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.

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.

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...

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.