Financial speculation and the food crisis
As in the case of current food prices, it was excessive speculation on the commodities markets that played a primary role in the creation of the 2007-08 food crisis. In outlining the action necessary to address the dangers of such speculation, Olivier De Schutter, the UN Special Rapporteur on the right to food, underscores the crucial importance of reforming the global financial system to attain the goal of food security.
AS a result of the increases in prices of basic food commodities and oil in 2007-08, the number of people in extreme poverty rose by 130 to 150 million, according to an estimate of the World Bank. At least 40 million people around the world were driven into hunger and deprivation as a result of the 2008 food price crisis, raising the total number of people living in hunger to 963 million in 2008. As is nearly always the case, the brunt of the food price spike was borne by people in the Low Income Food Deficit Countries (LIFDCs), or the poorest developing countries. In these countries, of special concern are the urban and rural poor who even at the best of times must spend up to four-fifths of their income on food. The food price crisis undermined this already meagre ability to meet essential food needs. This should not be allowed to recur. This article seeks to explain the role that speculation on the commodities markets may play in increasing volatility of prices, and what can be done about it in order to better protect the right to adequate food.
Beginning around 2005, markets for numerous agricultural commodities started to witness price increases and higher levels of volatility. According to a document circulated under the auspices of the UN Conference on Trade and Development (UNCTAD), food prices rose by 83% between 2005 and 2008, with maize prices nearly tripling, wheat prices increasing by 127%, and rice prices by 170% between January 2005 and June 2008. Moreover, the June 2010 issue of Food Outlook published by the UN Food and Agriculture Organisation (FAO) finds that implied volatility in wheat and soy rose steadily from 2005 to 2008, and that the rise in implied volatility for maize continued, albeit at a much lower rate, until 2009.
present, there is a lively debate as to whether these developments were
the result of factors adversely affecting food supply, or whether they
were caused by excessive speculation in food commodities derivatives.
Advocates of the first position maintain that the price spikes were
attributable to factors such as a decline in the rate of growth of food
production, climate change and water depletion, and the growth of biofuels.
For instance, Wright and Bobenrieth ('Special Feature: The Food Price
Crisis of 2007/2008: Evidence and Implications', December 2009, FAO
Food Outlook 59, 62) argue that the roots of the food price crisis lie
in the fact that between 2007 and 2008, stocks of world wheat, maize
and rice were low. Wheat production, they note, was lower than expected
because of a severe drought in
Certainly, supply and demand fundamentals played an important role in the creation of the food crisis. However, closer examination reveals that the abovementioned arguments of supply and demand are insufficient to explain the full extent of the increases and volatility in food prices. For instance, the price of rice rose by 165% between April 2007 and April 2008 - a magnitude difficult to explain by reference to market fundamentals. In fact, Wright and Bobenrieth acknowledge that 'rice stocks were not unusually low in 2007/2008' and that even though maize stocks were low, production remained high. Nor, as Wahl ('Food Speculation as the Main Factor of the Price Bubble in 2008', February 2009, Briefing Paper, World Economy, Ecology & Development, 6-7) observes, is it likely that a group of people suddenly developed a taste for consuming vast quantities of dairy products, driving its price up by 157% between 2006 and November 2007, only to lose it starting from July 2008, allowing prices to start falling again.
is also difficult to accept the IMF's thesis that the food price increases
were the result of per capita income growth in
The speculative bubble effect
Instead, a number of signs indicate that a significant portion of the price spike was due to the emergence of a speculative bubble. Prices for a number of commodities fluctuated too wildly within such limited time-frames for such price behaviour to have been a result of movements in supply and demand: wheat prices, for instance, rose by 46% between 10 January and 26 February 2008, fell back almost completely by 19 May, increased again by 21% until early June, and began falling again from August. The 2008 food price crisis was unique in that it was possibly the first price crisis that occurred in an economic environment characterised by massive amounts of novel forms of speculation in commodity derivative markets.
The particular area of concern is speculation in derivatives based on food commodities. A study conducted by Lehman Brothers just before its bankruptcy revealed that the volume of index fund speculation increased by 1,900% between 2003 and March 2008. Morgan Stanley estimated that the number of outstanding contracts in maize futures increased from 500,000 in 2003 to almost 2.5 million in 2008. Holdings in commodity index funds ballooned from $13 billion in 2003 to $317 billion by 2008. In the light of such developments, the UNCTAD Trade and Development Report 2009 found that 'the trend towards greater financialisation of commodity trading is likely to have increased the number and relative size of price changes that are unrelated to market fundamentals'. In other words, the changes in food prices reflected not so much movements in the supply and/or demand of food, but were driven to a significant extent by speculation that greatly exceeded the liquidity needs of commodity markets to execute the trades of commodity users, such as food processors and agricultural commodity importers.
In fact, while the food price crisis may have been sparked off by the abovementioned developments affecting demand and supply, its effects were exacerbated by excessive and insufficiently regulated speculation in commodity derivatives. The promotion of biofuels and other supply shocks were relatively minor catalysts, but they set off a giant speculative bubble in a strained and desperate global financial environment. These factors were then blown out of all proportion by large institutional investors who, faced with the drying up of other financial markets, entered commodity futures markets on a massive scale. Therefore, the policy solutions that are needed to avert another crisis must address both the problems affecting underlying financial market fundamentals, and the conditions under which speculation is allowed to take place in essential food commodities, thereby exacerbating the effects of those movements in market fundamentals.
Speculation in agriculture
in agricultural derivatives has an ancient history. One of the earliest
descriptions of derivatives is to be found in Aristotle's Politics.
Aristotle tells of Thales the Milesian, a professional philosopher who
began to tire of being mocked for his poverty. His meteorological expertise
led him to anticipate a bumper olive harvest that year, so he hired
all the oil presses in Chios and
Traditional speculation in agricultural commodities markets is based on market fundamentals - above all on the demand and supply for any particular commodity. Thales purchased his option on the oil presses because he expected the supply of olives to increase. The farmers sold him the option because they were hedging against the risk of a poor olive harvest. This form of speculation is generally considered necessary and useful in the market: it facilitates commercial hedging against risk, and it allows for price discovery, assisting farmers and buyers in discovering the reasonable price for a particular commodity in individual trades and on spot markets. If the buyer is willing to offer a higher price for a future than before, it means that she expects the eventual price of the commodity to increase further. As such, if the price of commodity futures goes up, it signals to sellers on spot markets to raise their prices. Indeed, the grain futures prices quoted by the Chicago Mercantile Exchange tend to be incorporated directly into grain trade contracts the world over. Moreover, it is conventionally thought that such speculation reduces price volatility, because speculators provide a market for hedgers, and because they buy when the price is low and sell when the price is high, thus evening out extremes of prices.
course, such speculation is not an unalloyed blessing: it can have significant
price effects without adding anything of economic value. A speculator,
unlike other investors in agriculture, does not create new capital such
as barns or tractors. If that speculator goes bankrupt, her creditors
will have nothing they may satisfy their debts upon. It can also be
extremely dangerous - the terrible
Another form of speculation is based simply on market momentum. This has been described as 'herding behaviour in times of strong (usually upward) price trends, which in developed and easily accessible markets can result in the emergence of speculative bubbles.'. Far from providing a stabilising hand, such speculation tends to increase price volatility. Such momentum-based speculation may have been the main cause of the food price crisis in 2007-08.
The particular derivative instruments that require our special attention are the commodity indexes. A commodity index, put simply, is a mathematical value largely based on the returns of a particular selection of commodity futures. The most famous of these is the S&P GSCI, formerly known as the Goldman Sachs Commodities Index, which was set up by Goldman Sachs in 1991. Others include the Dow Jones-AIG Index and the Rogers International Commodities Index. The composition of the 'basket' of commodity futures varies according to the index, but agricultural commodities normally do not account for the majority of the commodities included in the basket. For instance, agricultural commodities only make up 12.2% of the value of the S&P GSCI. Commodities indexes themselves form the basis for a number of instruments such as commodities index funds, commodity exchange traded funds (ETFs), and commodity index swaps. For instance, a commodity index fund is a large sum of money managed by a 'sophisticated' manager who uses that money to buy the futures that comprise the basket of futures that make up any particular commodity index.
Even though they were advertised to institutional investors as ideal mechanisms for hedging against adverse movements in other financial markets, it could be said that the animating principle behind the commodities index funds was momentum. The strategy evolved by the Goldman Sachs managers who ran the GSCI was to have nothing but 'long' positions, to keep on acquiring them, and to 'roll' them over as they expired, no matter how high the price of those futures climbed. As Kaufman ('The Food Bubble: How Wall Street starved millions and got away with it', July 2010, Harper's Magazine, 32) puts it, the purpose was to accumulate 'an everlasting, ever-growing long position, unremittingly regenerated'.
As mentioned above in the section on speculation based on market fundamentals, speculation can be useful because it helps farmers and buyers determine prices. As such, ordinarily, futures prices are lower than spot prices, and this ordinary situation is known as 'normal backwardation'. However, the effect of the commodities index funds appears to have been to throw the commodities futures markets into 'contango', producing a vicious circle of prices spiralling upward: the increased prices for futures initially led to small price increases on spot markets; sellers delayed sales in anticipation of more price increases; and buyers increased their purchases to put in stock for fear of even greater future price increases. When the spot prices increased, this fed an increase in futures prices, which attracted even more speculation, thus setting the whole process into motion once again. Indeed, the whole structure of commodity index speculation was premised upon contango. Commodity index speculation was the gift that was designed to keep on giving.
It is difficult to imagine creatures more different from Thales than the index speculator and the manager of a commodities index fund. The index speculator and the fund manager, far from being acquainted with crop production cycles and patterns, will never see a grain of wheat in their professional lives. Nevertheless, the index speculator and the fund manager have one thing in common with the traditional speculator: whereas the traditional speculator may drive up the price of a commodity by hoarding the physical commodity, the index speculator and the fund manager accomplish the same by hoarding futures contracts for those commodities. However, the index speculator and fund manager are spared the bother of maintaining a warehouse: their hoarding is entirely virtual.
It is important to note that different kinds of speculation in different markets combined to create the food price crisis, and that no one category of market conduct was singly responsible. For instance, market-momentum-based speculation in oil contributed to the food price crisis, by affecting fundamental conditions of supply of an essential agricultural input. Petrol is an integral component of modern food supply chains, being used for fertilisers, food processing and transportation, and the rise of bioenergy leads to an increased merger of the food and energy markets. Moreover, small changes in market fundamentals such as oil price increases, the growth of agrofuels, and underinvestment in agriculture can act as a catalyst for momentum-based speculation. The fact that market-momentum-based speculation may have been the main contributing cause of the food price increases is no reason to lower one's guard against other factors which also cause food prices to rise. Indeed, we should be ever more vigilant, because momentum-based speculation may magnify the effects of changes in market fundamentals.
The larger financial market
The sudden massive entry of index funds into commodities should be placed against the background of developments in the broader financial markets. Following the passage of the US Commodity Futures Modernisation Act in 2000, Over The Counter (OTC) derivatives were exempted from the oversight of the US Commodity Futures Trading Commission (CFTC). As a result of the Commodity Futures Modernisation Act and the decisions of the CFTC, such trading was allowed to take place without any position limits, disclosure requirements, or regulatory oversight. Moreover, the Act permitted for the first time OTC derivatives contracts where neither party was hedging against a pre-existing risk; i.e. where both parties were speculating. Also, it enabled hedging against those risks by taking positions on exchanges.
At this point, it is crucial to observe the difference between investment in commodities futures and investment in commodity index funds. Commodities futures, being standardised contracts, are traded on exchanges, so investment in them is not OTC. Participation in a commodities index fund, however, is mostly OTC. Institutional investors such as pension funds typically enter into agreements with fund managers whereby in addition to the investor paying an annual management fee to the manager, it also pays the fund manager the 3-month Treasury Bill rate. In exchange, the fund manager pays the total return on the futures included in the commodities index. Such agreements to exchange streams of income, or 'swaps', are almost always traded on an OTC basis. The lack of regulation of such derivatives greatly facilitated the entry of institutional investors into commodities index funds.
summarise, deregulation in the
at the end of 2001, food commodities derivatives markets, and commodities
indexes in particular, began to see an influx of non-traditional investors,
such as pension funds, hedge funds, sovereign wealth funds, and large
banks that packaged and dealt the commodity index instruments mentioned
above. The reason for this was simply because other markets dried up
one by one: the dotcoms vanished at the end of 2001, the stock market
soon after, and the
In none of these markets was there any restriction of supply or expansion in demand even remotely sufficient to explain the full extent of price increases. The reasons for such movement were twofold. First, because it was thought that markets for food and oil would be profitable because they could not possibly dry up: people may lose interest in asset-backed securitisation, but they will always have to eat. Second, as mentioned earlier, a portfolio diversification practice appears to have emerged of spreading out risk in any investment portfolio by balancing out investments in securities or bonds with investments in markets that display unrelated or opposite behaviour, such as food and oil. Indeed, total index-fund investment in corn, soybeans, wheat, cattle and hogs increased from $10 billion in 2006 to more than $47 billion in 2007.
But these price increases in commodities futures were possible only if the permanent long positions in them could be funded. Previously, this had been made possible by the low margins that traders had to put up front in order to trade on commodities exchanges. The remainder of the funds could be invested in other financial instruments. The food price bubble burst when the giant non-traditional speculators lost the ability to carry on, as a result of their investments in other markets crashing. When they fell, the upward food price spiral also ended.
to address the dangers of speculation in basic foodstuffs is needed.
Although considerable progress appears to have been achieved in this
regard with respect to financial reform in the
Although the global stocks of grain are higher now than they were previous to the 2007-08 food crisis, the financial drivers of that crisis remain largely unchanged. More still needs to be done to curb the negative effects of speculation on basic food commodities. This is an important source of vulnerability, particularly for poor net food-importing countries, whose dependency on food imports has been increasing over the years, and who will in the future suffer more balance-of-payments problems if they are confronted with a new peak in prices over the coming weeks and months.
1. Given the numerous linkages between agriculture, oil, and other financial markets demonstrated above, comprehensive reform of all derivatives trading is necessary. The very first step would be to require registration, as well as clearing to the maximum extent possible of OTC derivatives, so that there is real time reporting of all transactions made, without information privileges for OTC traders, and in order to allow for effective supervision. The small minority of derivatives that cannot be cleared must nevertheless be reported without a time lag.
2. Regulatory bodies should carefully study and acquire expertise in commodity markets, instead of regulating commodity derivatives and financial derivatives as if they were the same class of assets. It may be appropriate to assign the task of regulating commodity derivatives to a specific institution staffed with experts in commodity regulation, rather than have a single body regulating both financial and commodity derivatives.
3. Access to commodities futures markets should be restricted as far as possible to qualified and knowledgeable investors and traders who are genuinely concerned about the underlying agricultural commodities. A significant contributory cause of the price spike was speculation by institutional investors who did not have any expertise or interest in agricultural commodities, and who invested in commodities index funds because other financial markets had dried up, or in order to hedge speculative bets made on those markets.
4. Spot markets should be strengthened in order to reduce the uncertainty about future prices that creates the need for speculation. However, these markets must also be regulated in order to prevent hoarding. Spot markets must be transparent, and holdings should be subject to strict limits in order to prevent market manipulation.
5. Physical grain reserves should be established for the purpose of countering extreme fluctuations in food price, managing risk in agricultural derivatives contracts, and discouraging excess speculation, as well as meeting emergency needs. Such measures and the abovementioned reform of commodity derivatives markets should be seen as complementary.
Olivier De Schutter was appointed the United Nations Special Rapporteur on the right to food in March 2008 by the UN Human Rights Council. He is independent from any government or organisation, and reports to the Human Rights Council and to the UN General Assembly. The above is extracted from his Briefing Note (No. 2, September 2010) entitled 'Food Commodities Speculation and Food Price Crises'. The full Briefing Note is available on the Special Rapporteur's website, www.srfood.org.
*Third World Resurgence No. 240/241, August-September 2010, pp 24-29