Some thoughts about price volatility and
speculation in agricultural commodity markets
Brice Hugou1, Programme Lascaux
The failures of the global financial architecture are unquestionable and a continuing concern for several decades. For the past twenty years, the erratic and uncontrolled development of OTC markets has generated excessive speculation in commodity markets, especially agricultural commodity markets, and led to the food price hyper-volatility at the root of the 2007/2008 food crisis.
We highly recommend this excerpt of a collective work conducted by the “Programme Lascaux”2 that reports on the existing links between volatility and speculation on food commodities in a clear and informative manner.
From the necessity to cover market risks to the excessive and uncontrolled speculation resulting from the growing financialization of agricultural markets, Brice Hugou reviews the evolution of the nature and terms of contracts signed between sellers and buyers, before they became “mere management tools of price risks” disconnected from agricultural realities. Hence, increasing market transparency and regulating both physical and futures agricultural markets seems like an overriding objective.
momagri Editorial Board
The definition of food security given by the FAO in 1996 specifies that it “is assured when all people, at all times, have economical, social and physical access to adequate, safe and nutritive food that provides them with nutritional requirements and food preferences to lead an active and healthy life.”3 Although it is as vital as air for mankind, food nevertheless remains a product than can be traded. Consequently anybody wanting to feed himself must be able to produce––or buy––what is necessary to sustain his livelihood. People’s economic access to food therefore presumes that it is marketed at reasonable prices for both sellers and buyers. So it is appropriate to examine this price-setting process.
The very nature of agricultural activities makes setting prices at ideal levels a very difficult task, since farming is taking place over time and must deal with the various hazards affecting sellers’ production volumes and buyers’ requirements4––that is to say supply and demand. In fact, between the time when farmers are making the decision to sow the seeds and the time when they harvest and then sell their crops, many weeks and month will pass. And yet the occurrence of climate, economic, political or even social events might upset the balance between supply and demand that existed at time of sowing, which might generate the strong price volatility that many have tried to surmount.
At various times and places, public authorities have certainly attempted to control food prices to safeguard food security by avoiding shunning price setting for the sole confrontation of supply and demand. In Ancient Egypt for example, certain laws did set maximum prices from which it was impossible to deviate, or face sanctions5. The same applied in Greece6 or in France with some of Charlemagne’s legislation. But most of such measures were poorly received and deemed unsuitable to trade requirements, and were finally eliminated to let markets set prices.
In practice, managing of food prices is mostly conducted at the time of transactions between sellers and buyers. In fact, by modifying the terms of sales contracts, they created tailored-made contracts that allowed both trading and controlling price volatility. Initially, the modifications simply involved adapting contracts to the span between production and sales by adding what can be retroactively qualified as suspensive conditions.
This will in fact defer the time at which the commitment becomes due––thus agreeing on the price to be paid and the goods to be delivered at the time of the contract arrangement––and only actually pay the price and deliver the goods later. By disconnecting the steps of contract formation and execution, covenants were adopted to neutralize the impact of time on the trade value of goods. Contracts were thus modified to include a new purpose. Admittedly, it still concerns transferring ownership of goods, but at the same time it also protects contractual partners from price fluctuations by creating “a closed and protected world that is impervious to internal or external influences, […] that stands the test of time without being impacted by change.”7 Once contracts are signed, it does not matter that market prices are not the same than when contracts are executed: The parties committed to deliver the goods and pay the determined price remain bound by contracts. They are thus protected from being subjected to market price fluctuations and are getting what was promised at time of commitment.
But while contracts proved to serve as very effective tools, the fact of letting the private sector control price fluctuations nevertheless generated some consequences, since public authorities set standards to ensure food security while private persons primarily seek to safeguard their own interests. Yet contracts remain instruments whose use relies of the will of parties, and contracts allowing price volatility control can also be used with opposing views of risk protection (“coverage”) and its abuse (“speculation”).
As one might expect, since it was the objective of their creation, contracts were first used for coverage operations. Buyers who feared rising prices formed contracts with sellers who feared price declines, and therefore mutually protected themselves from any price fluctuation that could penalize margins. However, there cannot be a permanent perfect fit between those who want to hedge against high and low prices. Yet, this absence of balance might lead to the inability of some to get coverage due to the lack of available contract partners, which required the involvement of third parties. Such third parties have historically been the first speculators: They are accepting to take the place a buyer or a seller in the framework of a contractual agreement in order to provide risk coverage. By doing so, they are incurring the risk of losing money, but are really hoping to turn a profit. If prices rise, speculators/buyers might sell their just-purchased wheat at a higher price. Sellers, for their part, would have lost the opportunity to get a good deal but would not lose money. Conversely, if prices decline, speculators would lose money while sellers will not be subjected to the impact of lower prices.
The problem is that these contracts encountered such a success that they were assimilated into markets, and gradually became basic tools to manage price risks, thus relinquishing their primary aim of supporting trade transactions. When markets are allowing a large number of sellers and buyers to trade goods, they are playing the role of price indicators for these goods, and impact all contracts entered into, even outside of their premises. While the ability to control price risks was initially only a secondary effect of contracts, whose key objective was to trade food commodities, it gradually became the main goal of contracts. In fact, market rules have altered the terms of contracts, and introduced legal arrangements that render the transfers of good no longer compulsory but only optional. In practical terms, this led to an almost total disconnection between trade and price risk management operations8.
Food commodities are consequently considered among other financial assets in market rules, and no consideration is given to the specific character they derive from their vital nature.
As far as economics is concerned, the transition was a genuine success since markets experienced exponential growth. But if there were initially ten traders seeking risk coverage to one speculator, the ratio has now been reversed and speculators are much more present. It thus seems that food commodity prices are strongly influenced by financial market prices, which are determined by mostly speculative and non-commercial transactions. Obviously, the system is quite effective for insiders. Yet without outside intervention, we are talking about a system whose effectiveness is only measured when compared with its intrinsic performance, and which sets aside any concern for food security.
But saying that speculation only has negative aspects is a step we will not take. First, because we have already emphasized the usefulness of speculation for those seeking to protect themselves from price fluctuation risks. Then because even if speculation is accepted, it should only be in respecting certain rules that aim to make sure it does not affect the free setting of prices. Nevertheless, this must not hide the fact that increased speculation has forced markets to adopt practices that are sometimes too artificial, which can be worrisome when they contribute to setting prices for the agricultural commodities we eat. Indeed, the volumes of food commodities included in contracts in financial markets are such that if all were asking to take delivery of wheat for instance, there would certainly be not enough wheat throughout the world to fulfill these contracts. If markets are ultimately becoming places where “people sell what they do not own to people who do not want it”9, can we consider that we are really dealing with the supply and demand of agricultural commodities?
It is true that if one only literally reads contracts, they take the form of sales including due dates, and when the terms become due, buyers will take delivery of the goods and pay the price to sellers. But the procedures introduced by markets are circumventing this system by eliminating the transfer of ownership in favor of payment of money. Market prices are thus set by the number of contracts that might lead to trade transactions, but will not do so for most of them.
This is why, without outlawing speculation in food commodities––which has been repeatedly attempted without success––it seems valuable to return some “legal order” and non-market values in the economic operations of markets to lessen the negative effects they can generate on commodity prices, while maintaining their economic effectiveness.
1 Brice Hugou is a doctoral student at the Nantes School of Law and Political Science, IRDP (E.A.1166) and a member of the “Programme Lascaux”.
2 The “Programme Lascaux” is a European legal research program under the scientific leadership of François Collart Dutilleul. The complete work has been published by Editions Inida and is available on the website of the “Programme Lascaux”
4 J. Cordier, “Assurance, marchés financiers et puissance publique”, Économie
Rurale, 2001, n° 266, p. 111; F. Declerck and et M. Portier, “Comment utiliser les marchés à termes agricoles et alimentaires”, France Agricole, 2007, pages 19-21.
5 A. Berg, “The rise of commodity speculation: from villainous to venerable”, in
Safeguarding food security in volatile global markets, edited by Adam Prakash,
FAO, 2011, p. 242, partly quoting J.P. Lévy, “The Economic Life of the Ancient
World”, University of Chicago Press, 1967.
6 W.H. Waddington, Diocletian’s Edict setting maxima in the Roman Empire, 1864, p.5.
7 C. Thibierge-Guelfuccci “Libres propos sur la transformation du droit des contrats”, RTD civ., 1997, p. 357
8 In financial markets, 97 percent of contracts are not executed by the delivery of goods, thus representing blatant operations to manage price risks.
9 M. Rothstein, “Frank Norris and Popular Perceptions of the Market”, Agricultural
History, vol. 56, No. 1, January 1982, p. 58.