Has financial speculation in food commodity markets increased food prices?

By Noemi Pace, Andrew Seal, Anthony Costello

Noemi Pace is research fellow at University College London, Centre for International Health and Development. She was previously a visiting researcher at the Centre for Health Policy at Stanford University and the Sphere Institute in the US. She holds a B.A. in Economics, a Master Degree in Development Economics and a Ph.D. in Economic Theory from the University of Rome "Tor Vergata".

Andrew Seal is a Lecturer in International Nutrition at UCL CIHD. His portfolio of work includes epidemiology of micronutrient deficiencies and approaches to enhancing the nutritional quality of food aid; assessment, diagnosis and management of acute malnutrition; nutritional support in HIV/AIDS; and the use of GIS for the analysis of access to programmes. Andrew has worked in Bangladesh, Eastern Europe, and many countries in Africa.

Anthony Costello is Professor of International Child Health and head of the Centre for International Health and Development at the UCL Institute of Child Health, and Director of the UCL Institute for Global Health. His areas of scientific expertise include the evaluation of community interventions on maternal and newborn mortality, nutritional supplementation and international overseas aid flows for maternal and child health.

A different version of the article, shorter and slightly more technical, was published in the Lancet, No. 371, May 17 2008, pp. 1648-1650

WFP food distribution in El Barde, Somalia where rising food and fuel prices have combined with insecurity and a succession of poor rains and harvests

In recent months, prices of rice, wheat, corn, palm oil and other essential staples have increased dramatically, leading to much debate about "the end of cheap food"¹. The causes of, and remedies for, the food crisis are contested and how this rupture in the status quo is resolved will have implications for ecological sustainability, the roles of international financial institutions, and the risk of future nutritional emergencies. In rich countries, food is a relatively small part of household consumption (10- 15 %) but in poor countries, many households (especially wage labourers and the landless) use a large share of their income (40% or more⁴) to purchase food, so food price rises adversely affect their purchasing power by reducing real income. Staples account for most food expenditure for the poorest, so increases in their price are particularly damaging, reducing the amount and quality of food consumed, and increasing the risk of malnutrition and its consequences. In this paper we consider the role that financial speculation in food commodity markets has played in contributing to increases in food prices.

Most analyses focus on changes in demand and supply to explain increased food prices. With rapid economic growth, along with a global population growth, demand for meat and grains (and grain-fed animals) has increased. This rising demand is coming up against supply constraints due to bad weather (a severe drought in Australia, for example)³ and increased production of crops for biofuel. Moreover, the high cost of oil (at over US$130 per barrel) is increasing investment in ethanol production. An additional cause of the food crisis, often mentioned by the media, are export bans. Around 40 foodexporting countries have imposed some sorts of trade restriction of food: taxes, quotas, or across-the-board bans. A study by the International Food Policy Research Institute (IFPRI) predicts that getting rid of these would reduce world cereals prices by an average of 30% (See Figure 1 for a simple diagram of the determinants of higher food prices). Joachim von Braun, the head of the IFPRI, says that international action should focus on four things⁴:

1. Expand emergency responses and humanitarian assistance: food or cash transfers should be expanded and should target the poorest people (even though this kind of intervention may distort local markets).
2. Eliminate food export bans: it could be addressed by an ad hoc forum of global players negotiating according to a code of conduct and in a spirit of "mutual trust building".
3. Undertake fast-impact food production programmes in key areas: a new Green Revolution is needed, consisting of short-term action to promote agricultural growth by improving access to seeds, fertilizers, and credit for the small farm sector package.
4. Change biofuels policies: a range of measures should be considered to make more grains and oilseeds currently used for fuel available for food and feed.

The Food and Agricultural Organisation (FAO) High- Level Conference on World Food Security, held in Rome at the beginning of June 2008, was mandated to tackle the global food crisis but, in our opinion, failed to address effectively several issues⁵. Regarding biofuels, the summit made no headway because there are many different opinions on the effect of an increased production of ethanol on food prices. Some nongovernmental organisations (NGOs) want a moratorium on ethanol output, saying this would cut grain prices by 20%. Parts of the United Nations (UN) bureaucracy and some big food companies say they would support international restrictions on the production of corn-based ethanol. Others argue that biofuels are fine in concept, but the whole system is based on a set of subsidies, tariffs and production targets that should be changed or reduced. Moreover, there is not agreement on the size of the effect of ethanol production on food prices. Estimates ranges between 1-2% by Perrin (2008) at the University of Nebraska at Lincoln and 30% by von Braun (2008)⁶. Regarding export bans, there is no agreement because countries' interests differ significantly. Summing up, the FAO summit did little to address the issues surrounding biofuels, export bans or social safety nets and completely neglected the role of market speculation and trading in commodity derivatives, partly because empirical evidence on the causal relationship between price increase and volume of trading needs further investigation.

Certainly there is a compelling case to examine critically the role of food derivatives in the ongoing food crisis. Without considering the role of speculation, it is impossible to understand fully how any market functions, especially in today's interconnected and electronically-accessible trading system. Speculation might help explain movements in food prices that demand and supply factors are, by themselves, unable to account for. Indeed, there is now convincing evidence that the recently expanded market opportunities in food commodity derivatives has led to large increases in speculative investment, pushing global food prices far higher than predicted by demand-supply effects.

What are food commodity derivatives?

Derivatives are shadow financial instruments that include types of contracts called forwards, futures, options or swaps⁷. The derivative itself is merely a contract between two or more parties that agree to sell or buy a certain quantity of assets, including stocks, bonds, commodities, currencies, interest rates and market indexes, or in this case, food commodities. These contracts may be used as insurance or for speculation. Speculation is "engagement in business transactions (commodities, stocks, etc) involving considerable risk but offering the chance of large gains in the hope of profit from changes in the market price"⁸. Speculative purchasing can create inflationary pressure, causing particular prices to increase above their real value by artificially increasing demand. Sometimes price rises due to speculation cause further speculative purchasing in the hope that price will continue to rise. This creates a positive feedback loop in which prices rise far above the underlying value of the commodity, generating an "economic bubble".

Why should the role of speculation in the current food crisis be taken into account?

First, investments in food derivatives such as futures and options have increased greatly⁹. The website of the Chicago Board of Trade encourages speculators, for example, to "trade to hedge or speculate based on expectations of directional price or spread movement in rough rice". Moreover, most of the recent increase in buying food derivatives has come from large investors who invest mostly for speculation.

Even the investment bankers are suspicious of the role of speculation in global food markets. Jim O'Neill, chief economist at Goldman Sachs, said that the rising demand from emerging countries explained some, but not all, of the price surges. "I see so much focus on food, and it seems to be so trendy in the investment world", O'Neill told The Observer. "The underlying dilemma has been created by the wealth of the BRICs (Brazil, Russia, India, China) countries; but, for the past year or so, it's also been a major theme for financial institutions. The markets seem to me to have a bubble-like quality"¹⁰. George Soros added his opinion. "You have a generalized commodity bubble due to commodities having become an asset class that institutions use to an increasing extent,'' he said. "On top of that you have specific factors that create the relative shortage of oil and, now, also food"¹¹.

There is no consensus in the literature about the relationship between food commodity derivatives markets and price increase and volatility. Some work shows that speculation by large or small traders does not cause sharp changes in prices or volatility and, on the contrary, may provide a useful price discovery role^12,13,14,15. Some other studies show that volume of trading in commodities futures affects commodity prices. Sahi and Raizada (2006)¹⁶ also found that the higher volumes in futures markets had significant causal impact on inflation.

Chan, Fung and Leung (2004)¹⁷ find that, in the Chinese futures exchanges, the volume of commodities derivatives trading has a positive effect on volatility. Yang, Balyeat and Leatham (2005)¹⁸ examined the lead-lag relationship between futures trading activity and cash price volatility for some agricultural commodities and found that the sign of the causality running from unexpected futures trading volume to cash price volatility is typically positive. This suggests that an increase in unexpected trading volume causes an increase in cash price volatility.

Figures 2 and 3 show the trend of price and volume of trading for corn and rice, respectively. In a recent testimony before the Committee on Homeland Security and Governmental Affairs United States Senate, Michael Masters, Portfolio Manager of Masters Capital Management, a hedge fund, suggests that a particular category of investors, the institutional investors, are contributing to food and energy price inflation¹⁹. Institutional investors are corporate and government pension funds, sovereign wealth funds, university endowments and other institutional investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant. Masters' position is in line with a very recent OECD study that states that the sharp increase of prices may be caused by an increasingly large long position (buying contract) placed by institutional investors.

Note: Volume of trading and open interest refer to the primary Y axis on the left (CBOT data: http://futures.tradingcharts.com/chart/CN/M), while price refers to the Y axis on the right (FAO data: http://www.fao.org/es/esc/prices).

Note: Volume of trading and open interest refer to the primary Y axis on the left (CBOT data: http://futures.tradingcharts.com/chart/RI/M), while price refers to the Y axis on the right (FAO data: http://www.fao.org/es/esc/prices).

Masters proposes three actions to reduce speculation on food prices and in particular, to reduce the practice of index speculators. The US Congress should:

• Modify the regulation of pension funds to prohibit commodity index replication strategies because of the damage that they do to the commodities futures markets.
• Act to close a gap in legislation that allows 'hidden' trading in swaps.
• Compel the Commodity Futures Trading Commission to reclassify all the positions in the commercial category of the `Commitments of Traders Reports to distinguish those positions that are controlled by "bona fide" physical hedgers from those controlled by Wall Street banks. The positions of Wall Street banks should be further broken down into "bona fide" physical hedgers and speculators.

The argument is sometimes made that speculation is unimportant because the futures speculators will never take delivery of the actual food; but this is precisely the problem and it is why this speculation is highly destructive of the true market. Purchases of agricultural commodities futures contracts have classically been the means by which a limited number of traders stabilised future commodity prices and enabled farmers to finance investments in future crop production. Speculative purchases have no other purpose than to make money for the speculators, who hold their contracts to drive up current prices with the intention not of selling the commodities in the real market, but of unloading their holdings onto an artificially inflated market, at the expense of the ultimate consumer.

This analysis raises two issues. First, if speculation is a major cause rather than supply/demand factors, then prices would be expected to fall significantly over the next months. Robert Ward, of the Economist Intelligence Unit, expects prices to drop by 9% next year and 18 per cent in 2010. Sean Rickard, from the Cranfield School of Management predicted a 40% drop in wheat prices in 2009. But second, it confronts health and nutrition policymakers with a huge new problem. Speculative food price increases are expected to increase directly the proportion of people who are food insecure and will therefore suffer from hunger and malnutrition. This, in turn, will severely setback efforts to achieve the Millennium Development Goals.

More economic research is needed to fully understand the impact on prices resulting from the large increase in food commodity speculation over the past two years. However, in our opinion there is already compelling evidence that increased speculation is causing adverse impacts on global food prices and there is therefore a need for the commodities futures market to be regulated more effectively.

For more information, contact: Noemi Pace, University College London, Centre for International Health and Development, Institute of Child Health, 30 Guilford Street, London WC1N 1EH, UK.
email: n.pace@ich.ucl.ac.uk
Tel: +44 (0)20 7905 2262

¹"The end of cheap food", The Economist, December 6th 2007. Available at: http://www.economist.com/opinion/displaystory.cfm?story_id=10252015

²United States Department of Agriculture (USDA), Economic Research Service. Available at: http://www.ers.usda.gov/Data/InternationalFoodDemand/

³"Raw deal", The Economist, April 27th 2008. Available at: http://www.economist.co.uk/daily/columns/marketview/PrinterFriend ly.cfm?story_id=11114653

⁴von Braun, J. (2008). Rising food prices: what should be done. IFPRI Policy Brief. Available on-line at http://www.ifpri.org/pubs/bp/bp001.pdf

⁵"Declaration of the high-level conference on world food security: the challenges of climate change and bioenergy", June 2008. Available at: http://www.fao.org/fileadmin/user_upload/foodclimate/HLCdocs/declaration-E.pdf

⁶Perrin, R.K. (2008). Ethanol production and food prices: a preliminary assessment. Faculty publication: Agricultural economics. Available at: http://digitalcommons.unl.edu/ageconfacpub/49/

⁷In the commodity derivatives markets, the most common contracts are options and futures. Options are financial instruments that convey the right, but not the obligation, to engage in a future commodity transaction. A future contract is a standardized contract to buy or sell a commodity at a certain date in the future, at a specified price. A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. The owner of an options contract may exercise the contract, but both parties of a futures contract must fulfil the contract on the settlement date. The seller delivers the commodity to the buyer, or if it is a cash settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling their contract or buying back a short position, effectively closing their contract obligations.

⁸"Speculation". Available at: http://dictionary.reference.com/browse/speculation

⁹"Exchange Volume Report", Chicago Board of Trade. Available at: www.cbot.com

¹⁰"Speculators fuel bubble in global food costs", Heather Stewart, The Guardian, Sunday April 20th 2008. Available at: http://www.guardian.co.uk/business/2008/apr/20/globaleconomy.food

¹¹"Oil Is Little Changed After Retreating From Record on Dollar", Mark Shenk and Samantha Zee, April 18th 2008. Available at: http://www.bloomberg.com/apps/news?pid=20601081&sid=aEPHdFg5Y7L0&refer=australia

¹²Chatrath, A. and F. Song (1999). Futures Commitments and Commodity Price Jumps. The Financial Review 34:95 - 112.

¹³Garcia, P., R.M. Leuthold and H. Zapata (1986). Lead-Lag Relationships Between Trading Volume and Price Variability: New Evidence. Journal of Futures Markets 6(1):1-10.

¹⁴Haigh, M., J. Hranaiova and J. Overdahl (2007). Hedge Funds, Volatility, and Liquidity Provision in Energy Futures Markets. Journal of Alternative Investments 9(4):10-38.

¹⁵Irwin, S.H. and S. Yoshimaru (1999). Managed Futures, Positive Feedback Trading and Futures Price Volatility. Journal of Futures Markets 19(7):759-78.

¹⁶Sahi, G.S. and G. Raizada (2006). Commodity Futures Market Efficiency in India and Effect on Inflation. Available at: http://ssrn.com/abstract=949161

¹⁷Chan, K.C., Fung H.G. and W.K. Leung (2004). Daily volatility behavior in Chinese futures markets. Journal of International Financial Markets, Institutions and Money 14:491-505.

¹⁸Yang, J, Balyeat, B.R. and D.J. Leatham (2005). Futures Trading Activity and Commodity Cash Price Volatility, Journal of Business Finance Accounting, Vol 32, No 1 & 2, pp. 297-323

¹⁹Testimony by Michael Masters available at: http://hsgac.senate.gov/public/_files/052008Masters.pdf

²⁰"A note on the role of investment capital in the US agricultural futures markets and the possible effect on cash prices", OECD. 2008, Document TAD/CA/APM/CFS/MD(2008)6