Commodities Speculation Doesn't Increase Food Prices

By Tim Worstall of Forbes. Excerpt:

"A few years back it was all the rage to go around shouting that commodities speculation drove food prices higher. This betrayed a startling lack of understanding of how commodities markets actually work but it really was popular to say so. This led to proposals to limit the amount of speculation that could be done in things like wheat futures and so on. Not a good idea and not likely to be a productive public policy simply because it wasn’t the speculation driving prices higher. We’ve now also got an interesting little data point with which to refute that original contention.

The basic claim was that as more people went and played with corn and wheat futures this drove up the price in the physical market and thus poor people starved. No, even us capitalist plutocrats don’t like that idea so if it were true something would indeed be necessary to stop it. But that’s to misunderstand how commodity markets work. Futures prices collapse down to physical as the maturation date approaches. Rather than futures prices driving up physical. As both Craig Pirrong and Paul Krugman pointed out you can only have futures driving the physical price if you also see hoarding or stockpiling. And we saw no evidence at all of such stockpiling so don’t think that high futures prices were driving high physical ones.

People really were quite irate about this:

Since the publication of the foodwatch report “The Hunger-Makers” in October 2011, foodwatch has demanded that banks cease all speculative trading with soft commodities in order to eliminate the risk of speculation-related food price spikes. With Commerzbank , Landesbank Baden-Württemberg (LBBW), Landesbank Berlin (LBB), DekaBank of the Sparkassen and now DZ Bank and Union Investment, the list of banks abandoning food speculation is getting longer and longer. On the other hand, Deutsche Bank , Germany’s largest player in this field, announced their decision at the start of the year to continue distributing products that speculate on the price development of soft commodities.

And the egregious Deborah Doane was also on the case:

The irony, of course, is that while they’re serving up a few meals, their core business is virtually starving people at the same time. In 2012, the US investment bank made an estimated $400m from speculating on food. The World Bank estimated in 2010 that 44 million people were pushed into poverty because of high food prices, and that speculation is one of the main causes.

Since Goldman led the drive to deregulate commodity markets in the 1990s, after constraints were imposed following the 1930s Wall Street crash, they’ve been at the vanguard of creating and promoting complex commodity instruments, from which they’ve raked in huge profits. Wallace Turbeville, a former vice president and the inventor of commodity index funds, has been outing the company’s methods. He says that in his time at Goldman, investment increased from $3bn in 2003 to $260bn in 2008, and commodity prices rose dramatically during the same period, increasing from 2006 to 2008 by an average of 71%.

In 1996, speculators held 12% of the positions on the Chicago wheat market, with most of the market being made up of the legitimate users of food – from farmers to producers. But the legitimate hedging element of commodity markets has virtually disappeared in the intervening years. By 2011, pure speculators made up a staggering 61% of the market. Of course, Goldman Sachs isn’t the only player, but it is certainly the largest.

The allegation really was more speculation, higher food prices, thus poor people starve. Which brings us to this interesting little chart from Mark Perry:



Food is now cheaper than it was before the spike supposedly caused by speculation. And there hasn’t been any reduction in the amount of speculation, far from it. In the near zero interest rate world of the past few years speculation in commodities has risen, not fallen. Thus our conclusion must be that it isn’t the volume of speculation which drives food prices. Entirely contrary to the entire story behind that campaign.

The lesson for our public policy from this being twofold. The first is that if the volume of speculation doesn’t drive food prices then we don’t need to control the volume of speculation in order to keep a lid on food prices." 

Historians frequently misunderstand and falsely portray

From Cafe Hayek.

"from pages 91 of Robert Higgs’s 1971 volume, The Transformation of the American Economy: 1865-1914; Bob’s discussion here is of the manner in which historians frequently misunderstand and falsely portray the economics of land, but the underlying point is more general (original emphasis):

Historians have similarly erred by using the term “speculator” to characterize a person who buys solely with the intent to resell and not to cultivate.  The objection to this usage is that in a private property system every owner of an asset is necessarily a speculator in the sense that he bears the risk of reductions in the value of the assets but hopes that the value will rise."

Gary Becker Explains Why Supply And Demand Explain Oil Prices, Not Speculators

See Fluctuations in Oil Prices, Speculation, and Strategic Reserves

"The International Energy Agency (IEA) recently coordinated the release onto the oil market of some of the strategic oil reserves of the United States, Japan, and ten other countries that hold reserves. The release was motivated by the rapid run up in oil prices from about $95 a barrel at the beginning of 2011 to over $120 a barrel in April of this year. I will discuss the fundamental determinants of the sharp fluctuations in oil prices, the role of “speculators”, and why it was unwise at this time to release oil from these reserves.

After the initial huge increase in oil prices following the Arab oil embargo in 1973, the magnitude of the fluctuations in these prices has been impressive. In 2008 dollars (i.e., adjusted for inflation), prices were about $40 a barrel in 1973, rose to $75 in 1981, fell to around $20 in the mid 1980s, and then stayed low until the early part of this century. These prices rose spectacularly to reach over $140 a barrel before the financial crisis hit, then fell sharply, and they have been recovering rapidly since the world economy again began to grow more rapidly.

Fundamentals in the oil market, that is, the supply and demand for oil, explain the vast majority of the large fluctuations in oil prices. Demand for oil changes over time because of recessions that reduce world output and hence demand for oil, and also because of world economic growth, especially in the developing world. Economic development raises oil demand because the demand for cars, and hence gasoline, increases rapidly with development, and because manufacturing and other sectors increase their demand for oil-based inputs.

To get a feel for the effects of demand changes on oil prices, consider a 3% increase from one year to the next in world demand for oil. The induced increase in price depends on how responsive (or elastic, in economists’ terminology) is the quantity of oil produced to higher oil prices. Oil production is not easily increased in the short run, especially with Opec controlling about 35% of the world supply of oil. A typical estimate of the short run world supply elasticity for oil is quite low at about 0.1. This number means that to induce a 3% increase in the supply of oil would require a 30% increase in oil prices, which is ten times at large as the increase in world demand. This example shows that the low elasticity of supply implies that even modest changes in the demand for oil have very large effects on its price.

The sensitivity of oil prices to underlying shifts in the fundamentals is made even greater by the fact that the short-run elasticity of demand is also about 0.1. To show the effects of such low demand elasticity, suppose world production of oil falls by about 1.5%. This is about the magnitude of the reduction in world supply from the civil war in Libya that cut its daily oil output from 1.4 million barrels of oil to about 200,000 barrels. For world consumption to fall by a mere 1.5% would require a 15% increase in price, given the very low demand elasticity for oil.

The actual fluctuations in prices due to shifts in supply and demand would be smaller than in these examples. When Libyan production fell and oil prices rose, other oil producers raised their supply of oil to take advantage of the higher prices. But since the overall supply elasticity is also very small, that response was small, so that oil prices still rose by a lot. Similarly, when world demand for oil grows by 3% and oil prices increase, demand for oil falls because of the higher prices. However, since the elasticity of demand for oil is also low, that response is limited, so that oil prices would still rise by a lot. A general analysis of market equilibrium shows that given supply and demand elasticities of 0.1, the percentage increase in price, after taking account of all these adjustments, would still be 5 times (rather than 10 times) the reduction in supply or increase in demand.

Moreover, both supply and demand for oil are more responsive to prices over longer time periods. This implies that the price rise due to more permanent falls in supply would initially be quite high, but they would get smaller over time. A higher maintained price of oil induces consumers to economize on the use of oil by buying fuel-efficient cars, by carpooling, and by driving fewer miles. Companies would substitute gas, coal, and other energy sources for oil. Similarly, on the supply side, higher long run oil prices induce greater efforts to discover new oil fields, whether deep under the sea, or in other remote places. Inefficient oil fields would also be brought back into production since their higher costs would be covered by higher oil prices.

Of course, speculators also are active in the oil market. They may buy oil futures in the expectation that oil prices will increase in the future, or sell oil futures-go “short”- hoping that prices fall in the future. If their expectations are correct, they help stabilize oil prices by increasing supply when prices are rising, and raising demand when prices are falling. Put differently, speculation tends to be stabilizing when speculators are making money because they have correct expectations about price movements, and destabilizing when they are losing money because their expectations turn out to be wrong. Given that the fundamentals imply large price movements from rather small shocks to supply and demand, and that successful speculation tends to moderate price movements, it is hard to believe that speculation has played a major role in causing the large swings in oil prices.

When the IEA countries on June 23 agreed to sell 60 million barrels (half by the US) from their oil reserves over the subsequent 30 days, it basically acted as a speculator on oil prices. Since oil was in plentiful supply then at about $110 a barrel, the only economic, as opposed to political, justification for the move was the belief that the IEA countries thought oil prices were too high and would be falling in the future. Perhaps these countries are privy to special information not available to private participants in the oil market about the recovery of Libyan oil production over the next few months, and about whether the unrest in the Middle East and North Africa would spread to other major oil producers in that region. Special knowledge is required to justify the IEA’s intervention because otherwise that information would already have lowered the price of oil. Such special knowledge does not seem likely, given that the unrest itself caught all the major governments (and private participants) by surprise.

Moreover, government oil stocks should not be used with the intent to profit from special information. Instead the information should be made public (if not based on politically sensitive information). Strategic reserves should be a hedge against supply disruptions during wartime or other crises when oil is not readily available even at so-called market prices. The only two previous interventions by the IEA were due to large supply shocks: the Persian Gulf War in 1991, and the effects of Hurricane Katrina, although the world oil market continued to function without major supply disruptions during these crises. The oil market is presently functioning very well, despite the high price of oil, so there is no good economic case for selling oil from strategic reserves at this time."

The Important Role of Speculators And Futures Markets

See Oil Speculators Are Your Friends by Jerry Taylor and Peter Van Doren in Forbes. Excerpt:

"Are futures markets a friend or foe of consumers? To hear the political class tell it during this season of soaring gasoline prices, they are clearly an enemy of nearly all mankind, a playpen for wild speculative orgies where nothing is produced--except higher fuel prices--and no services are rendered except to those who profit from the resulting price volatility.

Economists, however, argue that futures markets serve two essential functions. First, they allow us to learn about the future prices of commodities given the best information available to the market. This price discovery is helpful to consumers and investors because it assists them in deciding whether certain expenditures or investments today make sense. Second, the existence of futures markets allows people to buy insurance against price increases (or declines). Given the volatility of oil prices, the ability to purchase certainty is very useful. Allowing risk to trade from those who don’t want to bear it to those who do enhances efficiency."

Then they cite research that shows that futures markets generally reduce volatility.

Onion Prices Fluctuate More Than Oil Prices Even Though Onion Futures Are Banned

See What Can Onions Teach Us About Oil Prices? by Mark Perry of "Carpe Diem." Excerpts:

"Fortune Magazine (June 30, 2008) -- "Before the government starts scrutinizing the role that speculators may have played in driving up fuel and food prices, investigators may want to take a look at price swings in a commodity not in today's news: onions.

The bulbous root is the only commodity for which futures trading is banned. Back in 1958, onion growers convinced themselves that futures traders were responsible for falling onion prices, so they lobbied an up-and-coming Michigan Congressman named Gerald Ford to push through a law banning all futures trading in onions. The law still stands.

And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings. Since 2006, oil prices have risen 100%, and corn is up 300%. But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April (see top chart above, click to enlarge)."

MP: The bottom chart above shows the monthly percentage changes in oil prices and onions prices. Between 2000 and 2011, onion prices have been 7 times more volatile than oil prices, based on the difference in the standard deviations of monthly price changes."

Speculators Don't Seem To Be Driving Up Oil Prices

See Are Speculators Gouging Us at the Pump? by Jerry Taylor and Peter Van Doren of Cato. Excerprt:

"If this [speculation] is going on we would expect to see some sort of inventory buildup. While crude inventories in the U.S. are increasing, they always increase at this time of year, and this year's increase is well within the normal range. More important, gasoline inventories are decreasing and decreasing much more rapidly than normal. Hence, there's no evidence that speculators are reducing the supply of crude or gasoline through increased storage.

Producers, however, could react in the same way to higher futures prices by decreasing current production to allow more future production at higher prices. Alas, we see no evidence of suspicious reductions in producer output that might give this story credence.

More formal statistical tests (known as "Granger-causality tests" to economists) examine the impact of traders' behavior on prices within futures markets. Do futures prices follow the bets taken by market participants or do those bets follow prices? A federal interagency task force undertook one such econometric analysis in 2008 and found that futures price changes from January 2000 to June 2008 preceded net position changes by any group of traders. An updated and more rigorous econometric study by economists Bahattin Buyuksahin and Jeffrey Harris found the same thing for July 2000-March 2009.

These findings undermine the claim that speculators' behavior increases gasoline prices. "The lack of even Granger-causality (let alone true causality) between positions and prices undermines the prospect that speculative trading has driven recent dramatic price swings in the crude oil futures market," concludes Buyuksahin and Harris. "Rather, we believe it more likely that both prices and positions react to the same factors, such as global demand and supply.""