Most shipped bulk commodities

One other factoid I found interesting in Prime Movers of Globalization was the relative volumes of the most shipped bulk commodities (besides crude and petroleum products, which dwarf them).

• iron ore, ~800 million tons


• coal, ~800 million tons


• grain (I think including oilseeds as well), ~300 million tons


• bauxite and alumina, ~80 million tons


• phosphates, ~30 million tons
  

This might only be interesting for commodity nerds, but I thought the drop-off was impressive.

Fragiler-than-it-seems-Brazil, continued

I've worried before about whether Brazil's economic and political progress would falter if commodity prices swooned. Via MR, this FT article not only puts a number on that...

Plug in 2005 commodity prices, for example, and Brazil’s $23bn trade surplus would become a $20bn deficit.

... it also calls out another worrisome trend, the explosion of consumer leverage.

Bank credit is now growing at a 20 per cent annual clip.

That has given Brazil’s economy an appearance of strength, but also risked stretching it thin. Typically, Brazilians now spend a quarter of disposable income on debt payments. At the height of the US credit boom, by contrast, American households spent about 15 per cent.

With the real now at 1.57 vs. the dollar - higher than it ever got in 2008 - I am pondering whether now is the time to trim my Brazil investment exposure...

Could U.S.-Brazil relations watershed survive commodity crash?

A very high percentage of "Event X was a true watershed" articles turn out to be crap, but this one on U.S.-Brazil relations (via MR) is pretty good. (Maybe because that narrative device is totally extraneous - this change has been coming for years and Obama's visit didn't actually change that much). Worth reading in full, but the punch line is:

... the major strategic interests of the US and Brazil are so closely aligned that cooperation between the two countries will be one of the building blocks of the new century... [Brazil’s] its instinct for “order and progress” (the slogan appears on its flag) dovetails very closely with what the United States wants to see in the world.

I agree except for a nagging doubt - with Brazil's economic ascendancy so dependent on commodities, how much of this unravels if resource scarcity isn't all it's cracked up to be and prices crash? After all, we've heard the same arguments before (ahem Paul Ehrlich).

Let me back up a bit to build up the logic. Brazil has historically been commodity-dependent...

In the 19th century Brazil was part of Britain’s ‘informal empire’; Britain was the dominant foreign investor in the country and Britain controlled the markets for the primary commodities (sugar, rubber, cotton, coffee) whose falling and rising prices set the tempo for Brazil’s growth. But the system seemed rigged in Britain’s favor; Brazil could never escape its role as a commodity producer — a hewer of wood and a drawer of water in the international community. Brazil did the backbreaking labor; Britain grew rich.

... but isn't it still? I don't have the stats on hand about how much soy, iron ore, etc. etc. Brazil exports, but it's a lot; it's not clear to me that the economy has fundamentally transformed, rather than simply ridden the latest commodity wave on the way up.

The premise continues that Brazil has demonstrated a successful new model...

Lula’s Brazil stuck up for Venezuela at international gatherings and danced with it at parties. But all the while, Lula’s Brazil was destroying the political logic of the Bolivareans by demonstrating that a pluralistic democracy integrated into the global market can do more for the poor than incompetent populist blowhards. Chavez talked; Lula delivered

(again, on the back of a commodity boom...)

What that means is that Brazilians, even those on the left like former president Lula, are now less inclined to think that Brazil needs to overturn the global economic system.

I have lived in Brazil and I agree with this sentiment, and that "Brazilians have an immense capacity for hard and focused work." But in a world with lower commodity prices (and, again, I don't think this is the most likely scenario, but remember it's been less than 30 months since crude oil was in the low $30s), how will the Brazilian economy hold up, and if it falters, won't that popular support as well?

This is very much a preliminary perspective and I would welcome debate and pushback on it.

Commodity dependence of Brazil

The Globalizer, via MR:

When Lula won the presidency in 2002, Brazil’s main trading partners were the United States (25.5%), the Netherlands (5.3%), Germany (4.2%) and China (4.2%).

Over the eight years, the U.S. share collapsed, while the Chinese share more than tripled. By 2009, Brazil’s main trading partners were China (13.2%), the United States (9.6%), Argentina (7.8%) and the Netherlands (5.0%).

The writing was on the wall. As long as demand in these two nations continued for commodities, Brazil will continue to grow — but if demand were to fall abruptly, the situation could get difficult.

Brazil is currently a darling of economic and political progress, but lots (most? >100%?) of the underlying growth has been driven by commodity exports, and that story has ended badly before.

This article on Lula, also via MR, is also worth reading - it starts:

... in democratic conditions, to be more popular at the close than at the outset of a prolonged period in office is rare. Rarer still – indeed, virtually unheard of – is for such popularity to reflect, not appeasement or moderation, but a radicalisation in government. Today, there is only one ruler in the world who can claim this achievement, the former worker who in January stepped down as president of Brazil, enjoying the approval of 80 per cent of its citizens. By any criterion, Luiz Inácio da Silva is the most successful politician of his time.

Blaming and curbing food speculators

With wheat prices up 50% since June and Russia banning grain exports, the media is all over "the next food crisis." I'm disappointed that former IFPRI Director-General Joachim von Braun appears to lay much of the blame on those evil speculators.

The setting of prices at the main international commodity exchanges was significantly influenced by speculation that boosted prices. Not only are food and energy markets linked, but also food and financial markets have become intertwined – in short, the “financialisation” of food trade. There are increasing indications that some financial capital is shifting from speculation on housing and complex derivatives to commodities, including food.

von Braun is right to call for "accelerated public investment in agriculture." But I believe it's misleading to imply that speculation-curbing measures such as requiring larger capital deposits of traders will really help moderate either prices or volatility. For prices, note how prices also rose in non-speculatable food commodities in 2008, and for the impact of speculation (a.k.a. liquidity) on volatility, just remember the onions.

I'm not 100% sure I'm right on this, but I would have appreciated a more robust substantiation of the claims about speculation's impact from someone of von Braun's stature.

Price rises in non-speculatable food commodities

I recently had a contentious discussion over the extent to which financial speculation caused the food price run-up of 2008 (and prior years). I am skeptical that speculation was a major culprit, and I was unable to remember the specifics of the argument that prices rose similarly in commodities which are not index-traded. For future reference (my own as much as my readers'), I tracked it down in this paper recently released by the OECD. (emphases are mine)

If index fund buying drove commodity prices higher then markets without index fund investment should not have seen prices advance. Again, the observed facts are inconsistent with this notion. Irwin, Sanders, Merrin (2009) show that markets without index fund participation (fluid milk and rice futures) and commodities without futures markets (apples and edible beans) also showed price increases over the 2006-2008 period. Stoll and Whaley (2009) report that returns for Chicago Board of Trade (CBOT) wheat, Kansas City Board of Trade (KCBOT) wheat, and Minneapolis Grain Exchange (MGEX) wheat are all highly positively correlated over 2006-09, yet only CBOT wheat is used heavily by index investors. In a similar fashion, Commodity Exchange (COMEX) gold, COMEX silver, New York Mercantile (NYMEX) palladium, and NYMEX platinum futures prices are highly correlated over the same time period but only gold and silver are included in popular commodity indexes. Headey and Fan (2008) cite the rapid increases in the prices for non-financialized commodities such as rubber, onions, and iron ore as evidence that rapid price inflation occurred in commodities without futures markets. While certainly instructive, the limits of these kinds of comparisons also need to be kept in mind. Bubble proponents have pointed out that commodity markets selected for the development of futures contracts may be naturally more volatile than those commodities without futures markets.

The paper also includes more far more statistical including the latest Granger causality analysis, which is more rigorous, but also in my view less effective than anecdotes like the above in many informal discussions. Their overall conclusion is unequivocally in line with my view that

... at this time, the weight of evidence clearly suggests that increased index fund activity in 2006-08 did not cause a bubble in commodity futures prices.

In related reading, here are previous posts citing Thomas Malthus and Darrell Duffie on the benefits of speculation in food markets, and here is Scott Irwin (one of the OECD paper co-authors) last year on why index speculators didn't break the wheat market.

A meta-verdict on commodity speculation

A new OECD meta-study has concluded that financial investors (a.k.a. the dreaded "speculators") were not largely responsible for commodity price run-ups in 2008. The two main arguments will be familiar to regular readers.

Higher futures prices could have sent a signal to commodity producers, who then decided to hoard their stocks rather than sell them in the cash market. The shortage might then have pushed spot prices higher. The evidence, however, is that inventories were falling, not rising.

An even more telling argument is that commodities without futures markets (apples, edible beans) or futures markets where index funds did not get involved (milk, rice) also saw price rises during 2006-08. Nor was there any correlation between the size of index funds in particular commodities and the price rise for those raw materials.

The study also draws the intuitive conclusion that larger financial participation probably lowered volatility, rather than raising it.

From the Economist (subscription required).

P.S. The same issue has a number of good pieces (all subscription required) on topics like Zimbabwe's Marange diamond field (prior to latest Kimberley ruling), the success of environmental activists in influencing the palm oil supply chain, and how chimps go to war over land rather than females.

Commodities not an asset class

I'm reading old Rick Bookstaber posts on the advice of a friend, and he is quite a thoughtful guy. I found this snippet from his post on asset allocation interesting:

Commodities do not form an asset class
This sounds heretical given what we have seen oil and gold do recently, but a lot of the reason that has happened is precisely because people are treating them as an asset class when they are not.

Commodities are not assets. They are factors of production. They do not generate returns, they have no claim on production. They have supply that flows out at a nearly fixed rate short term, and they comprise very small markets compared to the financial markets. If pension funds all decided to put two percent of their capital into commodities, two things would happen. First, that two percent would be a rounding error in their returns, no matter how commodities behaved. Second, they would swamp the supply of the commodities for economic purposes – i.e. for their true role as factors of production. I agree with Michael Masters’ view that oil prices were pushed up by this sort of financial activity. I might quibble with one chart or another, I might not couch it in the loaded terms of speculation. But the subsequent behavior of the market demonstrated that he was right and Goldman and others who took the opposing view were wrong.

This is an interesting take on the "speculation in commodities" debate - that financial investors played a big role in the commodity price boom, but that it was institutional investors, not nimble hedge funds, who were the financial market movers. And in this case, probably inadvertently so, and probably not lucratively either, since its hard to imagine them getting out of the way in time. A much different story than Bookstaber sees playing out in gold, by the way.

Speculation is not manipulation

In the fine tradition of Thomas Malthus, famous Stanford finance professor Darrell Duffie has penned an op ed entitled "In Defense of Financial Speculation: It is not the same thing as market manipulation." He has a sharp mind and makes the case well.

First, speculators perform valuable market functions by taking risk and disseminating information (remember Enron?).

Speculators earn a profit by absorbing risk that others don't want. Without speculators, investors would find it difficult to quickly hedge or sell their positions.

Speculators also provide us with information about the fundamental values of investments. When the fundamentals appear favorable, they buy. Otherwise, they sell. If their forecasts are correct, they profit. This causes prices to more accurately forecast an investment's value, spreading useful information. For example, the clearest evidence that Greece has a serious debt problem was the run-up of the price for buying CDS protection against the country's default.

Is this sort of speculation wrong? I have not heard why.

The distinction between "speculation" and "manipulation" is important.

Those who call for stamping out speculation may be confused between speculation and market manipulation. Manipulation occurs when investors "attack'' a financial market in order to profit by changing the value of an investment. Profitable speculation occurs when investors accurately forecast an investment's fundamental strength or weakness.

Manipulation is much harder to pull off than making a simple directional bet.

Market manipulation for profit is not easily done... Simply driving up the price, as speculators are alleged to have done in the oil market in 2008, is not enough. To make a profit, a manipulator needs to obtain monopolistic control of the supply. Given the size of the oil market, that seems implausible, absent a major and sustained conspiracy.

As long as speculators do not crash and destabilize financial markets with them, they are not where regulatory attention should lie.

It would be better for our economy to enforce anti-manipulation laws, and require that speculators have enough capital to cover their risks, than to attempt to squash speculation.

Worth keeping in mind the next time someone starts ranting about "reckless speculation."

Julian Simon got lucky (or not)

Paul Kedrosky re-analyzes the famous Simon-Ehrlich bet on commodity prices, and concludes that Simon (who won) got lucky.

It will surprise no-one that the bet’s payoff was highly dependent on its start date...

Simon was right but fairly lucky. There is nothing wrong with being lucky, of course, but compulsive Simon/Ehrlich-citers need to be reminded that it is no law of nature (let alone of rickety old economics) that commodity prices (inflation-adjusted or otherwise) trend inexorably downward, even over a decade.

Here's how the bet would have turned out since:

Via MR, and by the way, I am a bit confused by Alex Tabarrok's take - he seems to say that Ehrlich was betting on "scarcity", but instead the "value" of commodities has since gone up as developing countries got richer, increasing demand. He is the economics professor, but isn't the cardinal precept of economics that scarcity and value are fundamentally linked?

Update: Or not... Mark Perry responds:

I'm not so sure that Simon was just lucky. If Simon's position was that natural resources and commodities become generally more abundant over long periods time, reflected in falling real prices, I think he was more right than lucky, as the graph above demonstrates.

Stated differently, if Simon was really betting that inflation-adjusted prices of a basket of commodity prices have a significantly negative slope over long periods of time, and Ehrlich was betting that the slope of that line was significantly positive, I think Simon wins the bet.

Turning Oil Into Salt (4): Selective thinking on fungibility

The authors recognize that:

Oil is a globally traded, fungible commodity, so stifling U.S. purchases from the Persian Gulf and buying from other regions like Africa would just mean that someone else would buy more from the Persian Gulf with no impact on price and availability, certainly not on oil’s status as a strategic commodity.

This is one of their multiple (and good) arguments against the “Cheney plan” of diversifying America’s oil imports to non-OPEC countries.

Unfortunately, they don’t extend this level of understanding to their analysis of agriculture and biofuels:

How could that drastic increase in the price of food commodities from fish to rice possibly be attributed to ethanol? Nobody was growing corn in rice paddies or making biofuels out of fish.

Yikes. Agricultural commodities are largely fungible from both the supply and demand sides. Increased corn cultivation reduces the land available to grow other cereals like wheat, and higher prices affect the prices of substitutes like rice as consumers shift their consumption patterns in response. Farmed fish are often fed corn, as are industrially-raised cattle, pigs and poultry, which are meat substitutes for fish. Ethanol is certainly not responsible for all of the rise in food prices, but the most credible estimates link it to ~30% of the rise in grain prices (more for corn and less for wheat and rice).

Not only are the crops themselves fungible commodities, some of the resources required for production are fungible and, like oil, fundamentally scarce (think arable land and water). Like diversifying away from Middle Eastern oil, diversifying into biofuels is no free lunch.

Commodity risk premia

Here's a discussion I had with Michael Roberts in the comments of this post at Greed, Green and Grains. The themes of risk premia for natural resources commodities and the implications for asset pricing and discount rates are pretty interesting for someone with a finance nerd inside them.

Teaser/spoiler: this will also be of interest to anyone interested in arguing that climate policy cost-benefit analysis should use a low discount rate, i.e. should value the future almost as highly as the present, rather than discounting it heavily.

[end of original post]

My dissertation, which I never published, argued that these negative risk premiums help to explain why natural resource prices haven't trended up over time. A negative adjustment for risk means Hotelling's interest rate is probably close to zero.

I'm a little less confident than I used to be about this story. But I still think there is some truth to it. I really need to dust off that paper...

R:

Not sure I understand your dissertation thesis - I thought that for Hotelling's theory the relevant interest rate (/risk premium) was that available in broader financial markets? I.e. even if a resource extractor can't get a positive risk premium from holding natural resources, they could by buying a bond...

Michael:

Yeah, I could have been way clearer in this post. Sorry, this was really more of a note to myself than a genuine effort to communicate an idea.

I'll try to give the intuition briefly.

Take oil, for example, say back 10-30 years ago. Prices generally bounced around due to news about supply or potential supply in the future. The really big price spikes came from oil embargoes, wars, etc. If prices go up, those who own the oil are very happy. But the rest of economy is not so happy. A reduction in oil supply is a real shift inward in the productive capacity of the aggregate economy.

Now asset pricing theory tells us that in equilibrium we should expect the risk premium to depend on the covariance with the aggregate economy. So, if oil prices go up when the aggregate economy goes down, going long on oil is like buying insurance for a bad economy. Insurance, like buying and holding oil, has a negative risk premium--it's an investment that loses money on average but you're willing to do it because it pays off most when you need it most.

Assets like stocks are the opposite, they pay most when the economy is booming and you need the money least.

Now Hotelling is just asset pricing for natural resources. It says prices should generally go up at the rate of interest. The thing is, for some basic commodities, the risk-adjusted rate is about zero. So prices don't go up in the long run.

Today demand shifts are driving oil prices, and that changes things. But I think the story still holds for precious metals and natural gas where supply uncertainty remains significant.

The same idea applies to climate change discounting. Investment in curbing global warming reduces the chance of a bad thing happening. It is an investment that pays off a lot of climate change is a really bad thing and an investment that pays nothing if climate change really isn't so bad. This means the risk premium is negative.

Somehow many of my colleagues (especially environmental economists) seem to forget or overlook this essential fact. Weitzman gets it. So do the macro/finance guys who care about climate change. So does John Quiggin. Rank and file environmental economists don't get it, and it really shows in the literature.

R:

Ah, I understand now - thanks for the longer explanation.

So what are the practical implications of the negative risk premium for investing in climate change prevention? (e.g., what mistakes would policy made based on the work of the "rank and file" be prone to?)

And does the asset pricing analogy really hold for climate change or other environmental public goods, where the "proceeds" of investment are shared broadly, rather than captured by the investor alone?

Michael:

Yes, I think all of this matters a lot for climate policy. A big part of the debate in economic circles pertains to the discount rates that should be used in weighing the benefits and costs of regulation.

If someone naively things the risk premium is positive, then the future--where all the benefits of climate change mitigation reside--gets discounted heavily. If we see it is actually a negative risk premium, then we discount the future much less.

Strangely, depending on one's assumptions, all of which may seem reasonable, one can get discount rates anywhere from slightly negative to 10% or more. And these different assumptions lead to cost/benefit calculations for curbing C02 that range from HUGE, like approaching 100% of GDP to basically nothing.

This ambiguity is not inspiring for economists...

R:

Nice - as an advocate of something being done about climate change sooner rather than later, I like this argument for why the financial discount rate should be low (for those who don't believe a lower "social" discount rate is appropriate).

Back to the original point, the more I think about it, the more I struggle to believe that natural resource commodities (even aside from oil) have a negative beta. Natural gas, iron ore, copper, phosphate fertilizer, most ag crops - pretty much you name it, it spiked in mid-2008 and fell dramatically when the world economy nose-dived. I'm sure someone has actually run the numbers before, but it seems anecdotally that demand is a big driver for all of them and they're only occasionally countercyclical.

Unfortunately that's as far as the conversation got (unfortunately because I think there is more to be done to hash this out completely) - but hopefully this is a good starting point for exploring these issues further in the future.

P.S. For anyone confused by the asset pricing jargon, here's Wikipedia on the Capital Asset Pricing Model (CAPM). The key idea relevant here is that diversification is valuable, so investors are willing to accept lower rates of return for assets whose returns are less correlated with the overall market (and this correlation is called beta).

Commodity share of retail food prices

Michael Roberts lays out some back-of-the-envelope math to back up the common (and true) assertion that “ Raw commodities make up a tiny share of retail food prices” in developed countries:

The numbers in the quote came from my own back-of-the-envelope calculations. There are about 6 lbs. of corn used to produce each lb. of beef. Corn sells for about $3.70/bushel. A bushel is 56 lbs. So I figured the value of corn in a pound of beef was about 40 cents, or 10 cents in a quarter pound hamburger. If corn when up to $37.00, a lot of people in poor countries would starve to death. But the price of a burger would go up just 90 cents.

Also, empirically, retail prices tend vary less than wholesale prices in absolute terms. In other words, I was being conservative--a pound of beef would probably go up a lot less than 90 cents.

On the topic of commodity prices, Michael also cites a recent paper on whether futures prices are effective predictors of commodity prices; the conclusion seems to be they they outperform a random walk, but that isn't necessarily significant in the statistical sense.

Blackstone and Warburg win big with oil

Raw commodities are far from the ideal private equity play - heavy value exposure to volatile commodity prices and seemingly little competitive advantage in either deal flow or operations. But a brave few have tried, and in at least one case succeeded:

Warburg Pincus and Blackstone Capital Partners are set to make a four times return on their investment in West African oil company Kosmos after oil giant ExxonMobil agreed to acquire Kosmos’ stake in Ghana’s Jubilee oil field for $4bn, according to reports.

I checked the Warburg Pincus website and found that:

Warburg Pincus led the company’s initial $300 million equity financing in 2004, and also led a $500 million follow-on equity financing in 2008.

I then checked the news for when in 2008 (makes a big difference!), and it was in June, or basically when oil prices were well above $100/bbl and racing towards $150. So it's not as if Blackstone and Warburg simply bet on and nailed the commodity cycle - it seems their add-on investment came at the peak. It seems the bet was more on the management team and their track record, which is impressive. That said, I doubt we see too many more of these deals - with the recent levels of commodity volatility, most major PE firms are shying away from direct commodity price exposure and looking for more indirect ways to get exposure to the overall volume and price growth.

Barrick bullish, buys out gold hedges

Barrick really wants to get out of its fixed-price gold hedges:

Barrick Gold will issue $3 billion in stock to eliminate all of its fixed-price gold hedges and a portion of its floating hedges, taking a $5.6 billion hit to third-quarter earnings, the world's top gold miner said on Tuesday.

For Barrick, which expects gold prices to keep rising, the deal should remove what has been a big drag on its shares, the legacy of the company's past reliance on hedging, a practice it abandoned in 2003.

Presumably they're buying out the contracts at market prices, making this a strong bullish bet on gold prices (not only do they now have directional exposure, they've also assumed the risk of earnings volatility that was hedged away before).

The supports rationale the NYT cites seems questionable, though:

A raging gold market also made the timing right, the source said.

Unless you are a big believer in the commodity super-cycle, a "raging market" should sound like a market peak, i.e. a good time to lock in long-term prices for your production... and yet Barrick is doing the exact opposite.

Only time will tell how this works out, but it is a naked directional bet - and not as sure a thing as media coverage would have you believe.

Update: The investor community seems to like it - the offering was so oversubscribed that they've raised their target to $3.5bn.

Update 2: The broader market isn't as convinced the move will add value for existing shareholders - Barrick is down 6%.

Update 3: My favorite finance blogger Felix Salmon agrees with me, only more harshly:

And then there are the hedges which just don’t make any sense at all: like Barrick Gold, which locked in low gold prices and is now spending a whopping $3 billion to unlock them at the top of the market. Anybody care to explain that one to me?

Commodity specialization in Latin America

Here's a striking stat from last week's Economist:

But the pattern of trade and investment so far reinforces the fear among some Latin Americans that China is causing the region to respecialise in commodities, as it did in the 19th century, to the detriment of industry. While China’s exports to the region span a wide range of manufactured goods, its imports are highly concentrated in a few commodities (see chart 2). Soyabeans and iron ore account for two-thirds of Brazil’s exports to China, and crude oil for a further 10%. (By contrast, Brazil’s exports to the United States are mainly manufactures.)

If I were an aspiring economic superpower and almost 80% of my exports to my largest trading partner were three essentially raw commodities with little value-added, I'd be a little concerned. One is hard-pressed to find any examples of nations who climbed (and stayed atop) the economic ladder through commodities alone. Maybe Norway is the best example? But I feel like Norway had a lot else going for it as well. And as the Economist article points out, while "this specialisation is not necessarily damaging in itself," Latin American countries will have to find ways to improve the competitiveness of the parts of the economy that actually make widgets, rather than pulling black or green gold from the earth.

Creating markets is hard

William Easterly's Aid Watch blog cites an interesting project in Ethiopia as an example of the impossibility of assessing development projects on a binary scale:

This month, while the G8 continued their vague pledges of billions in food aid, Eleni Gabre-Madhin was busy bringing a market-based solution to the problem of food security in Ethiopia, as the CEO of the Ethiopia Commodities Exchange (ECX). After years of studying Ethiopia’s agricultural markets, Gabre-Madhin hit upon a central commodities market as a way to end the country’s deadly boom and bust cycle, which has seen overproduction and low food prices one year and famine the next.

The ECX has been running for a little over a year now, and lists five commodities traded on its website—coffee, sesame, beans, maize and wheat. With a central trading pit in Addis Ababa, eight warehouses throughout the country, and market data being transmitted through a network of electronic display tickers, text messages, TV, internet and radio, the ECX is designed to reduce the burden of high transaction costs and excessive risk on farmers and traders, and increase access to information for small-scale farmers in remote areas.

In 2008 when the ECX was launched, the Economist called it a “bold experiment to improve the efficiency of agricultural marketing,” and Eleni Gabre-Madhin herself has been lauded as a visionary and a pioneer.

Sounds great, right? There is certainly much to be said for transparency and liquidity in agricultural markets. But interference by the corrupt and untrusted government has apparently damaged ECX's credibility, highlighting the challenge of building markets in countries with weaker legal and institutional frameworks than we're used to here in the developed world.

China is the ants, West is the grasshoppers

Via The Oil Drum, Dr. Stephen Leeb opines that resource scarcity means commodity-rich countries (the "BRACCs", Brazil/Russia/Australia/Canada/China) are the soundest long-term investment. Not sure I would go quite that far, but I do like this quote on China's recent pursuit of resources:

China has been stockpiling commodities, particularly oil and iron ore. Unlike Americans, the Chinese think long-term. Rather than worry about next quarter or next week, China plans decades in advance – and it has over a billion people to house, clothe, feed, and transport to work each day.

Buying resources makes perfect sense if you have even a broad idea of the resource crisis that's approaching. The problems we have today may seem big, but at least they can be solved by money. The coming resource shortage cannot. China's method of using money to accumulate resources is now one of a few possible answers. As the fable goes, they are the ants, and we unfortunately are the grasshoppers.

Academia: indices DIDN'T break the wheat market

A few weeks ago the Senate released a report blaming speculation and specifically index funds for high wheat prices and non-convergence of the futures and spot markets. It was interesting reading but received mixed reviews. At the time I stated:

It's very complicated to prove anything in this arena - my hunch is that the indices did play a large part in non-convergence of wheat contracts at the least, and maybe higher volatility as well, but I haven't seen anyone prove it to my own satisfaction.

Well, turns out I was wrong, according to Scott Irwin, a professor of agriculture at the University of Illinois. In a recent post on Econbrowser, he assembles the academic work on the topic and points the finger at two other culprits:

Our research at the University of Illinois pinpoints two major factors contributing to the lack of convergence between cash and futures price in wheat. The first factor is the tendency for spreads in the futures market to reflect a relatively high percent of full carry (contango) since 2006. The second factor is long-term structural deficiencies in the delivery system for CBOT wheat.

I won't do more than summarize (you should read his whole post if you're interested), but on the latter, the basic idea is that because of non-negligible delivery costs and an oligopoly controlling delivery locations, the market isn't entirely efficient (for reasons not yet understood).

It is not clear why these firms have apparently left so much money on the table by not arbitraging the very large differences between cash and futures prices. Understanding the motivation and strategies of these firms would be a far more informative line of inquiry than the current obsession with index funds.

As for the former, the following chart is worth a thousand words:


Days 5-9 are when the so-called "Goldman roll" takes place, i.e. where we would expect to see the impact of the influx of money into long-only commodity indices. And we see a bump... but the effect is not persistent (it subsides immediately in Days 10-13) and it dates back at least a decade. In light of this evidence, it's hard to believe the Senate report's assertion that index rolling was responsible for the recent and persistent widening of spreads.

Commodity trends: ag vs. oil

As I mentioned in my previous post, Michael Roberts at Greed, Green and Grains had a thought-provoking post on commodity trends. His mini-thesis is that, over the last few years, "Price fluctuations have become much more a demand-related phenomenon than a supply-related phenomenon."

He summarizes how for the last few decades, oil prices were driven mostly by supply shocks (embargoes, wars, etc.), whereas (falling) agricultural prices were driven mainly by "remarkable yield growth." But today...

But today it's all about demand. Demand for all kinds of commodities from oil to food grains came from tremendous growth in China and India. Supply growth couldn't keep up. Agricultural commodities got an additional demand boost from ethanol, which also linked agricultural prices more closely to energy prices. Then, when the global economy tanked, so did commodity prices. And today speculation, instead of being about possible supply disruptions, is all about when demand growth will resume.

I agree with him on oil - demand certainly has tanked due to the recession. I am not so sure on ag. First, the 2007/8 run-up in world cereal prices was caused by a complex set of factors including some on the supply side, like droughts in Australia and rice export bans in Vietnam, India and Egypt. Second, food demand is not as elastic as oil demand - people for the most part keep eating in a recession (not to insensitively downplay unfortunate exceptions), and the RFS mandates which drive the majority of corn ethanol and biodiesel demand remained in place. Third, unlike oil (where supply proved fairly inelastic in the face of record prices), high food prices provoked an impressive supply response - according to The Economist, "farmers harvested 2.3 billion tonnes of cereals in 2008/09, the biggest crop ever seen."

In conclusion, while in oil a peak supply/Peak Oil dynamic may be in play, I don't think we are at Peak Ag yet (although the more one looks at water, soil degradation and climate change, the more one worries it may be closer than most people think). In the medium term, both supply and demand in ag are flexible and speculation will continue to be about both, and at what price they'll meet to clear the world market.