Thursday, March 24, 2011

Are Speculators to Blame for High Food Commodity Prices? No, and this Explains Why.

photo: flickr

In this post, I have the good fortune of having permission to use the writing of two Ag/Economic experts on the subjects of:
  • why people think that speculators drive food commodities
  • why speculators, in actuality, do not drive food commodity prices
At the risk of discrediting myself, I have held back on this subject, therefore this post is long overdue. When I (reluctantly) listed "speculation" in a list of reasons for higher food prices sometime back, I had three friends who are a lot smarter than I am each give me a gentle and polite nudge suggesting that this was not the case. Since I rarely get this type of feedback on anything, the good news is, I must be right about everything else (laugh out loud), but it also meant that I'd better pay attention to what they were telling me.

So, I continued to try to educate myself on the subject, reading Paul Krugman's take, the Naked Capitalism/Paul Krugman Debate, reading Bloomberg and others as they continued to blame speculators, listening to video talks, and the like. Still, I was getting conflicting information and not ready to make a proclamation on this blog.

The first friend who challenged me on this subject linked a Paul Krugman post and told me I should read the Sanders and Irwin paper which Krugman referenced below his post. Imagine my surprise when the third person who contacted me was Irwin himself, whom Krugman cited. I was humbled to have Scott a reader here, but also delighted to have his expertise for consultation.

To present the explanation, I have chosen the writing of Nevil Speer PhD, University of Western Kentucky. He explains it as clearly and simply as I have seen in writing to date. Then, following his article, I have added some critical material given to me from Scott Irwin to help complete the understanding.
K. McDonald

The following is from Agsight March 2011 by Nevil Speer, PhD, MBA of Western Kentucky University:

“Food prices have sparked a media feeding frenzy of late.” That observation from last month’s AgSight stemmed from the seemingly unending stream of headlines about the current inflationary environment. Such widespread media attention is relatively new - the business surrounding agriculture and food production doesn't normally attract much attention. What isn’t new is the finger pointing.

More specifically, the commodity run of late has revived long-standing accusations about speculators. They're the alleged culprits of higher prices and accused of unduly profiting from their respective commodity positions. Meanwhile, the rest of the world suffers the fallout – especially significant in the food arena.

That sentiment was on clear display at a recent meeting of international farm ministers in Berlin. The consortium collectively declaring that, “excessive price volatility and speculation on international agricultural markets might constitute a threat to food security.” And some were individuals were harsher yet; for example French Agriculture Minister Bruno Le Maire: “We don’t want to accept this speculation on agricultural commodities, which…enriches a lot of people but which impoverishes the rest of the planet.” In other words, speculator positions are “excessive” and circumvent underlying fundamentals.

It’s one thing to hear foreign ag ministers condemn the role of speculators in the futures markets but it’s another matter when a market regulator (Bart Chilton, Commissioner, CFTC) does so: “Some people are arguing that we are seeing ‘delinked prices – prices ‘delinked’ from true demand and supply…I’m not an economist. I can’t say what percentage is due to speculation. But it’s easy to find evidence that they are having an impact.” That’s a troubling observation on a number of fronts.

The political rhetoric conveniently avoids market realities. One, futures markets are a zero-sum game: every contract mandates a buyer on one side and a seller on the other (yes, it’s that simple). Hence, hand-wringing about speculative buying is a one-sided venture; there must be an equal value of willing sellers on the other side. Two, in light of simultaneous and balanced price agreements, it’s impossible to assert whether speculators are actually driving the trend or simply chasing it. Lastly, speculators possess no association with the physical product.

Therefore, the only means by which speculative buyers can impact the spot market is to take delivery and remove the physical product from the marketplace. Dr. Craig Pirrong (Professor of Finance and Energy Markets, Univ. Of Houston; summarizes futures markets like this (Regulation, Summer, 2010):
…even if speculation caused prices to go up, that does not necessarily imply that prices were too high as a result. It is possible that speculators recognized that prices were too low (given fundamental information) and that their buying moved prices to the right level…[and] although the speculator may buy, he is almost invariably a seller when a commodity futures contract nears delivery. This would suggest that even if his initial purchase drove up prices, his subsequent sale would drive down prices. Absent some (unexplained) asymmetry in price response to the speculator’s purchases and sales, it is difficult to understand how his actions could affect the prices consumers pay and producers receive.

In other words, placing blame on one side of the equation (non-commercial longs) is misplaced. As alluded above, none of this is really new. Historically, though, the assertions have arisen from the other direction. That is, speculators force prices lower (not higher) with producers being the casualties (not end-users). Charles Geist (Wheels of Fortune: The History of Speculation from Scandal to Respectability) cites a popular 1880's publication entitled, Seven Financial Conspiracies That Have Enslaved the American People. Geist explains the publication’s theme was, “…to show how the average agrarian was at the mercy of the Wall Street crowd that cared only for money, not products.” So either way, the speculator is to blame.

Food prices are driven, like any other market, by supply and demand. Markets work: higher prices occur because of relative scarcity fundamentals: tight supplies amidst strong demand and forecasts for the ongoing continuation of that trend propel the market higher. Simultaneously, price volatility is amplified as scarcity (or at least the perception thereof) becomes more extreme. Moreover, we work in a new reality; money flow occurs faster (24-hour, electronic trading) and with more breadth (globally, across all classes of assets) than ever - that makes for more active markets.

Reining in speculators seems politically expedient. But we live in complex times. Throwing darts becomes perilous when policy makers begin to advocate (and worse yet, actually believe) that speculators should be removed ag / food markets. Such a move would dismantle futures markets. Imagine what the world might look like a without market liquidity, price discovery and risk mitigation; not to mention the inability to establish pricing plans, attract new capital investment and stimulate innovation across the food business. The absence of those influences, facilitated by futures markets, would ultimately lead to less global food security – NOT the other way around. Taking speculators out of the mix would be devastating.

[END Speer Article]

Next, are Scott Irwin's responses to some questions I posed to him.

First, I asked him why Bloomberg was wrong for blaming speculators for driving oil prices up lately. (His answer applies to food commodities, as well.)
I don’t doubt that speculators are moving from food to oil, but the question remains whether the speculators are following price trends or causing the price trends. The flow of speculators across markets could have a price impact but I would expect it to be temporary in nature and only last a few days at most.

The available research indicates speculators as a group are trend-followers, not trend-makers. Certainly, some speculators are able to anticipate trends and they therefore look like “trend-makers,” but over time this can only be true in a reasonably competitive market if they possess valuable private information or are better at interpreting public information than other traders.

So, to my way of thinking (admittedly very econocentric) the key driver of price trends is changing information about supply and demand prospects. In terms of current events, I believe the price moves generally reflect the best information available about market conditions.

Obviously this is an incredibly dynamic and volatile situation, so there will be large differences in beliefs/perceptions about supply and demand prospects and it is very hard to sort the wheat from the chaff in real time. And when it is so difficult to peer into the future it is tempting to ascribe causality to something that is tangible and measurable---changing positions of speculators.

Next, I asked why wheat prices went up more than 50% the last part of 2010 when supply had remained fairly constant:
In terms of the wheat market specifically last fall, I think the run up made good sense given that there was a truly tight supply in HRW due to production problems in Russia. Looking at the all wheat figures masks what was going at the margin in hard wheat. The other classes had to move in tandem to maintain price relationships.

This next statement and graph from Scott is most critical to understanding the concept:

In addition, the wheat price move also reflected the fundamental “non-linearity” in the relationship between inventories and price. The figure above, drawn from Wright (2009), illustrates this point. Note that a given reduction in quantity due a to supply and/or demand shock will have a much larger impact on price when starting with a low quantity (inventories) compared to when starting with a high quantity. It also implies that relatively minor reductions in quantity can result in very large increases in price when the market supply/demand balance is especially tight. This is a key point that I think is missed by many people.

[END Irwin answer]


For further references, see Dwight Sanders and Scott Irwin's most recent paper on this subject here: Index Funds, Financialization, and Commodity Futures Markets.

Paul Krugman: Commodities, This Time is Different; and Nobody Believes in Supply and Demand.

Note that Scott Irwin PhD, University of Illinois, has a newly revised and updated agricultural news blog site, "Farm Doc Daily" which you may access from the left sidebar here.


  1. This is great stuff! Thanks.

    One question I have is why do some of the major cereals tolerate different levels of stocks before reaching the steep slope of the price curve? Does it have anything to do with the rate of consumption and the seasonality of production? Or the ability to switch between one cereal and another in products?

  2. Hi Kay,

    As you know, I am not a member of the "Speculators Did It!" club, particularly when it comes to foodstuffs. The obvious culprit there is biofuels, The End.

    However, that is not to say I do not see a shift underway that will continue to impact consumer prices.

    Consider how much investment capital was flowing into financial 'assets' prior to the bust in 2008 (hindsight suggests the descriptor 'liabilities' makes more sense). Given that wealth destruction was not 100%, investment continues and investors are reallocating significant percentages of their portfolios out of 'derived' products into tangible holdings. Your farmland pricing posts effectively document this trend as each post reflects new, all-time high prices.

    More money chasing an investment of finite supply will cause the price to rise. In the case of perishables, those products either have to get used at some point or are lost so price distortions due to rapid investment influx should be relatively shortlived. That's not to say I believe prices will remain essentially stable. The increasing demand for foodstuffs will remain unabated. Simple math. Higher prices.

    Where I would anticipate an impact from the influx of new capital will be in the actual operation of landholdings. I expect the longer-term, larger investor/investment vehicle(pension fund, hedge fund, etc) diversifying into farmland to operate the agribusiness more sharply than, say, a family farmer or smaller syndicate.

    As such, I believe the ability to pass-thru increses in input costs will increase dramatically - a state that does not currently exist. At present there is quite a lag with respect to actual production. Larger entities are less needful of the cashflow for financing expenses and more immediately sensitive to the margins.

    I anticipate greater price volatility going forward.


  3. TOTN: I'm not sure that I agree with you on a couple of points. But perhaps I'm just not understanding what you've written.

    First, I doubt very much that the large investors that you point to will know anything about or be interested in "operating" the agribusiness. Also, since so little farmland comes on the market in a given year, it would take a VERY LONG time for them to gain a critical mass by actually owning farmland. Of course, maybe they will be syndicating and/or buying CDOs of farm mortgages and farm operating loans?

    The other thing that I have to wonder about is whether they will have any greater ability to pass through input costs. Aren't the "products" that you are talking about generally commodities which are traded on exchanges? So how will they be able to influence the prices of these products?

  4. Hey DB!

    Yep, I was in a hurry - a neighbor called and invited me out to the local for lunch while I was forming my thoughts....a poor excuse for a flimsy argument I know but I'm sticking w/it.

    Anyways, my premise is larger holdings (not necessarily domestic) are less likely to be financed/leveraged, more likely to be professionally (and I mean expertly) managed.

    For example, a couple of years back I was listening to a farmer from Iowa - the family had a few thousand acres under cultivation - who had left the family biz and was working for a syndicate buying S. American ag land. In short order they had 50k acs under cultivation. So that lends credence to the notion of new economies of scale being created. And they were cash land buyers / equipment leasers so that example also tends to support my premise that cash flow will be less important to them than to a smaller holding who is leveraged.

    It is my observation that the smaller guys will just keep trying regardless of overall conditions - higher oil or lower crop prices or higher financing or whatever adverse market conditions they are confronted with, because they persist on the cash flow while hoping for a better year in the future, effectively reacting to the current state of affairs and with an annual lag to boot. Whereas I'm supposing these big players are much more proactive, able to hedge input costs far more effectively and will alter their operations far more dramatically whenever deemed warranted (i.e. advantageous).

    So what I'm predicting (FWIW) is that the new big ag investors will not only be quicker to adjust what they plant but their decision to plant (or not plant) will be quicker and better informed and solely based on ROI, not so much their cost of capital. And to me that suggests they will be less tolerant of collapsing margins as often happens in the ag biz. If they can't reasonably lock their expected ROI, they will sit it out until they can....

    My disclaimer now is we had a couple (read several) drinks @ lunch.....hehe


  5. DB,

    It occurs to me I didn't really give you an idea of the mechanics of what I was suggesting.

    Let's say I am the operator of a large tract of ag land. Absent some exigent circumstance:

    I know what my wage expense for planting, tending & harvesting the new crop will be before I start.

    I know my seed expense...

    I know the amount of fuel I will need and can lock the price via a hedge (i.e. I know my cost)....

    I know my expense for fertilizer, herbicide & pesticide....

    And I know how much my proposed crop is worth today (the futures price).

    So I can tell with near certainty what my rate of return will be assuming my crop comes-in at or near my expectation (always going to be some risk - which is why the syndicates shoot for around 15% yoy).

    A a good scale operator can virtually lock it all down before he drills his first seed. I assert this new scale will alter the landscape! (pardon the pun DB, couldn't help myself.)


  6. TOTN
    I endorse what you wrote, drinks and all. The momentum behind the land buying globally, and the farms getting bigger is not going to stop. Whatever size a farm is today, its owner wishes it were bigger. And once they've invested in their expensive GPS tractors and computerized input capable equipment, they really want more to make that investment worthwhile. And, yes, they do have the bargaining power.

    Not to ignore your question, I want to do a more in depth post on the subject of stocks to use and how to interpret them and what it means for different commodities. Storage availability, time for production, animal vs human food, substitution ability, and multi-factors would be the answer and my impression is that the comfort levels are constantly changing, too.

  7. TOTN:
    As they say where I come from … Hold Your Horses! I’m not convinced.

    With respect to farmland buyers using leverage vs. paying cash, I have to disagree. I think you are trying to extrapolate your S. American cash purchase example to the land market as a whole. It would make no sense for buyers to use cash when interest rates are so low, particularly in the US. On the other side, just look at the land sale near Le Mars, Iowa that is getting all the attention because the buyer paid $10k/acre. That deal was entirely financed by a very large operator. So I would be just as accurate as you if I extrapolated that example to a wider market.

    As far as your statement that larger operators can hedge expenses that smaller ones can’t, I again disagree. These days even smaller operators can lock most of their expenses in advance if they so desire. The seed and fertilizer dealers, fuel companies, et al, are very willing to do this for just about anyone. Local coop elevators and local ag banks can help to hedge a variety of inputs. Anyone can buy and sell crop futures on the board.

    In many ways, these new large investors will be at a disadvantage. They will mostly be buying the land that nobody else wants and raising crops in marginal areas. They will be the first to be crushed when crop prices and land values fall. The only advantage that the large operators have is economies of scale. I don’t think that they will be able to alter their operations as much as you believe. They will not have the option of “not planting” when they have so much invested and at stake.

    It will be interesting to see where we are five years from now. By then we will know which one of us is right.


  8. question from a non-ag economist who talks to farmers now and then. I remember talking to one a few years ago when corn had first spiked and congratulating him on being able to clean up. He told me that while the future price had really jumped, he was not able to actually sell his future crop forward at that price to his local elevator. Regardless of the alleged market, nobody would buy the actual corn. That suggests to me that part of the future market is pure gambling between futures buyers and sellers, neither of whom actually want to deal with real corn. It seems to me that this could explain some of the volatility, just as happened in the gambling on synthetic CDO's.

  9. Hey DB,

    I'm not rejecting your view - you could certainly be correct. However I would merely assume that an investor paying $10k/acre in rural Iowa is not making an Ag investment but rather they are likely making a real estate investment. Now I say this while being uncertain of what lease rates are in that part of the world but I suspect lease rates do not currently align with a $10k/acre sale price.

    Kay? Any ideas what the lease rate in prime Iowa these days? $750-ish maybe?

  10. Hiram,

    I had a fairly extended exchange w/Kay on your topic but let's zero in on your main question: is part of the futures market pure gambling between buyers and sellers, neither of whom actually want to deal with real corn?

    Short answer: absolutely

    As far as increasing volatility goes however, increased liquidity actually has a dampening effect on volatility except when everyone shares the same view. And our Futures markets are extremely liquid.

    As far as a farmer unable to get the same price for a Cash Forward at his elevator vs the posted price on a regulated futures exchange, there can be any number of possible reasons. The simplest reason is that you can compare the Cash Forward to an Over The Counter derivatives contract (i.e. a private contract). Pricing in such instruments is rarely transparent and often, um, strongly favors the issuer (i.e. the elevator). I'm not casting aspersions @ elevators BTW. They build economies of scale in grain storage & marketing. The offsetting of crop price risk is not a core activity.

    That said, a farmer can hedge future production w/futures although I swent to great lengths explaining to Kay why that is not recommended for operators without dedicated hedging staff.

    Hope this helped.

  11. Hiram,

    There isn't always a cash market for corn out as far as the futures market trades. Like all markets, the greatest liquidity is always in the nearby part of the curve. My guess is your farmer was looking to sell corn for future deliver period beyond which the local cash market participants were willing to buy. As you go further out on the curve you see declining buying interest in both the futures and cash markets.

    Typically the cash markets don't trade as far out as the futures markets. A physical buyer takes on more risk than a buyer of futures. The have both the credit risk of the producer and, assuming they are hedging their risk in the futures market, the risk of having to meet margins call on the futures position over the life of the contract. These risks can be considerable and more and more buyers have a decreased appetite for purchasing physical corn for deferred delivery.

    Even a physical market participant looking to get forward coverage might decline to buy you farmer friend's corn. Suppose he farms in Iowa and a corn processor in Decatur, IL is looking to get forward coverage. It wouldn't make sense for the processor to buy from the producer as the corn isn't "freight logical" to his facility. He is better off buying futures to hedge his risk and then later replace his long futures hedge with physical corn purchased from a local producer. The producer would be better off selling futures and then replacing his short hedge with a physical sale to local elevator when they started bidding. The whole point of a futures market is to facilitate this type of transaction.

  12. TOTN:

    There's some info here about Iowa cash rental rates:

    Personally I like to look at the the "Average Iowa Cash Rent as a Percent of Crop Value". Unfortunately when you have a lot of volatility in crop prices, rents are volatile too.

  13. DB: Great link! I guess I was way off on my lease rate estimate. Which further persuades me that a sale price of $10k/acs has nothing to do with agriculture.

    Here's another data source FWIW. From a family friend last July:

    "I have 2500 acres. All is in two counties in Northwest Iowa. I cash rent it to a couple of local farmers, and we have a formula which pegs the rent to the price of corn. I like it cause its easy to manage, and it has in recent years been a terrific investment...Price of land in these counties has nearly doubled in the last four years, and annual rent produces a 5% -8% return."

    Does this sound like your idea of a typical passive ag investor? I could see that. But at some point, and I suspect that point arrives soon, he's going to ring the register on the cap gain in the land. I'm not sure what type of investor follows him but I don't see the basic math working out @ $10k/acs and $4/gal diesel for an ag operation when corn is $7/bu....

  14. TOTN: Your friend in NW Iowa is just being a smart landlord. These flexible leases (based on prices, yields, or both) are being used more and more. Do you really think that your friend would sell, even at these high prices? Landowners hold these parcels for a variety of reasons. They are a great annuity for retired farmers - many of them hold on to the land they used to farm for many years after they stop being active.

    After reading several articles about that $10k land sale, I think this was an unusual situation. I wish that I knew who the other active bidders were and what they were planning on doing with the land. As I recall, the CSR (Corn Suitability Rating) for that piece of property was on the low side which tells me that it wasn't being purchased for its productive qualities. I've seen higher CSR parcels sell recently for much lower prices.

  15. Glad to see your reference to Scott Irwin and his article with Dwight Sanders. Your post hits all the right points, and the fact remains, there are many more recent reports that refute the notion of demonizing speculators. Dr. Speer nailed it when he wrote:

    “Imagine what the world might look like without market liquidity, price discovery and risk mitigation; not to mention the inability to establish pricing plans, attract new capital investment and stimulate innovation across the food business.”

    My colleague, Dave Lehman, just posted a blog last week ( that cites several such studies. There continues to be growing evidence on prices – and it’s not pointing toward speculators.

    Placing the burden entirely on biofuels (per the previous comment) would be extreme, because there are many macroeconomic factors at play. Take corn, for example. Extremely tight supplies in the U.S., inelastic demand due to ethanol mandates, currency volatility, increasing energy prices, and growing appetites for U.S. corn in world markets, including China, are just a few of the economic forces causing corn prices to rise.

    Allan S.