Commodity market speculation played major role in food crisis

Dear friends and colleagues,

The article below was published in the South-North Development Monitor (SUNS) #6596 on 24 November 2008, and is reproduced here with permission.

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Third World Network
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Geneva, 21 Nov (Kanaga Raja) -- Excessive speculation in agriculture commodity markets has played a major role in the rapid rise and fall in global food prices, contributing to a massive increase in undernourished people and commodity market instability, a new report by the Institute for Agriculture and Trade Policy (IATP) has said.

In its report, "Commodities Market Speculation: the Risk to Food Security and Agriculture", the Minnesota-based organization concluded that the US government de-regulatory steps opened the door for large financial services speculators to make huge "bets" that destabilized the structure of agriculture commodity markets.

Commercial speculation in agriculture has traditionally been used by traders and processors to protect against short-term price volatility, acting as a sort of price insurance while helping to set a benchmark price in the cash market. But the elimination of speculative position limits for financial speculators and the rise of commodity index funds undermined traditional price risk management. These funds create a constant upward pressure on commodity prices, alleviated abruptly only when fund contracts are "rolled over" to take profits.

According to the report, as of July 2008, $317 billion had been invested in commodities index funds, led by major traders Goldman Sachs and American Insurance Group.

Commodity index funds bundle futures contracts of up to 24 agricultural and non-agricultural commodities, including oil, energy, and base and precious metals. The bundling of agricultural commodities with precious and base metal commodities means that the price movements (and the larger trading weight of the metals in the fund) can trigger the sale of a fund contract, regardless of the supply and demand situation in an agricultural commodity, said the report.

(A report this week in the Wall Street Journal, focussing on bonuses for "trading desks" at several large banks, has highlighted the billions of dollars in profits that commodity traders have brought in for banks such as Morgan Stanley, Goldman Sachs and Barclays PLC. The article provides some collateral evidence of the commodity trades and speculative activities of these major banks.

(According to the Journal report, the commodity trading desks of both Morgan Stanley and Goldman Sachs may contribute some $1.5 billion to each of the banks' bottom line this year -- about a third of both banks' estimated net income. The report said that the commodity trades business is set to make $2.5-$3 billion in net revenue for Morgan Stanley, and as much as $3 billion in net revenue for Goldman Sachs, a major commodities dealer. Another leading commodities dealer, Barclays Capital, is projected to make some $2.2 billion or more in net revenue this year, according to the Journal article, which suggests extensive speculative trade and "investments" in commodity funds by pension funds, hedge funds and others, as also via OTC derivatives).

The IATP report, released in mid-November, reviews the role of speculation in the global food crisis, and explains the particular role of US regulation of commodities markets within the global regime.

The report notes that due to high prices, the total developing country food import bill rose from about $191 billion in 2006 to $254 billion in 2007. Today, developing countries are consuming less food. About 43% of more than 27,000 people polled in a recent 26-nation survey said that they had cut back food consumption as a result of higher prices.

The number of those undernourished and food insecure in the world has increased along with prices. Over the last year, riots broke out over food prices, lack of available and affordable food, and insufficient food aid. The UN Food and Agriculture Organization (FAO) estimates that in 2007, 75 million people were added to the 850 million already defined as under-nourished and food insecure.

The IATP notes that commercial speculation, i. e. speculation by buyers and sellers of commodities, has been used since the 19th century to enable commodity traders and processors to protect themselves against short-term price volatility. Buyers are protected against sudden price increases, sellers against sudden price falls. For commodity buyers and sellers, commercial speculation is a form of price insurance. Non-commercial speculation takes place not to protect against or "hedge" price risk, but to benefit by anticipating and "betting long" for prices to go up or "short" for prices to go down.

Non-commercial speculators provide capital to enable the ongoing function of the market as commercial speculators liquidate their contract positions by paying for the contracted commodity or selling the contract to offset the risk of other contract positions held. Non-commercial speculation is an investment, but one that can overlap with the interests of agriculture when appropriately regulated.

However, said the report, today's speculation has become excessive relative to the value of the commodity as determined by supply and demand and other fundamental factors. For example, according to the FAO, as of April 2008, corn volatility was 30% and soybean volatility 40% beyond what could be accounted for by market fundamentals. Price volatility has become so extreme that by July, some commercial or "traditional" speculators could no longer afford to use the market to hedge risks effectively.

The report explained that the futures contract is the fundamental building block from which other speculative instruments are built. The contract obligates parties to buy or sell a specified quantity of a commodity at a specified price at an agreed date in the near future, usually one to three months from the contract date for agricultural commodities. An options contract does not oblige the parties and costs less to execute but provides less price protection. Futures and options contracts enable those who buy and sell commodities to manage short-term price risks and to "discover" the price at which those contracts settle as the due date for fulfilling the contract approaches.

In the US, according to the report, futures contracts were useful and affordable as long as futures prices and cash (spot) market prices converged as the date for the contract's execution approached. Futures prices helped commodities traders to set a benchmark price in the cash market. With convergence came some degree of contract predictability needed to calculate when to buy or sell. Similarly, option contracts, in which "buyers have the right but not the obligation" to buy or sell a commodity at a specified price at a specified time, relied on price convergence to provide some contract predictability.

As prices have become more volatile and convergence less predictable since 2006, the futures market has lost its price discovery and risk management functions for many market participants. According to the FAO, as of March 2008, volatility in wheat prices reached 60% beyond what could be explained by supply and demand factors.

The report noted that the prices affected by speculation for most global agricultural trade are determined at the Chicago Board of Trade, the New York Board of Trade and the London International Financial Futures Exchange. The US Commodity Futures Trading Commission (CFTC) regulates US-based commodity exchanges based on the legislative authority of the Commodities Exchange Act.

As of July 2008, $317 billion was invested in commodities index funds. The major traders of these funds, especially Goldman Sachs and the American Insurance Group, are headquartered in the US but their investment products are traded globally.

Therefore, said the report, any regulatory reform affecting those funds will affect commodity markets outside the United States, just as the deregulation of US markets has contributed to excessive speculation worldwide.

For example, in 2004, Hank Paulson, current Treasury Secretary and then chief executive officer of Goldman Sachs, successfully lobbied for an exemption from the rule that investment banks, like commercial banks, keep large enough currency reserves to cover their unsuccessful trades.

The rule exemption freed billions of dollars that Goldman and four other banks used for high-risk investments, including commodity index fund bets. When these investments went sour, the erstwhile beneficiaries of deregulation either were bailed out by the US government, or, in the case of Lehman Brothers, went bankrupt with global repercussions.

With the rise of financial futures and options instruments, such as the credit derivatives that famed investor Warren Buffet described in 2003 as "financial instruments of mass destruction," agricultural and non-agricultural commodities futures and options "now account for only around 8% of total futures and options volume."

The futures and options industry lobbyists are loath to have futures markets tightly regulated for the sake of that 8%, never mind for the sake of food security. They have been out in force at the CFTC and US congressional hearings to lobby against "over-regulation", the report found.

According to IATP, commodity index funds bundle futures contracts according to a formula that weighs and tracks the prices of up to 24 agricultural and non-agricultural commodities as a single financial instrument. They have become the most notorious speculative instrument, in part because of the huge amount of money invested through them and the price volatility that results from index fund "bets".

It cited US Congressman Bart Stupak, basing himself on Lehman Brothers research, stating in testimony before the House Agriculture Committee, that "since 2003, commodity index speculation has increased 1,900%, from an estimated $13 billion to $260 billion" in March, resulting in a crude oil price increase of at least $37 a barrel largely decoupled from supply and demand factors.

Stupak noted various legislative and regulatory loopholes that have been created since 1991 to enable the "excessive speculation" prohibited by the Commodities Exchange Act and is proposing legislation - the Prevent Unfair Manipulation of Prices Act (PUMP or H. R. 6330) - to close the loopholes.

Perhaps the most crucial loophole is the one that exempts financial speculators from the speculation position limits of commercial hedgers, provided that the speculator "swap" the futures contract through a middleman, such as Lehman Brothers, which would then itself seek to sell the contract it had just bought to spread its risk, said the report.

It noted that as of July, the Standard & Poors-Goldman Sachs Commodity Index (S&P GSCI) held about 63% of the index fund market share and the Dow Jones-AIG (American Insurance Group) index had about 32%. Agricultural commodities make up an average 29.6% of these indices, with energy, base metals and precious metals making up the rest.

Designed to spread investor risk among commodities and serve as a buffer from riskier financial and real estate speculative instruments, the index funds are hardly immune to loss, the report found. One commodity index price declined about 19% from June 30 to September 1, as investors took profits following record or near record high prices. But the potential for a return to speculation-fueled price spikes, devastating to food security, remain. Financial speculation in commodities markets is expected to continue to attract more regulatory and legislative scrutiny.

There is a difference of opinion about how much speculation in agricultural commodities has increased food prices beyond what can be accounted for by traditional market fundamentals and energy-related factors. A US academic review of two dozen studies on causes of the price increases stated in July, "Based on existing research, it is impossible to say whether prices levels have been influenced by speculative activity." Another study from the University of Illinois concludes, "There is no pervasive evidence that current speculative levels, even after accounting for index trader positions, are in excess of those recorded historically for agricultural futures markets."

However, said the report, these conclusions do not take into account the OTC (over-the-counter) trades of privatized risk management that dominate commodities speculation. Their analysis is limited by the quantity and quality of CFTC reported data upon which they rely.

While it is generally agreed that some speculative capital is necessary for the effective operation of commodities futures and options markets, it does not follow that the amount of capital must be unbounded for futures and options trading to carry out its price discovery and risk management functions. Nor are those calling for limits on both the amount of commodity index fund trading in commodities exchanges characterizing all speculation as price manipulation, the report added.

Manipulation is an intentional and therefore very difficult to prove anti-competitive business practice that is relatively seldom disciplined by the CFTC.

The larger concern is about the systemic effect of the commodity index funds, since they almost always invest "long," i. e., for prices to increase. Traditional hedgers, such as grain traders, manage risk in different commodities by investing "short" to drive their own raw materials prices down. However, the commodity index fund investors create a constant upward pressure on commodity prices, interrupted only when they take profits on the futures and options contracts they "roll over" according to a trading algorithm.

According to the report, the bundling of agricultural commodities with precious and base metal commodities means that the price movements and larger trading weight of the metals in the fund can trigger the sale of a fund contract regardless of the supply and demand situation in an agricultural commodity.

Because the funds often invest with the long-term horizon of pension funds, unlimited and unregulated index fund "bets" could roil commodities markets for at least 20 years. The danger of unregulated index funds and OTC trades to both food security and the agricultural production finance system should be apparent to anyone who looks beyond the great limitations of CFTC data and rules.

The report noted that there is currently no multilateral framework to respond to global speculation in food prices. Indeed, financial industry lobbyists are pressing World Trade Organization negotiators to further weaken the ability of governments to regulate financial markets that include commodity exchanges. Developing country negotiators, remembering only too well the lack of international financial institution reform that followed the East Asian economic carnage in 1997 resulting from real estate speculation, have thus far resisted.

Despite the global consequences of the US financial services debacle, former US Trade Representative, former Goldman Sachs executive and current World Bank president Robert Zoellick has indicated his opposition to any normative role for UN agencies in managing the current financial crisis, of which commodities speculation is a part, said the report.

The report further said that there are many elements of the food crisis other than commodities speculation that require urgent attention. But if deregulated speculation continues to induce artificial volatility in agricultural markets, it will be very difficult to finance innovative investments in rebuilding domestic agricultural production and distribution capacity in net food import-dependent countries.

The artificial inducement of commodity price volatility by deregulated speculation will further make it difficult to internalize the costs of agriculture natural resource re-mediation and climate change effects in commodity prices. For these and other reasons, governments and regulators must assert control over the futures markets to prevent destabilizing "excessive speculation" in commodities.

The report makes a series of recommendations towards regulating commodities speculation.

At the multilateral level, these include creating an independent global commodities futures and options exchange regulatory agency. Such an agency would support consistency and enforcement of national commodity futures exchange rules and deter exchange shopping for weaker regulatory regimes. It could also be granted authority to collate and analyze trading data reported to national commodity exchange authorities.

Also, lobbying UN Conference on Trade and Development (UNCTAD) member governments to authorize UNCTAD staff and consultants to study the price transmission effects of commodities speculation on agricultural commodities prices at national and farm-gate levels. Another study could assess the effects of commodities speculation on setting the international reference prices that developing countries use in outlook studies that help set agricultural policy and allocate state resources to agriculture.

With respect to the United States in particular, recommendations include requiring the Commodities Futures Trading Commission to ban access of foreign commodity exchanges and their participants unless those exchanges adopt and enforce limits on non-commercial (i. e. purely financial) speculation relative to the size of the market for a specific commodity; establish position limits on futures and options contracts bought and sold in US commodity exchanges; and set up agriculture and energy futures advisory groups of commodity exchange participants to help set, monitor and modify position limits and prevent excessive speculation.

In addition, the report recommends dis-aggregating agricultural and non-agricultural commodities futures and options contract data to enable more transparent and fair markets, and to study the effects of speculation on agricultural and energy prices, as well as requiring that all OTC trade data be reported to the CFTC and to other national commodity exchange authorities so that regulators have a better grasp of the dimensions and changes in the markets they are regulating. +