Category Archives: speculation

Federal Reserve Bank of Dallas Clearly Explains Why Speculation Didn’t Drive Oil Prices in 2008

And that applies similarly to food….
This past week there have been a couple of news items announcing that a large petition by “450 economists” wants to limit global food commodity speculation which is causing high food prices for the world’s poor food consumer. Since I just posted, Round Two. Does Speculation Cause High Food Prices? on this blog ten days ago, I wanted to follow-up by connecting a few dots.

Just my luck, the Federal Reserve Bank of Dallas has just produced a new report which clearly states and illustrates why the oil price peak of 2008 was not caused by speculators but by the fundamentals of supply and demand. (The dynamics for oil are very similar to the food commodities.)

First, about this news item that the world’s “economists” are going after the food speculators:

Economists demand curbs on food speculators

More than 450 economists from some 40 countries, and at institutions including Berkeley, Cambridge and Oxford universities, urged this week’s meeting of finance ministers from the G20 group of leading industrialised countries to “curb excessive speculation” in agriculture futures. The letter, which blamed speculators for “contributing to increasing volatility and record high food prices”, and so “exacerbating global hunger”, demand caps on their positions.

“Limits could be set at a level that would maintain sufficient liquidity in the markets while preventing an excessive concentration of purely financial actors,” the letter said. “Clear limits would provide regulatory certainty, promoting stable and sustainable derivatives markets to the benefit of food producers, consumers and broader economic stability.”

… “On balance, we see more potential upside than downside to ag prices as speculators look to reposition on any sustained risk-on rally,” Mr Deane said.

G20 urged to help end world hunger by stopping commodity speculation

The economists said that proposals to increase market transparency were vital, but would not go far enough to tackle excessive financial speculation. Instead, they urged finance ministers to support a move to cap the proportion of agricultural commodity derivatives markets that can be held by traders. … Deborah Doane, director of the World Development Movement, said that “excessive” lobbying from the finance sector seemed to be delaying political action, both in the UK and elsewhere.

What does the Federal Reserve Bank of Dallas have to do with it?

Those concerned need pointed to this new report out from the Federal Reserve Bank of Dallas by Michael D. Plante and Mine K. Yücel which so clearly demonstrates and concludes that that market fundamentals, and not speculation, were behind the dramatic rise and fall in oil prices, the dynamics of which, are similar to food prices.

In the explanation, after going through hoarding possibilities, and comparisons to a few commodity movements not having futures markets that mirrored oil’s move, they conclude that the commodity movements were “consistent with a pure demand story, rather than a speculation one.”

This chart demonstrates the dynamics of the price movement quite well:

I hope this helps the doubters out there. I have been occasionally visiting a TED sponsored discussion thread about this that is attempting to convince readers that speculation is causing dangerous food price movements and many assume and believe this because it seems right to them (faith-based). I am grateful to Scott Irwin and a few other key economists such as Paul Krugman, Andy Harless, Michael J Roberts, James Hamilton, Mark Thoma, and Parke Wilde, who have helped educate me on this issue, along with others rjs, jjb, and Nevil Speer. And, lastly, if people want to go after something causing global high food prices, they need to go after the corn ethanol policy here in the U.S.
——Kay McDonald

UPDATE: 5 minutes after posting this I’ve seen the Bloomberg article “For those who say no evidence exists linking excessive speculation and prices, they just aren’t looking,” CFTC Commissioner Bart Chilton said today in a statement. “Scores of studies and papers exist which document the linkage.”

See: Businessweek article here

Round Two. Does Speculation Cause High Food Prices?

They’ve been pouring across my desk lately, the seemingly credible main stream news and high level PDF studies proclaiming that the global food commodity prices are being driven by speculation.

Since my March 2011 post, Are Speculators to Blame for High Food Commodity Prices? No, and this Explains Why, has anything changed? Where is all of this media momentum coming from of late?

Blaming speculators for high food prices has come from recent sources which include der Spiegel, Mark Bittman, Derek Thompson at The Atlantic, Tom Philpott, Tom Laskawy for Grist, The Guardian, Cornell University, and less recently, Oliver De Shutter, and Nicolas Sarkozy.

To begin with, here is a short list of some of the information that’s been presented:

1. Just this morning, in Mark Bittman’s news items (NYT’s), he included this:

Evidence is growing that financial speculators are responsible for the rising price of food. So the Commodity Futures Trading Commission just released new rules to curb excessive speculation, and the result is — you guessed it — a giveaway to speculators.

2. Last Saturday morning, Drumbeat, over at The Oil Drum, began with this top news link:

When food prices rise, some blame investors: Earlier this month, the German news magazine Der Spiegel published an in-depth article, called “Speculating with Lives,” looking at what’s driving up food prices. The authors argue that while some of the factors we hear a lot about, such as global warming, biofuels and population growth, are small contributors to rising food prices, they aren’t the main culprit. Instead, the article points a finger at investors who have increasingly fled the financial markets and started trading in commodities such as silver, gold and, yes, food.

3. One of my most valued readers sent me this news link a few days ago, of a new study out of Cornell University:

The Food Crises: A quantitative model of food prices including speculators and ethanol conversion [pdf] — SUMMARY: Recent increases in basic food prices are severely impacting vulnerable populations worldwide. Proposed causes such as shortages of grain due to adverse weather, increasing meat consumption in China and India, conversion of corn to ethanol in the US, and investor speculation on commodity markets lead to widely differing implications for policy. A lack of clarity about which factors are responsible reinforces policy inaction. Here, for the first time, we construct a dynamic model that quantitatively agrees with food prices.

4. From Nourishing the Planet, yesterday:

New IATP Report Shows Excessive Speculation Hurts Farmers and Increases Hunger By Kim Kido – A recent report published by the Institute for Agriculture and Trade Policy (IATP) describes how and why speculative trading has caused agricultural commodity prices to fluctuate wildly, irrespective of actual supply and demand. The report shows how such price fluctuations negatively impact farmers and consumers, and supports regulations that would stop this from happening.

5. And these last two items go back a bit further, this, from the April 2011 Foreign Policy Magazine:

How Goldman Sachs Created the Food Crisis — What was happening to the grain markets was not the result of “speculation” in the traditional sense of buying low and selling high. Today, along with the cumulative index, the Standard & Poors GSCI provides 219 distinct index “tickers,” so investors can boot up their Bloomberg system and bet on everything from palladium to soybean oil, biofuels to feeder cattle. But the boom in new speculative opportunities in global grain, edible oil, and livestock markets has created a vicious cycle. The more the price of food commodities increases, the more money pours into the sector, and the higher prices rise. Indeed, from 2003 to 2008, the volume of index fund speculation increased by 1,900 percent. “What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets,” hedge fund Michael Masters testified before Congress in the midst of the 2008 food crisis.

6. From the United Nation’s Oliver De Schutter (September 2010):

Food Commodities Speculation and Food Price Crises [pdf] SUMMARY: In this briefing note, the UN Special Rapporteur on the right to food examines the impact of speculation on the volatility of the prices of basic food commodities, and he identifies possible solutions forward. The global food price crisis that occurred between 2007 and 2008, and which affects many developing countries to this day, had a number of causes. The initial causes related to market fundamentals, including the supply and demand for food commodities, transportation and storage costs, and an increase in the price of agricultural inputs. However, a significant portion of the increases in price and volatility of essential food commodities can only be explained by the emergence of a speculative bubble.


So, Once Again, Does Speculation Cause High Food Prices?
Let us review this subject of speculation and food prices and see if any new issues have surfaced. If you missed it, my first post about this was quite simply stated, using easy-to-understand writing by Nevil Speer and some key questions which were answered by Scott Irwin from the University of Illinois-Urbana.

With all of the new articles out there and the media attention given to this subject, I contacted Irwin again, and he graciously replied to my new questions as follows:

Q: In your opinion, has anything changed since my post quoting you explaining that speculation doesn’t cause high food prices?

My views have not changed. However, I think some terms are thrown around in a confusing manner. Here is the way I describe the issues. The main point of argument is whether a huge wave of commodity index investment/speculation has overwhelmed the normal supply and demand functioning in commodity markets, including food, and created a massive bubble. It is important to recognize that the charge is a “massive” bubble, leading to, say, crude oil or corn prices 30, 40, 50% above fundamental value. Take your pick. The key is that prices are way above “fundamental” value. I like to call this the “Masters Hypothesis.” If this hypothesis is true it would indeed represent a large and deeply troubling market failure that could signal the need for costly new regulations to “throw sand in the gears” of the markets. I have not seen a shred of compelling evidence that the Masters Hypothesis is valid in any commodity futures market, including those for food products.

But that is not the end of the story. Something else may be going on that it is best considered using the term “financialization.” I use this to refer to the process of opening commodity markets to much wider participation via electronic trading/web access, commodity index investments, and ETFs. It is important to realize that all of these have worked together to increase participation and trading. Think of this as new technology that broke down old barriers and significantly drove down the cost of trading, particularly for non-traditional participants.

The structural changes wrought by financialization may change pricing in commodity futures markets. I emphasize “may” since the research in this regard is just beginning to roll out. It is also important to emphasize that economic theory predicts that these types of changes are not expected to be large but potentially long lasting. For example, a recent paper by Jim Hamilton and one of his students indicates that risk premiums in the crude oil futures market may have been driven down by the forces of financialization. This is a sensible and POSITIVE outcome as risk premiums represent the cost that hedgers pay to speculators to bear the risk they want to avoid.

The basic story is you open the markets to wider participation and the cost of shifting risk goes down. Who would be against this outcome? Other work focuses on liquidity costs and other types of market impacts. It is critical that readers understand that evidence like Hamilton’s has no bearing on what I called the Masters Hypothesis. Proponents of the Masters Hypothesis pounce on evidence like Hamilton’s as “proof” but nothing could be further from the truth.

Q: Do you feel any regulatory changes need to be done (today) to help protect the food commodities from speculation?

No. What has and is being proposed is counter-productive.

Q: If your position remains the same as previously, do you have any words of rebuttal for any of the articles or studies I’ve listed?

Der speigel: The IFPRI work by Torrero et al has not fared well under careful academic scrutiny. See my own work and that of my colleague Brian Wright. If you want to send readers to just one resource on this issue PLEASE refer them to Brian’s paper found here [PDF].

I have taken a look at the Cornell study. The analysis is simply not credible. Existing Granger causality analysis is simply dismissed with a single sentence. Not cool. Even more troubling is their approach to the inventory question. As is well known by now, if a bubble is created in a market for a storable commodity, the excess of supply over demand at the higher bubble price has to show up somewhere—in inventories. The authors conduct interviews with traders and wave this around as proof on this crucial question. Again, not cool. For the truly cynical, look at their figure on the fit of their model and corn prices I was taught in my first econometrics course was to be very, very skeptical of any model that nearly perfectly fits the data. Draw your own conclusions.

De Schutter: Hand waving and unserious analysis. Starts with conclusion and works backwards to fit the data to desired story.

Since all grain commodity futures contracts which are bought must also be sold, speculation should not cause more than short term price changes although it might contribute to volatility. The non-linearity between price and grain inventories during perceived times of scarcity might be the reason that some jump to the conclusion that speculators are causing rapid price rises during these time periods of real or perceived scarcity.

The work by Brian Wright, which Irwin refers us to states, “The recent history of grain markets supports two conclusions. First, the price spikes of 2008 and more recently are not as unusual as many discussions imply. Second, the balance between consumption, available supply, and stocks seems to be as relevant for our understanding of these markets as it was decades ago.”
——Kay McDonald

Are Speculators to Blame for High Food Commodity Prices? No, and this Explains Why.

photo: flickr

In this post, I have the good fortune of having permission to use the writing of two Ag/Economic experts on the subjects of:
  • why people think that speculators drive food commodities
  • why speculators, in actuality, do not drive food commodity prices

At the risk of discrediting myself, I have held back on this subject, therefore this post is long overdue. When I (reluctantly) listed “speculation” in a list of reasons for higher food prices sometime back, I had three friends who are a lot smarter than I am each give me a gentle and polite nudge suggesting that this was not the case. Since I rarely get this type of feedback on anything, the good news is, I must be right about everything else (laugh out loud), but it also meant that I’d better pay attention to what they were telling me.

So, I continued to try to educate myself on the subject, reading Paul Krugman’s take, the Naked Capitalism/Paul Krugman Debate, reading Bloomberg and others as they continued to blame speculators, listening to video talks, and the like. Still, I was getting conflicting information and not ready to make a proclamation on this blog.

The first friend who challenged me on this subject linked a Paul Krugman post and told me I should read the Sanders and Irwin paper which Krugman referenced below his post. Imagine my surprise when the third person who contacted me was Irwin himself, whom Krugman cited. I was humbled to have Scott a reader here, but also delighted to have his expertise for consultation.

To present the explanation, I have chosen the writing of Nevil Speer PhD, University of Western Kentucky. He explains it as clearly and simply as I have seen in writing to date. Then, following his article, I have added some critical material given to me from Scott Irwin to help complete the understanding.
K. McDonald


The following is from Agsight March 2011 by Nevil Speer, PhD, MBA of Western Kentucky University:

“Food prices have sparked a media feeding frenzy of late.” That observation from last month’s AgSight stemmed from the seemingly unending stream of headlines about the current inflationary environment. Such widespread media attention is relatively new – the business surrounding agriculture and food production doesn’t normally attract much attention. What isn’t new is the finger pointing.

More specifically, the commodity run of late has revived long-standing accusations about speculators. They’re the alleged culprits of higher prices and accused of unduly profiting from their respective commodity positions. Meanwhile, the rest of the world suffers the fallout – especially significant in the food arena.

That sentiment was on clear display at a recent meeting of international farm ministers in Berlin. The consortium collectively declaring that, “excessive price volatility and speculation on international agricultural markets might constitute a threat to food security.” And some were individuals were harsher yet; for example French Agriculture Minister Bruno Le Maire: “We don’t want to accept this speculation on agricultural commodities, which…enriches a lot of people but which impoverishes the rest of the planet.” In other words, speculator positions are “excessive” and circumvent underlying fundamentals.

It’s one thing to hear foreign ag ministers condemn the role of speculators in the futures markets but it’s another matter when a market regulator (Bart Chilton, Commissioner, CFTC) does so: “Some people are arguing that we are seeing ‘delinked prices – prices ‘delinked’ from true demand and supply…I’m not an economist. I can’t say what percentage is due to speculation. But it’s easy to find evidence that they are having an impact.” That’s a troubling observation on a number of fronts.

The political rhetoric conveniently avoids market realities. One, futures markets are a zero-sum game: every contract mandates a buyer on one side and a seller on the other (yes, it’s that simple). Hence, hand-wringing about speculative buying is a one-sided venture; there must be an equal value of willing sellers on the other side. Two, in light of simultaneous and balanced price agreements, it’s impossible to assert whether speculators are actually driving the trend or simply chasing it. Lastly, speculators possess no association with the physical product.

Therefore, the only means by which speculative buyers can impact the spot market is to take delivery and remove the physical product from the marketplace. Dr. Craig Pirrong (Professor of Finance and Energy Markets, Univ. Of Houston; summarizes futures markets like this (Regulation, Summer, 2010):

…even if speculation caused prices to go up, that does not necessarily imply that prices were too high as a result. It is possible that speculators recognized that prices were too low (given fundamental information) and that their buying moved prices to the right level…[and] although the speculator may buy, he is almost invariably a seller when a commodity futures contract nears delivery. This would suggest that even if his initial purchase drove up prices, his subsequent sale would drive down prices. Absent some (unexplained) asymmetry in price response to the speculator’s purchases and sales, it is difficult to understand how his actions could affect the prices consumers pay and producers receive.

In other words, placing blame on one side of the equation (non-commercial longs) is misplaced. As alluded above, none of this is really new. Historically, though, the assertions have arisen from the other direction. That is, speculators force prices lower (not higher) with producers being the casualties (not end-users). Charles Geist (Wheels of Fortune: The History of Speculation from Scandal to Respectability) cites a popular 1880’s publication entitled, Seven Financial Conspiracies That Have Enslaved the American People. Geist explains the publication’s theme was, “…to show how the average agrarian was at the mercy of the Wall Street crowd that cared only for money, not products.” So either way, the speculator is to blame.

Food prices are driven, like any other market, by supply and demand. Markets work: higher prices occur because of relative scarcity fundamentals: tight supplies amidst strong demand and forecasts for the ongoing continuation of that trend propel the market higher. Simultaneously, price volatility is amplified as scarcity (or at least the perception thereof) becomes more extreme. Moreover, we work in a new reality; money flow occurs faster (24-hour, electronic trading) and with more breadth (globally, across all classes of assets) than ever – that makes for more active markets.

Reining in speculators seems politically expedient. But we live in complex times. Throwing darts becomes perilous when policy makers begin to advocate (and worse yet, actually believe) that speculators should be removed ag / food markets. Such a move would dismantle futures markets. Imagine what the world might look like a without market liquidity, price discovery and risk mitigation; not to mention the inability to establish pricing plans, attract new capital investment and stimulate innovation across the food business. The absence of those influences, facilitated by futures markets, would ultimately lead to less global food security – NOT the other way around. Taking speculators out of the mix would be devastating.

[END Speer Article]

Next, are Scott Irwin’s responses to some questions I posed to him.

First, I asked him why Bloomberg was wrong for blaming speculators for driving oil prices up lately. (His answer applies to food commodities, as well.)
I don’t doubt that speculators are moving from food to oil, but the question remains whether the speculators are following price trends or causing the price trends. The flow of speculators across markets could have a price impact but I would expect it to be temporary in nature and only last a few days at most.

The available research indicates speculators as a group are trend-followers, not trend-makers. Certainly, some speculators are able to anticipate trends and they therefore look like “trend-makers,” but over time this can only be true in a reasonably competitive market if they possess valuable private information or are better at interpreting public information than other traders.

So, to my way of thinking (admittedly very econocentric) the key driver of price trends is changing information about supply and demand prospects. In terms of current events, I believe the price moves generally reflect the best information available about market conditions.

Obviously this is an incredibly dynamic and volatile situation, so there will be large differences in beliefs/perceptions about supply and demand prospects and it is very hard to sort the wheat from the chaff in real time. And when it is so difficult to peer into the future it is tempting to ascribe causality to something that is tangible and measurable—changing positions of speculators.

Next, I asked why wheat prices went up more than 50% the last part of 2010 when supply had remained fairly constant:
In terms of the wheat market specifically last fall, I think the run up made good sense given that there was a truly tight supply in HRW due to production problems in Russia. Looking at the all wheat figures masks what was going at the margin in hard wheat. The other classes had to move in tandem to maintain price relationships.

This next statement and graph from Scott is most critical to understanding the concept:

In addition, the wheat price move also reflected the fundamental “non-linearity” in the relationship between inventories and price. The figure above, drawn from Wright (2009), illustrates this point. Note that a given reduction in quantity due a to supply and/or demand shock will have a much larger impact on price when starting with a low quantity (inventories) compared to when starting with a high quantity. It also implies that relatively minor reductions in quantity can result in very large increases in price when the market supply/demand balance is especially tight. This is a key point that I think is missed by many people.
[END Irwin answer]


For further references, see Dwight Sanders and Scott Irwin’s most recent paper on this subject here: Index Funds, Financialization, and Commodity Futures Markets.

Paul Krugman: Commodities, This Time is Different; and Nobody Believes in Supply and Demand.

Note that Scott Irwin PhD, University of Illinois, has a newly revised and updated agricultural news blog site, “Farm Doc Daily” which you may access from the left sidebar here.