[NB: Paper is from October 2010.]
Excerpt:
Unlike producers and consumers who use such markets for hedging purposes, financial firms and other speculators increasingly entered the [commodities] market in order to profit from short‐term changes in price. They were aided by the ‘swap‐dealer loophole’ in the 2000 legislation, which allowed traders to use swap agreements to take long‐term positions in commodity indexes. There was a consequent emergence of commodity index funds that were essentially ‘index traders’ who focus on returns from changes in the index of a commodity, by periodically rolling over commodity futures contracts prior to their maturity date and reinvesting the proceeds in new contracts. Such commodity funds dealt only in forward positions with no physical ownership of the commodities involved. This further aggravated the treatment of these markets as vehicles for a diversified portfolio of commodities (including not only food but also raw materials and energy) as an asset class, rather than as mechanisms for managing the risk of actual producers and consumers. At the height of the boom, it was estimated by the hedge fund manager Michael Masters in a testimony to the US Congress that even on the regulated exchanges in the United States, such index investors owned approximately 35 per cent of all corn futures contracts, 42 per cent of all soybean contracts, and 64 percent of all wheat contracts in April 2008. This excluded all the (unregulated) ownership through OTC contracts, which were bound to be even larger.
As the global financial system became fragile with the continuing implosion of the US housing finance market, large investors, especially institutional investors such as hedge funds and pension funds and even banks, searched for other avenues of investment to find new sources of profit. Commodity speculation increasingly emerged as an important area for such financial investment. The United States became a major arena for such speculation, not only because of the size of its own crisis‐ridden credit system, but because of the deregulation mentioned above that made it possible for more players to enter into commodity trading.
This created a peculiar trajectory in international commodity markets. The declared purpose of forward trading and of futures markets is to allow for hedging against price fluctuations, whereby the selling of futures contracts would exceed the demand for them. This implies that futures prices would be lower than spot prices, or what is known as backwardation. However, throughout much of the period January 2007 to June 2008, the markets were actually in contango, in which futures prices were higher than spot prices. This cannot reflect the hedging function and must imply the involvement of speculators who are expecting to profit from rising prices. Indeed it hasbeen argued that contango was so strong that the futures markets were essentially driving the spot prices up in this period.
Then, by around June 2008, when the losses in the US housing and other markets because intense, it became necessary for many funds to book their profits and move resources back to cover losses or provide liquidity for other activities. UNCTAD (2009: 25) notes the sharp decline of financial investment in commodity markets from mid 2008. This caused futures market prices to fall, and this transmitted to spot prices as well.
Thus international commodity markets increasingly began to develop many of the features of financial markets, in that they became prone to information asymmetries and associated tendencies to be led by a small number of large players. Far from being ‘efficient markets’ in the sense hoped for by mainstream theory, they allowed for inherently ‘wrong’ signalling devices to become very effective in determining and manipulating market behaviour. The result was the excessive price volatility that has been displayed by important commodities over the recent period – not only the food grains and crops mentioned here, but also minerals and oil. Such volatility has had very adverse effects on both cultivators and consumers of food. It is often argued that rising food prices at least benefit farmers, but this is often not the case as marketing intermediaries tend to grab the benefits. In any case, with price changes of such short duration, cultivators are unlikely to gain. On major reason is because they send out confusing, misleading and often completely wrong price signals to farmers that cause over sowing in some phases and under cultivation in others. Many farmers in the developing world have found that the financial viability of cultivation has actually decreased in this period, because input prices have risen and output prices have been so volatile that the benefit has not accrued to direct producers.
In addition, this price volatility has meant bad news for most consumers, especially in developing countries. It turns out that the pass through of global prices was extremely high in developing countries in the phase of rising prices, in that domestic food prices tended to rise as global prices increased, even if not to the same extent. However, the reverse tendency has not been evident in the subsequent phase as global trade prices have fallen. In June 2010 the FAO estimated that around 20 countries faced food emergencies and another 25 or so were likely to have moderate to severe food crises. Even in countries that are not described as facing food emergency, the problem is severe for large parts of the population. For example, in India retail prices of some important food items have risen by more than 50 per cent in the past two years, causing great hardship in a country in which just under half the population is malnourished.
So both cultivators and food consumers appear to have lost in this phase of extreme price instability, with the only gainers from this process therefore being the financial intermediaries who were able to profit from rapidly changing prices.
This can easily happen again, unless strict regulation prevents such financial activity. Despite reasonably good harvests in most countries and no likelihood of any serious supply shortfall at the global level, as well as healthy stock‐to‐utilisation ratios of around 23 per cent for most major food crops, prices have started rising. Wheat prices, as shown earlier, have risen more than 70 per cent in just three months. While the export ban in Russia has been blamed for this, the associated impact on global supply is simply not large enough to explain such a sharp price movement. Instead, it is likely that once again financial speculation is driving up wheat prices as index traders and other players move into futures markets for wheat.
While the data on recent OTC contracts in commodity derivatives markets are not yet available, the evidence on what is happening in the regulated exchanges provides some disturbing pointers. Chart 4 shows that after a period of slight decline, numbers of both futures and options contracts in the regulated exchanges have been increasing in the recent past. Once again long positions are dominating the market, suggesting upward pressure on futures prices and thereby also spot prices. This means that all the featuresthat created the recent food price spiral are still in place. In the current volatile situation, it is quite possible for finance to flow in such destabilizing ways once again.