Tuesday, September 27, 2011

A skeptical question about financial speculation and food prices

Tom Philpott at Mother Jones blames food price increases since 2007 on financial speculators.  He is quite harsh on the fools like me, who thought rising food prices reflected resource scarcity.

Here is my question in his comments section:
I don't understand how speculation could raise food prices for more than a few months. 

The financial speculators are placing bets on the futures market.  If they expect prices to go up in January, they will buy a contract today that guarantees them a certain amount of commodity in January.  When January comes around, they sell their paper commodities on the ordinary spot market.  If they are correct that prices rose, they make a profit, because their January sale is more than the price they originally paid. 

An essential feature of this game is that the speculators do not want to take possession of a ton of corn or soybeans.  For speculators, the game is not "buying and more buying," it is "buying and then selling."  The buying drives up prices, and the selling drives down prices.  Commodity futures are different from "dot com" stocks, which can be held for a long time.

Basically, I find it much more plausible -- as an economist and as an environmentalist -- to see rising food prices as a symptom of real resource scarcity.

But I'll keep an open mind.  Can somebody explain more clearly: beyond the first few months of a speculative boom, how can financial speculators keep driving the price higher and higher?

21 comments:

rjs said...

the way speculators could cause food prices to rise would be if speculation-driven rising prices causes hoarding and reduces supply...

we saw something like this occur last year after the russian fires destroyed 25% of their wheat crop; india, indonesia, & other countries stockpiled wheat because of rising prices, driving prices even higher...

Parke Wilde said...

That's just the situation in which I worry most about speculation, too. Just as a new crisis is going down, speculators can enhance the panic.

But, this still leaves me doubtful that speculation is responsible for the post-2007 increase over several years.

In the examples you cite, how long did the speculators influence the market? And if more than a couple months, can you explain how it worked?

rjs said...

it's nothing i can quantify; its just something i believed i was observing at the time...

like you, im skeptical that speculation has any lasting effects on the prices of commodities...but rising prices (or falling prices) over a period of time tends to influence behavior of the end users, which exacerbates the trend....

steve said...

I'm wondering about this question -- because "speculators" are not at all a monolithic lot, acting in unison.

Rather, some are buying while some are cashing in and all the churning in the market stimulates increasing numbers of players (and computer programs) looking for a piece of the action to enter over time -- making prices spiral higher and higher long term....

rjs said...

my understanding of the futures markets, for every long contract, there has to be a short; which means that someone had to have written a contract to sell that paper commodity to those speculators who bought it...that means that at any given price there are equal numbers of speculators betting that commodity would go down from that price as there are betting that it would go up...

Anonymous said...

These entry of a new class of "investors" betting large quantities of capital between themselves raises the risk premium of the system because of the greater price volatility due to very large amounts of capital fluxing in and out of short and long positions. A variance increase if you will. This can become a permanent condition as positions obviously have to be settled but the capital can get recycled into the next round of contracts. The larger amounts of capital in play and greater swings may also creater a greater incentive to manipulate the notoriously hard to track physical agricultural commodity inventory.
Not something very well accounted for in the nice rational expectations, frictionles models.

Parke Wilde said...

The frictionless model, like the efficient market hypothesis, is a straw dummy.

My question is more practical. Unless the speculators are actually taking possession of tons of food (which I doubt), how can speculation be responsible for medium- and long-term price increases?

I can believe that speculation would increase volatility, and I can believe that it would increase prices in the short term during a panic.

Trying to figure out how my assumptions could be so different from Philpott's, I've been reading his sources. Like the UN report, which says:

"Although all interviewees stressed the role of fundamentals in medium- to long-term commodity price formation, they conceded that substantial price distortions and herding effects could occur in the short term due to the participation of financial investors."

That pretty much sums up what I thought the situation might be.

freude bud said...

You might find the relatively recent post by James Hamilton on financial speculation and its role in high oil prices apposite: http://www.econbrowser.com/archives/2011/08/fundamentals_sp.html. One key point is that commodities which are only cash markets--have no derived futures market--also posted major gains in price. So, if index and pension funds and ETFs are responsible for the high prices, why, then are markets where said financial speculators cannot play a role also experiencing dramatic highs? It's one of the better pieces I've seen on the role of speculation in the oil markets in some time. (He and Jing Cynthia Wu recently put out a longer paper on the role of speculation in the oil markets which I haven't had time yet to read, but which also may prove enlightening: http://dss.ucsd.edu/%7Ejhamilto/hw4.pdf .)

freude bud said...

Players like Glencore could be buying up cash commodities speculatively, though I would guess there's a very low likelihood of hoarding.

Stephanie said...

did you get any responses to your question in the comment section of Philpott's article? And can you clarify what you mean by resource scarcity? Are you talking about the food itself?

I am not an economist and I have a hard time wrapping my head around the discipline, but your question sent me searching. See if this provides any answers: http://www.loe.org/images/content/080919/Act1.pdf

Stephanie said...

Also this: http://www.alternet.org/economy/93887/hot_commodities,_stuffed_markets,_and_empty_bellies_--_finance_industry_fuels_the_food_crisis/

rjs said...

it would be good to get a long term perspective on food prices:

adjusted for inflation, grain prices this this past decade are less than half that of the 40s:

http://earlywarn.blogspot.com/2011/03/long-term-crop-prices.html

Parke Wilde said...

The Alternet article that Stephanie linked is quite good. Here is the conclusion:

"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."

Stephanie said...

So, ultimately, what those traders are doing is trading in scarcity, and making huge profits off of it. That seems immoral on its face. So, really, its not an either/or question (resource scarcity vs commodity trading) in terms of ultimate answer. It's a "both of them" question, i.e. a global food system that animates in the context of scarcity and global corporate capitalism.

Great question, Parke.

Parke Wilde said...

Now finally read freude bud's Hamilton link also. Terrific explanation, in the case of a different commodity (oil), why speculation cannot possibly be the main cause of price increases.

freude bud said...

There's another element where hoarding is taking place, in part because commodities have been seen as good collateral for credit. See this post from Mish Shedlock which excerpts from an email report from Michael Pettis of China Financial Markets, which observes that China's take of the global commodities markets is quite a bit larger than its relative GDP, nominal or PPP -- http://globaleconomicanalysis.blogspot.com/2011/05/ponzi-financing-involving-copper-trade.html . Note that Pettis thinks the same collateral system is being used for soya, then look at the tables showing for food commodities China's share of the global total. This may well be a contributing factor.

freude bud said...

I'd be interested to get David Graeber's take on that one.

Anonymous said...

rjs and freude bud: those are the most enlightening comments/links on food price speculation that I have read in a year. Big thanks!!!

K McDonald said...

Parke,

I have covered this subject on my blog before, after Scott Irwin sent me some information which enlightened me. Now, someone sent me the new study out from Cornell. Please, what do you think?

[http://arxiv.org/PS_cache/arxiv/pdf/1109/1109.4859v1.pdf]

Kay @ Big Picture Agriculture

Anonymous said...

despite the fossil fuel-dependency of modern agriculture, drawing parallels between oil and food items just because the they all are labeled 'commodities' seems somewhat problematic to me. yet, if it helps you understand the difference between cash-settlement and physical delivery in derivative contracts, a first big misunderstanding is cleared. the missing piece, apparently, is the "for every long, there must be a short". so true, so reassuring that you should discard it at one. oil is certainly dealing with peak/near peak, but what if (in the era of near zero interest rates ... with the trimming starting around 2007!) the big bubble has just moved somewhere else? is it just resource scarcity that is driving US farmland prices or the global farmland grad? for sure, the food prices problem is in sour need of much more attention and honest analysis.

Anonymous said...

This may shed some light on the subject:
http://harpers.org/archive/2010/07/0083022