal holdings in 2001. As Masters emphasized, these are immense commodity holdings. The wheat contracts, for example, are good for the delivery of 1.3 billion bushels of wheat, equivalent to twice the United States' annual wheat consumption.

Index fund managers have defended against charges that commodity index investment contributes to higher prices, arguing that because index funds never take delivery on their futures contracts, they simulate commodity price shifts for their investors without affecting the price of the underlying commodity. Some economists have also expressed skepticism that investment demand has driven commodity prices higher. Paul Krugman of Princeton University has noted that there is no evidence of "the usual telltale signs of a speculative price boom" such as physical hoarding of commodities. Furthermore, Krugman and others have pointed to non-exchange traded commodities such as iron ore that have also experienced rapid price increases during recent years, arguing that fundamental supply and demand factors, not investors, are to blame for higher commodity prices.

Other economists and commodity market observers have argued that despite price increases in non-exchange traded commodities, and an absence of physical hoarding, the recent flood of money into commodity markets has altered the balance between speculators and hedgers, leading to higher prices and greater price volatility. Mack Frankfurter, a commodities trading advisor at Cervino Capital Management, suggests that the influx of commodity index investors has transformed commodity futures from tools for risk management to long-term investments, "causing a self-perpetuating feedback loop of ever higher prices." One reason the precise impact of index investors on commodity prices is difficult to determine is that the U.S. commodity trading regulator, the Commodity Futures Trading Commission (CFTC), does not collect data on so-called "over-the-counter" commodity trading—that is, trading on unregulated markets—even though the agency estimated that 85% of commodity index investment takes place on these markets. Because Masters's data on the holdings of commodity index investors only include the 15% of index investor contracts that are held on CFTC-regulated exchanges, total commodity index investor holdings may be much higher than his estimates.

In testimony that warned of the influence of these unregulated markets on commodity prices, Michael Greenberger, the former head of the CFTC's Division of Trading and Markets, estimated that if unregulated trading of energy and agricultural commodities were eliminated, the price of oil would drop by 25% to 50% "overnight." If Greenberger is correct, the effect on food commodity prices would likely be similar. However, index investment is just one of many avenues through which money can enter commodity markets, making it difficult to assess the impact of index investors without taking into account the recent deregulation of U.S. commodity markets that has facilitated the current boom in food and energy investments.

Commodity Trading Regulation, Enron-Style

Commodity index investment is deeply intertwined with the growth of unregulated commodity trading authorized by the Commodity Futures Modernization Act of 2000. Before 2000, U.S. commodity futures contracts were traded exclusively on regulated exchanges under the oversight of the CFTC. Traders were required to disclose their holdings of each commodity and adhere to strict position limits, which set a maximum number of futures contracts that an individual institution could hold. These regulations were intended to prevent market manipulation by traders who might otherwise attempt to build up concentrated holdings of futures contracts in order to manipulate the price of a commodity.

The 2000 law effectively deregulated commodity trading in the United States by exempting over-the-counter commodity trading outside of regulated exchanges from CFTC oversight. Soon after the bill was passed, several unregulated commodity exchanges opened for trading, allowing investors, hedge funds, and investment banks to trade commodities futures contracts without any position limits, disclosure requirements, or regulatory oversight. Since then, unregulated over-thecounter commodity trading has grown exponentially. The total value of all over-the- counter commodity contracts was estimated to be $9 trillion at the end of 2007, or nearly twice the value of the $4.78 trillion in commodity contracts traded on regulated U.S. exchanges. Once these unregulated commodity markets were created, energy traders and hedge funds began to use them to place massive bets on commodity prices. Enron famously exploited deregulated electricity markets in 2001, when the firm managed to generate unheard-of profits by using its trading operations to effectively withhold electricity and charge extortionate rates from power grids in California and other western states.

Although Enron went bankrupt later that year, the hedge fund Amaranth later exploited unregulated natural gas markets prior to its 2006 collapse. The fund had been heavily invested in complicated bets on the price of natural gas, borrowing eight times its assets to trade natural gas futures, and lost $6.5 billion when natural gas prices moved in the wrong direction. One month prior to Amaranth's collapse, the New York Mercantile Exchange (NYMEX), which is regulated by the CFTC, asked Amaranth to reduce its huge natural gas position. Amaranth reduced its position at NYMEX's request, but purchased identical positions on the unregulated InterContinental Exchange, where its transactions were invisible to regulators until the fund finally collapsed. Amaranth's implosion demonstrated the ineffectiveness of regulating some commodity exchanges but not others. Thanks to the Commodity Futures Modernization Act, traders could flout position limits and disclosure rules with impunity, simply by re-routing trades to unregulated exchanges. Although index investment in commodities does not typically involve white-knuckle, leveraged bets on a single commodity's short-term performance, index investment was made possible by the same deregulated environment exploited by Amaranth and Enron. Like Amaranth, commodity index investors commonly purchase futures contracts on unregulated markets when they exceed CFTC position limits on futures contracts for a particular commodity. And other financial actors such as investment banks, hedge funds, or even the sovereign wealth funds of other countries may also be heavily invested in these over-the-counter commodity contracts, but since this trading is unregulated and unreported, the holders of these $9 trillion worth of contracts remain anonymous.

This year, the CFTC has faced intense scrutiny from investors, politicians, farmers, and agricultural traders over the unprecedented volatility and price increases of several agricultural and energy commodities traded on U.S. exchanges. A lively CFTC roundtable on commodity markets in April appeared to confirm arguments made by Frankfurter, Greenberger, Masters, and other critics of commodity index investment. Representatives for farmers, grain elevator operators, and commercial bankers at the hearing repeatedly stressed that commodity markets were "broken," while the only pleas for calm came from CFTC economists and representatives for index investors and the financial industry. Unlike index investors, farmers have not benefited greatly from higher commodity prices, because extremely high levels of market volatility have made it difficult for some farmers to finance crop planting. National Farmers Union president Tom Buis sounded a particularly dire warning about the consequences of tight commodity supplies and burgeoning index investment demand: "We've got a train wreck coming in agriculture that's bigger than anything else we've seen."

Following these warnings from farmers and food producers about the presence of index investors in commodity markets, the CFTC's acting chair publicly acknowledged the ongoing debate over "whether the massive amount of money coming into the markets is overwhelming the system." Despite this admission, Greenberger, the former CFTC official, remains skeptical of the agency's capacity and willingness to regulate commodity markets effectively. He urged Congress and the Federal Trade Commission to circumvent the CFTC's authority and eliminate unregulated over-the-counter commodity trading. Recently, faced with strong criticism from Congress, the CFTC retreated further from its claim that commodity markets are functioning normally. A CFTC commissioner admitted: "We didn't have the data that we needed to make the statements that we made, and the data we did have didn't support our declarative statements. If we were so right, why the heck are we doing a study now?"

The Consequences of Financializing Food

Facing political pressure by constituents over high oil and food prices, several members of Congress have sponsored legislation that would bar index investors from commodity markets. One bill proposed by Sen. Joseph Lieberman (Ind- Conn.) would prohibit public and private pension funds with more than $500 million in assets from trading in commodity futures, and other bills would limit the maximum number of futures contracts an index investor could hold. These bills may stem the flood of money from index investors into commodities, but comprehensive reform is needed to reverse the Commodity Futures Modernization Act's authorization of over-the-counter commodity trading. Absent an outright repeal of this so-called "Enron loophole," energy and agricultural commodities will continue to be traded outside the reach of government regulation, making future Enron- and Amaranth-style market disruptions inevitable.

Ultimately, eliminating unregulated commodity trading cannot address the fundamental causes of higher agricultural prices. Even if speculative buying is curtailed, supply and demand factors such as falling crop yields, destructive trade policies, and the growing use of biofuels have likely brought the age of cheap food to an end. However, if the critics of commodity index investment are correct, then these investors have amplified recent food price shocks and are needlessly contributing to the impoverishment of the world's poorest citizens. Even though commodity market transparency and regulatory oversight will not solve the global food crisis, eliminating unregulated commodity trading can help resolve the debate over the effects of index investors on commodity prices and restore the accountability of commodity markets to the social interests they were originally established to serve.

Ben Collins is a member of the Dollars & Sense collective and a research analyst at KLD Research & Analytics, a sustainable investment research company. Mr. Collins's views do not necessarily reflect those of KLD or its clients.

Sources: Michael Masters, Testimony before the Committee on Homeland Security and Government Affairs, United States Senate, May 20, 2008; Daniel P. Collins, CFTC to up spec limits, Futures, May 1, 2005; Paul Krugman, Fuels on the Hill, New York Times, June 27, 2008; Michael Frankfurter, The Mysterious Case of the Commodity Conundrum, Securitization of Commodities, and Systemic Concerns, Parts 1-3; Michael Frankfurter and Davide Accomazzo, Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures, December 31, 2007, Graziadio Business Report; Regulator Commits to Futures Tracking Volatility, Associated Press, June 4, 2008; Commodity Futures Trading Commission, CFTC Announces Agricultural Market Initiatives, June 3, 2008; Michael Greenberger, Testimony before the Committee on Commerce, Science, and Transportation, United States Senate, June 3, 2008; Sinclair Stewart and Paul Waldie, Who is responsible for the global food crisis? Globe and Mail, May 30, 2008; Commodity Futures Trading Commission, Agricultural Markets Roundtable, April 22, 2008; Ann Davis, "Commodities Regulator Under Fire—CFTC Scrutinized As Congress Looks Into Oil-Price Jump," Wall Street Journal, July 7, 2008; Ed Wallace, ICE, ICE, Baby, Houston Chronicle, May 19, 2008; Laura Mandaro, Lieberman plans would bar funds from commodities, Marketwatch, June 18, 2008; Our Confusing Economy, Explained, Fresh Air, April 3, 2008.
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