For the past few months, the civil society and various governments have acutely criticized the speculation on agricultural commodities. Even Pope Francis at The Vatican recently condemned a practice that treats agricultural commodities “as any other good by disregarding their primary purpose”, and ultimately worsens world hunger.
A resurgence of speculation in agricultural futures markets has been recorded since November 2008. As useful as speculation might be in covering market risks when its levels are moderate, it becomes a destabilizing factor when it reaches excessive levels. Confronted to a disturbed system marked by endogenous and exogenous uncertainty, uncontrolled speculation can act as an amplifier of agricultural price volatility.
We highly recommend an article excerpted from a report on “The Involvement of Belgian Banks in Food Speculation” published in June by a collective of NGOs2
. The authors of the report insist on the imperative need to regulate markets––including the OTC markets known for their opacity––as we face the improper use of speculation on food commodities, and its impact on price volatility.
If regulatory tools are lacking, it is clear that standard economic models, especially those used in modeling the EU/US free trade agreement––or Transatlantic Trade and Investment Partnership (TTIP)––cannot account for the reality of agricultural market operations. The momagri economic model––a result of the work conducted since 2006––is today the only model able to model agricultural price volatility by including speculation in futures markets.
momagri Editorial Board
Without regulation, agricultural prices are inevitably volatile
As we have seen, agricultural markets are inherently volatile due to market fundamentals.
However, the higher the volatility, the more problematic it is: it creates enormous uncertainty for food chain actors– be they buyers or sellers. This prevents planning for revenue, activities and investments.
In the past, volatility could be mitigated by the implementation of agricultural policies, for example in Europe, via the common market organizations (CMOs) within the Common Agricultural Policy (CAP).
Historically, global food prices remained stable and relatively low from the 70s until 2006. Then they were affected by increased levels of volatility with two peaks respectively in 2007-2008 and 2010-2011.
Extreme volatility is explained by speculative bubbles
Many studies show that the fundamentals of supply and demand alone cannot explain the turmoil in agricultural markets, which goes well beyond regular volatility. They highlight the role played by speculation. For Olivier De Schutter, Special Rapporteur on the Right to Food at the UN, “many indications show that price increases and volatility in food produce can be explained in part by the emergence of new speculators who generate speculative bubbles.”
The industry itself has admitted that there is a fundamental problem with financial commodity markets. And some banks, by deciding to close a particular fund speculating on agricultural commodities, have implicitly recognized the role of speculation in price increases. Following the campaign by Oxfam France, “Banks: Profiting from Hunger”, launched on 14th
February 2013, BNP Paribas suspended a $214 million dollar agricultural fund and closed another fund partially indexed on raw agricultural materials. Similarly, Crédit Agricole closed three funds. Following a similar campaign led by Oxfam Germany in 2012, DekaBank, Landesbank Berlin, Landesbank Baden-Württemberg, Commerzbank AG and Österreichische Volksbank, all announced they were stopping speculation on food.
In the UK, Barclays announced on 12th
February 2013, their decision to “abandon their speculative activities on agricultural commodities.”
What is not known, nor measurable, is the extent of the influence of speculation on extreme volatility and price spikes. This is due to the deliberate complexity of speculative products, but also the opacity of the sector and the multiple factors that may influence the market and prices.
How do new speculators influence prices?
The food crisis of 2007-2008 coincided with high levels of investment in index funds on agricultural commodities. All index funds on commodities traded on the Chicago Stock Exchange exploded in 2007-2008.
In parallel, we observed that the prices of the 25 commodities that compose the S&P GCSI index increased on average by 183% between 2003-2008.
Price changes in real markets and financial product markets therefore coincide.
Of course, to the extent that prices on futures markets are reference prices for physical markets, when prices on futures markets increase, it sends signals to physical commodities markets and vendors increase selling prices on physical markets.
In a global context where market fundamentals indicate an upward trend in agricultural prices, this group of new investors massively buy futures on agricultural products, sending prices rocketing, until, for reasons of financial strategy, or following a major swing in market fundamentals, they withdraw from these markets. New financial speculators act without any consideration for physical markets or market fundamentals. They adopt herd behaviour and take advantage of their grip on financial markets; they create bubbles that they themselves burst. The critical mass of futures resold by speculators is disproportionate to the physical market (in 2008, in the United States alone, the ratio between the number of futures contracts on wheat and the actual quantity produced was 30 to 1).
When speculators represented only a small minority of players on futures markets, their behaviour and strategy could not disrupt the mechanisms of price formation. Once they become the majority on these markets, they are able to interfere and manipulate prices.
In 2011, the quantity of wheat traded on the Chicago Stock Exchange alone, amounted to more than 4,400 million tonnes, even though the world's annual harvest was only 670 million tons. During the G20 in Cannes, Nicolas Sarkozy, wanting to address agricultural price volatility, pointed out that speculators can exchange each year up to “46 times the annual global production of wheat” and “24 times that of corn.”
The explosion of index funds and OTC markets facilitates price spikes and extreme volatility.
Index funds constitute the dominant group of new investors in food markets and invest in futures on food produce without any concern for the supply and demand for these products.
In fact, index funds are almost entirely a gamble on price growth (termed as “long-term investments”). They put pressure on price increases, since futures contracts must continually be renewed before their expiration date.
And this generates a massive demand for futures contracts. It is estimated that less than 3% of futures contracts on commodities actually result in the delivery of a commodity. The remaining 97% are resold by speculators before their expiration date. This demand drives prices up and results in an upward trend for prices of agricultural produce.
Michael Masters, a prominent former pension fund manager, renowned on Wall Street, explained to U.S. Congress, that during the food crisis of 2008, it was a demand shock – a completely artificial demand - from this new category of actors, which was putting up the prices of agricultural produce not only on the futures markets, but also on physical markets.
In addition, contract “renewal” creates price changes that have the effect of attracting new traders who come to take advantage of the continual sale of contracts to buy and sell them before the expiration date, which amplifies, yet again, price volatility.
According to UNCTAD, the positions taken by index funds were positively correlated with the volatility of agricultural prices between January 2005 and August 2008.
For Watch for Food, the equation is clear: until 2004, the price of grain futures in Chicago varied between 20 and 30% in one year. Since the entry of index funds on the market, these fluctuations now reach 70%. The volatility of agricultural prices can be explained largely by the massive entry of index funds.
As for contracts on OTC markets, their numbers have exploded in recent years. As previously mentioned, they represent more than 7 times the transactions on regulated markets.
The total lack of transparency in purely speculative markets means they can gamble in all impunity.
When we know the harmful effects of the amounts invested in visible funds such as index funds, we should really be worried about the influence of OTC markets on prices.
1 CNCD 11.11.11, 11.11.11, SOS Faim, Oxfam-Solidarité, RFA (Réseau Financement Alternatif), FAIRFIN.
2 The entire report is available from http://www.cncd.be/IMG/pdf/2013-06_rapport_speculation_alimentation.pdf