Tuesday, April 22, 2008

Impact of commodities speculation on farming and food prices

An article in the New York Times by Diana Henriques entitled "Price Volatility Adds to Worry on U.S. Farms" provides a little insight into the impact of commodities speculation on farming and food prices, but really only scratches the surface. It does note that:

Prices of broad commodity indexes have climbed as much as 40 percent in the last year and grain prices have gained even more -- about 65 percent for corn, 91 percent for soybeans and more than 100 percent for some types of wheat. This price boom has attracted a torrent of new investment from Wall Street, estimated to be as much as $300 billion.

Whether new investors are causing the market's problems or keeping them from getting worse is in dispute. But there is no question that the grain markets are now experiencing levels of volatility that are running well above the average levels over the last quarter-century.

Mr. Grieder's crop insurance premiums rise with the volatility. So does the cost of trading in options, which is the financial tool he has used to hedge against falling prices. Some grain elevators are coping with the volatility and hedging problems by refusing to buy crops in advance, foreclosing the most common way farmers lock in prices.

"The system is really beginning to break down," Mr. Grieder said. "When you see elevators start pulling their bids for your crop, that tells me we've got a real problem."

...

... David D. Lehman, director of commodity research and product development for the C.B.O.T.'s owner, the CME Group ...

Many farmers and people in related businesses blame the tidal wave of investment pouring in from hedge funds, pension funds and index funds for the faulty futures contracts and rising volatility. But those institutional investors' money actually adds liquidity to the market, which in theory should reduce price volatility, Mr. Lehman noted.

First, we need to be clear that this so-called "investment" by Wall Street is absolutely 100% in the form of speculation.

Farmers and food producers need the futures trading system to smooth price fluctuation. So-called "investment" by Wall Street is only increasing the level of price volatility. And, because food producers need to use futures to smooth price fluctuations on their side of the table, the higher prices of futures contracts and options for hedging translates directly into higher input costs for food production.

The theory that the addition of liquidity will reduce volatility is fine on paper, but in practice is completely bogus. Hedge funds are trying to time the market, pouring money in one day when betting on bullish market moves and pulling money out on another day when they want to bet on a short-term market decline. The theory would be fine if the rise in liquidity was steady or always increasing, but the sudden and sharp swings in liquidity can only increase volatility.

This is another great example of how the media sometimes gets the story half right and then simply loses the thread and fails to see the full picture.

In any case, at least they gave us a hint of where the truth might lie.

-- Jack Krupansky

 

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