The role of financial speculators, especially when it comes to agricultural commodities, has often been villainized by political activists and special interests groups. The criticism has been particularly strong in my lifetime during periods of rising (food) commodities prices, such as the decade between 2005 and 2015. Check out this article and the study it refers to for an example of a typical attack to the role of speculators on the rising price of food. However, is it really that simple to blame speculators for rising food prices? Are speculators to be stopped (or curbed) in order to bring order to the commodities markets in general?
The dynamics of rising food prices are too complex to explain in a simple blog post, but let me use this criticism to explain the purpose of centralized commodities markets and the role speculators play in them.
Centralized, standardized markets such as of the Chicago Mercantile Exchange serve two primary purposes:
- Price discovery
- Risk management
Price discovery: This is how I explained it to my wife the first time I tried to explain commodities markets: Do you remember the time before eBay what you did when you found a collection of stamps in your grandparents’ attic? Where did you go to get an appraisal? To the local pawn shop or antique dealer. He was the only player in town who could give some insight. Assuming he was honest, he would tell you what the collection would sell in his market. Most likely his market was limited to a few hundred miles around the town, at best. However, what do we do today before we price something for a yard sale and we think it’s worth “something”? We look on eBay and see what the world is pricing the product. eBay has brought together thousands of market participants to one place to compare and contrast prices. The combined effect provides a truer value for the item we are trying to price. In other words, we discovered its real price. Centralized markets or exchanges for commodities function in the same way as eBay does for antiques or other products that come from many corners of the world. The shared insights and willingness to pay of market participants uncovers the price of the product.
Risk Management: The development of futures contracts and the exchanges where they are traded was the evolution of what then a forward contract which allowed a producer (i.e., a farmer, miner, driller, etc.) and a buyer (i.e., Kellogg, GM, Chevron, etc.) of a commodity to agree (months) in advance at what price to trade the product produced. Why would a producer agree in advance? Because it would alleviate the pressure of possible price fluctuation between the time of the investment in, for example, seed, fertilizer and machinery and the time of harvest and delivery several months later. The shrewd farmer knows the price of his inputs every year and if he can lock in a future sale at a profit, he can book that profit months in advance, taking out the risk of a loss, but also eliminating the potential upside of a price rise during that time.
Who then takes on the risk of the price change? Enter the speculator. She takes a gamble that prices will move in the direction of her purchase (or sale) of the product taking on the risk of losses that the farmer (or buyer) didn’t want to take, hoping to gain if the prices rise (or drop in case of a sale).
Similar to arguments involving national health insurance, the more participants come to the futures marketplace, the more spreadout is the price risk, therefore less risky for each individual pariticipant. Moreover, as more participants come to market, besides the obvious benefits to liquidity , there is also an improvement on the reliability of the price discovery process.
Back to the original question, are speculators to blame for price volatility or simply rising food prices and therefore the implications on the most vulnerable people in society? At times I believe speculators do play a role in accentuating volatility, especially when the fundamentals indicate tight supply & demand conditions. Speculators have also been notoriously troublesome when one or few of them tried to “corner a market,” which does lead to price manipulation, even though the ultimate outcome is usually resolved in a brief period of time and rarely in favor of the speculator. Controls in that area are present and are a valuable component of orderly markets. Overall, especially in large markets such as those of corn, soybeans, and wheat, with hundreds of thousands of participants (speculators and commercial, large and small), the ability of speculators to significantly impact prices is virtually non-existent compared to the actual supply & demand fundamentals of those markets.
More interestingly, on the topic of the above-mentioned period of rising prices, one should look at the staggering growth of places like China and India to find the answers for a fast rising demand for all commodities, including agricultural ones. Such growth had been predicted by investors like Jim Rogers years before what became known as the commodities super-cycle. The role of speculators in such a massive economy was minimal.
Lastly, should speculators be blamed for lower prices also? What now that prices are low? Well… now is no longer the poor people who can’t find food at a fair price, but it’s the small farmers who can’t get a sustainable price for their produce. It’s probably the speculators’ fault then, too….