Commodity and Food Speculation, Is there a Need for Regulation?
Christian A. Conrad,
University of Applied Science HTW at Saarbrucken, Germany
Here is an issue that will keep academia fired up: What are the links between speculation and volatility? The discussion has caused abundant publications whose conclusions are both countless and conflicting.
We highly recommend this except from a paper written by Professor Christian Conrad1. He reports on not only the recent publications but also the complex approach to speculation in agricultural markets and its impact on food security, and ultimately the need to regulate excesses.
While speculation in agricultural markets has always existed and has shown its usefulness to cover market risks when it is reasonable, the magnitude it has taken since the early 2000s tends to increase volatility, especially through the existence of new operators in these financialized markets.
This is why the uncontrolled liberalization of agricultural markets would lead to facilitate the development of this speculation, and thus amplify price volatility. In fact, so that unregulated trade liberalization stabilizes and directs steadily rising agricultural prices, we would need that agricultural markets self-regulate, and that the law of averages allowing wide scale pooling of risks is applied. The historical analysis of prices is contradicting this optimistic view, and the recent price hyper-volatility shows that the sole analysis of the fundamentals of agricultural markets is now not only incomplete but also incorrect to espouse the complex reality of price movements.
momagri Editorial Board
(…) After innumerable studies examining the same thing and coming to different conclusions, it is time to make a change. It is clear that using econometrics proves neither the influence of speculation nor its absence. Additional studies will not change that fact. The two camps of advocates and critics of speculation are still at a draw. Logic should therefore be used as an alternative economic method to analyze the effects of commodity speculation based on known and widely accepted facts.
The Logic of Speculation
Stoll and Whaley argue that investment in commodities is no different than invest in stocks, for example. They fail to note however, that the money flowing into commodities is not productive. No production sites are financed, as may be the case with stocks. Commodity investments do not increase the growth of a national economy. There is also no direct offset for scarcities, such as arbitrage and thus making the most of spatial price differences. An investment in commodities is always in the expectation of future price increases and is therefore speculation. Even if the motivation is to diversify a portfolio, the investor still expects increasing commodity prices. Prices may increase due to scarcity, but there are other causes such as cost increases and inflation. As the utilization of spatial price differences, speculation can balance out future imbalances between supply and demand if the speculation demand leads to a price increase that signals producers to increase their supply. Such a chain of events is not necessarily the case however, since the future scarcity of goods, thus prices different from current prices, is not assured. In order to divert production in the right direction, the speculators must be better informed than the market, which is not generally to be assumed. The opposite is also a possibility, namely that speculation creates a false signal for production.
Speculating at one’s own risk is a fundamental part of a market-based system. New market participants entering both sides of the market through speculation by buying or selling has a stabilizing effect on prices because of the increased liquidity. Gary Cohn, Co-President, Managing Director and CEO of Goldman Sachs New York, argues in favor of allowing non-commercials because where once there were only producers that wanted to sell on futures markets to secure their interests against price fluctuations, now liquidity is available from the other side thanks to non-commercials (Cohn, 2008). With this argument Cohn is forgetting to mention the downstream users of commodities, who are the traditional buyers of commodities and agrarian products on the futures market. In addition, index investors sell differently than speculators because they buy to diversify their portfolios or they want to keep long positions in commodities and risk diversification at a certain proportion to their other stocks. Their profit orientation is also contrary to the downstream users, who want to buy at low prices. Increasing prices attract more investors.
“Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.” (Masters, 2009).
Cheng, Kirilenko and Xiong also show the flip side of liquidity flow. Liquidity flowing in from non-commercials makes the goods dealt on the market fungible, but the 2008 reduction in liquidity put the market under pressure. Emerging markets experienced a similar phenomenon during the Asian crisis of 1997 (Cheng, Kirilenko, & Xiong, 2012).
Krugman considers speculation to be a zero sum game. Every futures long contract is accompanied by a short contract, which is why he does not see any influence on prices. “Buying a futures contract for oil does not reduce the quantity of oil available for consumption; there’s no such thing as “virtual hoarding””. (Krugman, 2008, June 21). One must point out however, that the supply and demand on the spot market may not be influenced, but they are on the futures market.
Of course a futures contract can only be concluded on the futures market if there is a short position corresponding to the long position, but excess demand will only increase prices until a market participant considers the offset lucrative. In short, if everything else says the same, an additional demand for commodities increases prices on futures markets. Even if futures prices do not influence spot prices with a supply scarcity resulting from increased stock holding, it is still possible for expectations to have an influence. Lagi et al. (2011a) have shown this: “… we interviewed participants in the spot market who state unequivocally that they base current prices on the futures market. The use of futures prices as a reference enables speculative bubbles on the futures market to influence actual food prices.”
Krugman is correct in that speculation is in principle a zero sum game. What one actor wins, another must lose. In the case of commodity speculation, the speculators can fulfill an important function by buying forward the commodities from downstream users and thus reducing the risk of price changes. In such a case they fill the purpose of insurance, which also a central argument of those in favor of unimpeded speculation (Pies & Will, 2013).
With such an argument however, we must remember that a producer can meanwhile be facing up to 4 speculators and thus speculation goes far beyond simple insurance. The speculators may buy and sell amongst one another (Domanski&Heath, 2007), which can nevertheless lead to an increase of futures prices with excess demand. The index funds invested almost exclusively long until the peak of 2008, which created a great deal of excess demand (Stoll & Whaley,2009).
Does speculation has an effect on spot prices which would increase the living costs with unethical effects especially for poor countries? The fact is that financialization has caused new market participants to join commodities and agricultural markets with distinct economic motivations. Because the investors were interested in diversifying their portfolios, massive long positions were built up until the financial crisis. Many billions of dollars thus came into the markets as additional demand. Since the investors did not want the commodities delivered, the additional demand ad a direct influence only on futures markets, not on spot markets. This caused an increase in the secure stock profits that, as long as they were greater than the cost of storage, would lead sooner or later to a scarcity in supply and thus to increased spot market prices. We can therefore assume an influence of futures prices on spot prices if the excess demand on the futures market is high and stays high over a longer time period. If commodity and agriculture producers think futures prices are at a historic high they will sell their production forward, which removes the supply from the future spot market.
Increasing prices for end and intermediate goods involving commodities and agriculture product are also possible if the downstream producers secure their positions on futures markets at a high price level. So we come to the conclusion that speculation influence spot prices of commodities and food prices if it creates a significant excess demand over a significant time period. In this case speculation might be seen as unethical, why regulation should be discussed.
1 The complete text of the paper is available from: http://redfame.com/journal/index.php/aef/article/view/548/494