A few weeks ago I investigated the currency markets and their role in our global system. They’re not well known or understood. Neither are the commodities markets. This is one of the more complicated things I’ve tried to write about, so if anyone gets these things more than I do and spots a mistake, please set me straight. There have always been commodity markets of one kind or another, such as the corn exchanges that feature in every English town. They are the meeting places where people trade commodities. These may be mineral based such as oil and natural gas, metals such as gold or copper. They may be agricultural, cotton or wool, livestock, or foodstuffs like rice, wheat, soy and corn.
Speculation, price booms and commodity bubbles are nothing new. The ‘tulip mania‘ of 1637 is considered to be the first economic bubble, when there was a boom in futures trading on tulip bulbs of all things, tulips being an exotic status symbol at the time. Today commodity markets are larger, more centralized, and infinitely more complicated, dealing both in actual commodities and derivatives. We’ve learned nothing about bubbles and the dangers of speculation, as the price of oil and food in 2008 proved. In a globalized world however, the consequences of boom and bust economics are felt worldwide, with the poor bearing the brunt of the fallout, despite being the least responsible.
Spots, forwards and futures
Different commodities are traded in different exchanges. London does metals, Malaysia specialises in Biofuels. There are a number of hubs for oil and for agricultural products. 40% of commodity trading takes place on US exchanges, with a further 25% based in China. It is these hubs that control the price of the things that we need. Stock markets deal in shares in companies, and these are constant and ongoing concerns. Commodity markets are very different. The products they deal in are things that are consumed. If it’s oil, there are old oil fields drying up and new ones coming online, so the market is always changing. If you’re selling foods it’s even trickier, because you have expiry dates to account for, seasons, good harvests and bad harvests. This means there are three kinds of trades on the commodity markets, ‘spot’ trades and ‘futures’.
A spot trade is when an actual product is bought and goods are transferred. Money is exchanged and a product is obtained. Forwards are advance payment for future supply, like reserving your share of next year’s yield. For example, I may need a certain amount of oil this year, but if I expect I will need more next year, I may choose to buy forward and guarantee supply. Futures are a contract on future supply that won’t actually be delivered. They’re derivatives, for speculative purposes, essentially a bet on future supply and demand. They are bought, and then swapped for new futures as they reach expiry. You can also use futures for ‘hedging’. If you are a corn farmer for example, you may wish to buy futures in corn. If you have a bad harvest one year, you won’t make as much profit on your actual crop, but the rise in value of your futures will offset the loss. However, you might also wish to buy futures with no interest at all in the actual product, and this is where the speculators come in.
Fund investment in commodities has risen enormously in recent years. There has been a rush of hedge funds and pension funds diversifying their portfolios by buying into commodities. They don’t actually want a warehouse full of rice, which is why they just trade on the futures. According to the FSA, “During the recent commodity bull market these markets have seen an influx of investors that can be seen as speculative in nature, for the most part with little interest in ever owning the physical underlying commodity.” There’s no denying it’s smart investing. The stock markets might crash, but people will still need oil and food. If you were one of the funds that diversified into commodities last year, you would have turned a profit despite the global downturn.
Opening the markets
As far as I can make out, there are two twin trends that invited this rush of new investment in commodities. The first is deregulation. The first was the deregulation of the US energy market in 1989, which created the possibility of energy futures – bets on oil, gas, and electricity delivery. These are what Enron used to manipulate the energy markets and inflate prices in their favour. The food markets were also deregulated. Previously, only those involved in the food industry were allowed to participate in the exchanges. Farmers’ cooperatives sold their harvest, businesses bought it for processing into foods, or governments bought it for reserves and so on, and it was carefully monitored. In 1991, following the successes on the energy markets, the US Commodity Futures Trading Commission (CTFC) began to allow investors into the market. At first there were caps on the amount of soy, wheat or corn that investors were allowed to trade in, but the CTFC lifted restrictions considerably in 2005.
At the same time, the exchanges were going digital, and this is the second major factor in the commodities boom. Commodity trading used to be done ‘on the floor’, and was fairly specialist – a “system of open outcry, hand signals and runners trampling each other on their way into the pits”. It wasn’t an easy world to be part of. Once markets starting converting their commodity trading floors to electronic exchanges, they were capable of handling many more trades, much quicker. One at a time, between 2000 and 2005, the exchanges went digital, and the whole market became much more user-friendly. With deregulation and now easy digital access, the investment funds came knocking. Funds control 4.51 billion bushels of wheat, corn and soybeans through the Chicago Board of Trade Futures alone. The graph below shows the rise in investment in commodities. Note that the 2008 figure is just quarter 1. It was to hit $317 billion by July, and then collapse.
The consequences for food
As the price of futures soars, those who do actually want to get their hands on the real food products find themselves unable to compete with the investors in obtaining futures. This means they’ll buy more of what is available now, in case they can’t secure future supplies. This creates increased demand for the ‘spot’ trades, which pushes up the price of food. This is great for investors, but terrible for anyone involved with the actual end product, ie farmers and consumers, you and I and our shopping baskets. As one US farmer lamented last year, “it’s the best of times for somebody speculating on grain prices.” As my previous post mentioned, there are now one billion hungry people, 100 million of those added last year because of the rise in food prices. It’s been estimated that “every percent point increase in the price of food pushes an additional 16 million people into hunger”. Unlike shares, commodities are necessary items for survival. They are a matter of life and death, and if gambling on them is completely irresponsible. Speculating on agricultural commodities is not the only factor in the food crisis, but it is a despicable way to turn a profit nonetheless.
Can it be controlled?
It is very difficult to ascertain what the role of speculation is now in the international food market, because the regulators no longer supervise the investors. After last summer’s bubble in commodities the US regulator (CFTC) and the UK regulator (FSA) agreed to share information better and look into it. Considering the CFTC have granted exemptions to their own rules in the past, and announced that funds that break them won’t be penalised, the chances of them reigning in commodity speculation are minute, if not non-existent. On this side of the pond, the FSA’s mishandling of the short-selling ban doesn’t promise much either. Government intervention is going to be necessary, limiting investors’ access to the commodity markets, and capping the amounts they are permitted to buy. Since the money from speculation is made in the West, and the fallout from rising prices is felt in the developing world, I doubt there will be any sense of urgency from our governments. Which leaves just one solution in my mind – break the dependency on the global food system, and re-localize food supplies.
- Useful post on how commodity speculation works
- Institute for Agriculture and Trade Policy report on speculation