The line between trading and manipulation

Ah, the publicity that comes from an IPO...

This is OK and unsurprising...

Glencore made a speculative bet on rising wheat and corn prices in the early stages of last summer’s Russian drought, the world’s largest commodity trader has revealed ahead of its initial public offering that will value the company at $60bn.

... but this is pretty sketchy:

As it bet on rising prices, senior traders at the Swiss-based company publicly urged Russia to impose a grain export ban... On August 3, Yury Ognev, head of Glencore’s Russian grain unit, encouraged Moscow to ban wheat exports, saying: “From our point of view the government has all the reasons to stop all exports.” His deputy made similar comments. At the time Glencore distanced itself from the comments, saying they represented Mr Ognev’s personal views. Russia imposed the ban on August 5, sending the price of the cereal more than 15 per cent higher in two days.

As longtime readers know, I generally believe and document that speculation in commodity markets does more good than ill, but this type of lobbying for trade-reducing, volatility and uncertainty-enhancing measures makes me very uncomfortable, and will never be popular.

Who are the real cotton speculators?

The WSJ (and the InterContinental Exchange, for that matter) always seem so quick to jump on financial speculators as the cause of price rises in any given commodity. Cotton prices more than doubled from Dec 2009 to Dec 2010, and have risen another 20% in 2011.

The top cotton-futures exchange is clamping down on speculation amid soaring demand that has sent prices up, threatening losses for mills, commodity merchants and apparel producers.

... Over the past year, the number of cotton contracts outstanding has grown by 21%, aided by an influx of hedge funds and small speculators.

ICE is apparently worried, although I can't tell how much of this is journalistic dramatization.

In response, ICE on Thursday said it will increase its scrutiny of big positions from now on.

"Increase its scrutiny," huh? A pretty threatening step!

A few maxims for analyzing commodity price spikes. First, always look to supply and demand first. Second, as Paul Krugman reminds us, speculators can't sustainably increase prices without actually withholding physical supply from the market, so if inventories aren't increasing, be skeptical.

What do we find in this case? First, the supply-demand picture looks tight, as the WSJ itself acknowledges:

Low global stocks of cotton and growing demand, particularly from China, have caused concerns of shortfall in the fiber this year. Rains in Pakistan and India, the second-biggest grower, and recent floods in Australia have fed fears of a shortage.

Second, there is actually cotton hoarding going on at scale - by cotton farmers in China (via Krugman). That is physical speculation (seems morally reasonable when it's farmers doing it, and incidentally not subject to ICE position limits). Finally, political uncertainty makes commodity markets jittery, and Egypt is a major cotton exporter. I think there might be something going on there.

P.S. Egypt is indeed a major cotton exporter, but I was surprised to learn that in 2004, Benin, Mali, Syria, and Greece exported comparable volumes, and FAPRI doesn't even track Egypt for cotton. Based on price per ton from FAOSTAT, Egyptians do the high-end stuff.

The opposite of speculation

A lot of people complain about speculation in agricultural commodities as the root of all sorts of evils. But what does it look like when there’s no speculation at all?

The pork belly is in danger of going belly-up... just six contracts changed hands in the month of November—fewer than uranium or palm oil. The once-bustling pork-belly pit has been moved to a corner of the CME's floor, an appendage to the lean-hog-trading pit.

There are several reasons, but a big one is that

Financial traders have largely shunned the contract because it requires buyers to take possession of massive quantities of meat.

It seems even small-scale market participants appreciate this dynamic:

"For a contract to be successful, you have to have fund participation" from hedge funds and commodity funds, said Dan Norcini, an independent livestock trader in Idaho who has been trading commodities for more than 20 years. "There're not enough volumes for them to move in and move out." Mr. Norcini stopped trading pork bellies about three years ago.

The moral of the story, as usual, is that “speculators” provide liquidity and liquidity is by and large a good thing.

Cocoa corner appears to fail

Remember the great cocoa heist of 2010? Seems that good weather and a promising harvest in the Ivory Coast sunk the whole scheme, which is now being unwound. Hard to tell outside-in how Armajaro (the market cornerer) made out, but prices are already 30% down from this summer's peak and it's hard to imagine that they made a fortune.

The moral of the story is: it is really, really hard to make good risk-adjusted returns by taking directional bets on agricultural commodities. And if nimble hedge funds struggle to do it, we should be very cautious about the expectations we set of any pseudo-public entity (see #5) created to intervene in markets to manage volatility in agricultural commodities.

More food price volatility drivers

Upon further reflection on Chris Blattman's rare dud, here are a few more (slightly overlapping) potential drivers of food price volatility in the future. Please note that I'm not saying these will definitely cause higher food price volatility in the future, only that it is very easy to believe that they might.

• Biofuels and bioenergy: An additional source of demand growth - potentially very large - that could keep demand at the very edge of supply capacity.


• Stronger links to energy prices: Energy prices have always been linked to agricultural input costs since the most widely used fertilizer (nitrogen) is generally made from natural gas. More recently ethanol has become at times the marginal buyer of corn (Bruce Babcock at CARD did some nice research demonstrating that ethanol was the marginal buyer from late 2007 to mid 2008; I couldn't find a link to the paper, but all you need to do is look at the high correlation between actual corn prices and break-even prices for ethanol production). If this continues - and it may well, particularly when oil prices are high - then volatility in oil prices will be transmitted to food prices more than in the past.


• Speculation: That old bugbear; I personally am more skeptical about this one, as longtime readers will know, but the former head of IFPRI isn't, and objectively I'm no more likely to be right than he is.
  

Update: Michael Roberts responds and reprimands:

Here Chris seems to talking as much about climate science as economics or politics. He has also stepped onto a pet peeve of mine, common among some economists, which is ascribing personal views as truisms stemming from the branch of social sciences in which one specializes. It's not quite as bad as Steven Levitt pontificating about global cooling, but it reeks of that kind of professional arrogance. If you're an academic and are going to start asserting scientific truisms you need to be more specific about the underlying science.

He also points out a few factors not yet on my list, which I'll paraphrase here:

• Globalization is not irreversible: Think about how surprisingly globalized the world became during 1870-1914, only to regress drastically following World War I and the Great Depression.


• Shifts in comparative advantage due to climate change, which Michael is "convinced" of:
  

  That is, [climate change is] going to shift where things are grown. A lot. It's also likely to change global quantities, but that's hard thing to put a finger on (i.e., model convincingly). With that much change going on, we should worry at least a little bit, and probably a whole lot, about how the kind of turmoil these changes will cause. Loss of comparative advantage is just the kind of thing that brings about bad policy response.

• Uncertainty itself can exacerbate market volatility, and uncertainty about the future is high, not just about long-term commodity prices, but also about the direction of the world economy and shifts in agricultural production due to climate change.

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.

Does Fairtrade take away the upside?

An interesting tidbit in an article about the mystery (well, not any more) trader who bought all of Europe's cocoa:

Barbara Crowther, a spokesman at the Fairtrade Foundation, said that no farmers in West Africa would benefit from the higher prices. She said: "This speculation only serves to increase volatility and uncertainty. Part of the problems in rent years have been the lack of investment in improving cocoa farms. But the farmers have already been paid a set price – none of this money will filter down to them."

If this is true, it points to a serious potential flaw in Fairtrade programs - the inability of participants to capture upside profits from price spikes. For many commodities, profits are concentrated heavily in a few spikes on a through-cycle basis, so missing out on those spikes is a big blow. Maybe Fairtrade compensates farmers in some way for the volatility premium it could be harvesting, but I'm skeptical until someone shows me.

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."

Malthus on food speculation

The man who refuses to send his corn to market when it is at twenty pounds a load, because he thinks that in two months time it will be at thirty, if he be right in his judgment, and succeed in his speculation, is a positive and decided benefactor to the state; because he keeps his supply in that period when the state is much more in want of it; and if he and some others did not keep it back in that manner, instead of its being thirty in two months, it would be forty or fifty.

If he be wrong in his speculation, he loses perhaps very considerably himself, and the state suffers little; because, had he brought his corn to market at twenty pounds, the price would have fallen sooner, and the event showed that there was corn enough in the country to allow of it: but the slight evil the state suffers in this case it almost wholly compensated by the glut in the market, when the corn is brought out, which makes the price fall below what it would have been otherwise.

I think Malthus is wrong that any price volatility caused by speculation is benign, but otherwise this is an admirable defense of the beneficial role that much-maligned (today and throughout history) speculation can play in food markets.

The quote comes from Cormac Ó Gráda's excellent book Famine, which I am reading and enjoying, and specifically from his outstanding chapter on the famous Bengal famine of 1943-44.

Eventual Nobel Prize winner in economics Amartya Sen made his name with his 1981 work which made the case that the famine was caused primarily by lacking "entitlements" (e.g., many were too poor to purchase food at escalated prices), rather than by what Ó Gráda terms a "Food Availability Deficit" (FAD). In other words, the famine was an issue entirely of distribution, rather than sufficiency. And moreover, Sen blames the entitlement issues (i.e. high food prices) primarily on speculation, which I hadn't previously realized.

Ó Gráda marshals quantitative and qualitative arguments to make the case that there was in fact a significant Food Availability Deficit in Bengal, despite the strenuous efforts of the governing British to mask this. Such deficits themselves cause price rises, which lead to entitlement issues, but after reading Ó Gráda I'm convinced that, as he says, "the heavy focus of the literature on hoarding is misplaced."

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?

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.

This time speculation DID drive up oil prices

Paul Krugman made some outstanding contributions to the fascinating blog debate on oil speculation about a year ago (which, incidentally, catalyzed my interest in the economics blogosphere). Then, he argued speculation wasn't a major factor because oil inventories weren't rising; this week, he asserted with scintillatingly simplicity that speculation drove the recent run-up in oil prices because - you guessed it - inventories are rising.

Hard to argue with that. I'm not always a fan of Krugman's argumentative style, but moments of brilliant clarity like the above attest to his Nobel-worthiness.

Further kudos to Paul for a healthier reaction than the CFTC and various European heads of state:

Now, “speculation” isn’t a synonym for “bad”. If the underlying assumptions that seem to have been driving oil markets were right — namely, that a vigorous recovery is just around the corner, and demand will shoot up soon — then it would be perfectly reasonable to accumulate oil inventories right now. But those assumptions are looking less reasonable by the day.

There's no nefarious market manipulation here - just people betting (unfortunately, probably wrongly) that an economic recovery is around the corner.

Via Greed, Green and Grains; the referring post is good in its own right and I'll post on it some time soon.

Oil speculator witch hunt goes global

Market speculation is a very convenient scapegoat. Having effectively blamed speculation for food volatility, U.S. regulators are moving on to oil:

The Commodities Futures Trading Commission (CFTC) is considering a plan, which already has widespread support in Congress, that would "impose limits as necessary to eliminate, diminish or prevent the undue burdens on interstate commerce that may result from excessive speculation."

To add international stature, none other than Gordon Brown and Nicholas Sarkozy penned a joint editorial in the WSJ calling on the International Organization of Securities Regulators to "reduce damaging speculation" in world oil markets.

Simon Johnson at the Baseline Scenario parses - he "welcomes" the CFTC's moves but calls the G8 rhetoric "disingenuous."

More generally, I question whether the actual rules which will be implemented to limit "damaging" speculation will actually reduce volatility overall - as someone else wrote recently (can't remember who but it stuck with me), one man's speculator is another man's welcome provider of market liquidity. Remember the onions...

The enduring importance of wheat

Great quote from the Levin-Coburn report on speculation in the wheat market:

“No man qualifies as a statesman who is entirely ignorant of the problems of wheat.”
--Socrates (469-399 B.C.E.)

Who knew Congress had a sense of humor?

P.S. The report itself is lengthy and conflates correlation with causation (as do many others), but nevertheless makes for fascinating reading, particularly the historical evolution of the wheat futures market. Speculation is clearly not a new issue:

The CBOT Annual Report for 1864 reflects how the nature of trading already had shifted from strictly cash transactions to speculative trading:

“It is true that speculation has been too much the order of the day, and buyers and sellers of ‘long,’ ‘short,’ and ‘spot,’ have passed through all the gradations of fortune from the lower to the higher ground, and in many instances have returned to the starting point, if not to a step lower, but it is to be hoped that with the return to peace this fever of speculation will abate and trade will be conducted on a more thoroughly legitimate basis.”

P.P.S. Another footnote reminds me of the hilarious and instructive case of onion futures.

Did commodity indices break the wheat market?

The Senate's newly published Levin-Coburn report thinks so. CME has promptly "refuted" the charges. Felix Salmon buys it (and makes the connection to the USO oil ETF's exacerbation of oil contango).

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.