The ongoing food crisis: market restructuring and global price formation
Eugenia Correa[1]
Wesley Marshall[2]
Roberto Soto[3]
Over the past few years, the world has witnessed sharp price movements not only in financial assets, but in other asset classes as well, perhaps none as vital as the prices of the basic grains and foodstuffs that provide the basis for human existence. As the Food and Agriculture Organization of the United Nations food price index shows, in mid 2011 food prices once again reached all-time highs (FAO, 2011). In light of the far reaching impacts of these developments, researchers from a wide range of institutions, academic and otherwise, have sought to pinpoint the causes of this widespread yet highly volatile rise in food prices. The results have varied greatly. Several authors identify speculative forces as the sole cause of recent price volatility, while others claim that speculation has absolutely nothing to do with the price formation of foodstuffs. In this paper, we implicitly criticize these extreme and often simplistic positions by emphasizing the fundamental changes in the composition of the principle markets in which food prices have been determined during the last decade. As often occurs in moments of financial crisis, many dominant actors fall while others rise in prominence (Correa and Vidal, 2011). The rapid and broad reshuffling and evolution of the markets in which commodity prices are determined therefore must be at the center of the debate.
The body of the article will be divided into five sections. In the first, we analyze and describe the recent evolution of the dominant actors in food production and speculative trading within the academic and policy debate over the causes of the current food crisis. In the second and third part, we examine the relevance of long term supply and demand shocks on commodity price formation. In the fourth section, we highlighting recent horizontal integrations between producers and traders, new forms of financial innovation, and the short term speculative price formation. In the fifth and final section, we analyze more recent trends towards monopoly price formation and assess their possible impacts.
The academic debate
As often happens with debates of great importance, positions tend to gravitate towards extreme opposing poles. Within the context of the price formation of commodities, a similar phenomenon can be seen, much to the detriment of an open and honest debate over one of the more important development in recent economic history. Many authors, most notably the OECD (2010), claim that there is no causality between financial speculation and sharply rising food prices. Other authors, with provoking titles such as “How Goldman Sachs caused the food crisis” (Kaufman, 2011) identify speculative activity as the sole cause of the rise and in food prices. We tend to agree with a more balanced debate, such as that proposed by Wray, in which arguments that are often presented as rivals do not necessarily have to be so, and that
“simply because one explanation is valid, the others are not necessarily incorrect. Indeed, there are synergies at work, such that the forces driving prices higher reinforce one another” (Wray, 2008: 8).
The goal of this paper is not to rehash a debate that has already been well developed, but rather to focus on the recent evolution of the roles of the dominant actors in the area in order to better understand current price formation and to gain a better idea of how commodities prices may be determined in the near future. However, in order to fully explore such considerations, we must first situate the changing roles of these dominant players and markets in the context of the quickly evolving commodities markets. This necessarily implies reaching the correct conclusions regarding the basic forces at work behind the recent rise in commodity prices and their volatility. Taking these factors into consideration, we feel that a relatively novel approach to the commodity price debate is to identify and analyze three different spacial/temporal elements of price formation: long term supply and demand price formation; short term speculative price formation; and short, medium and long term monopoly price formation. As will be shown in the pages that follow, it is our belief that commodity price formation is indeed a mix of these three elements, but as the offer or sell side of the equation has experienced the greatest changes in recent years, the temporal element must be at the fore of our analysis.
Long term demand shock
Many authors, such as the OECD (2010), Krugman (2008a; 2008b), and Irwin, Sanders, and Merrin (2009) have focused on the changing nature of the demand for commodities as an explanation for the increase in commodity prices over the last several years. Their basic hypothesis is that as consumers become more wealthy in the developing world, particularly in China and India, demand for all sorts of commodities increases, and this increased demand is reflected in generally higher prices. This argument is essentially a red herring, as it fails to address several central elements of the debate, and is misleading in other key aspects.
Regarding the first point, changes in the composition and level of commodities demand are necessarily long term phenomena, and if these indeed determined commodities prices, rises and falls should be slow and steady, as shifts in demographics and wealth tend to be. The demand argument therefore cannot explain the extreme short term volatility that commodity prices have demonstrated in recent years. Yet as Ghosh (2009) points out, developing world demand for many foodstuffs has actually not seen the increase that other authors have claimed. And also as Wray points out, Chinese demand growth in several commodities has been offset by sluggish growth elsewhere. Therefore, the global demand shock argument is flawed not only in its temporality, but also in its facts.
We do not wish to offhandedly dismiss the possibility that large population centers of the planet can experience increases in their wealth and/or populations and that these could lead to demand strains and upward pressure on commodities prices. Much to the contrary, we strongly feel that the policies of many developed nations has converted agricultural production into a strategic asset of utmost importance.
Long term shifts in agricultural supply
As 2009s World Development Report points out, there has been a greater convergence between international food prices and local food prices in recent years. This can be largely explained by the convergence of three factors: the application of Washington Consensus inspired policies in the global south, including the elimination of agricultural subsidies, the pursuit of export-led growth strategies in the primary sector, and the dismantling of structures and institutions that offered credit to agricultural activities; the preservation of agricultural subsidies in the global north; and the growing global dominance of agriculturally related transnational corporations (TNCs). The net result of these elements has been a wholesale shift in relations of economic power between the developing and developed world. Developing countries that were once independent in terms of food production are now highly dependent on grain imports. With important exceptions such as Brazil and Argentina, exported grains are cultivated in the developed countries. With far fewer exceptions, exported grains are under the management of agricultural TNCs (UNCTAD, 2009a).
The strategic control of grain production and distribution has been greatly strengthened by the development of corn-based ethanol, particularly in the United States, where 40% of corn production, equivalent to one-sixth of worldwide corn production (FT, 2011a), is currently channeled toward energy production. The fact that corn-based ethanol is energy negative, meaning that more energy is used in its production than is released by its combustion, and that the US government has relied on large scale subsidies to ensure its production, likewise points towards a conscious and strategic decision to limit the world’s supply of corn in its edible form.
However, much like the demand side consideration of greater grain consumption, the supply side consideration of the greater use of corn-based ethanol cannot explain the short term movements of commodities prices, particularly in the face of highly volatile short term price movements. Once again, this is not to dismiss the impacts of corn-based ethanol production, or other supply side shocks that grain production may face in the near term, such as changing climate patterns on food production or the possibility that political and social forces could modify the equation on either the demand or supply side. However, attempts by the OECD to explain commodity price formation in the last five years through supply and demand factors are not only grossly inadequate, they are downright misleading. In a later section, we will offer several hypothesis explaining why several official organizations have served up this red herring.
Recent changes in the supply side – horizontal speculative integration pre crisis
A fundamental aspect of the financialization of much of the global economy during the past decades has been the steady incorporation of wide variety of economic spaces into the dollar based international monetary circuit. As such, even though grain futures have existed in one form or another for centuries, it has only been in recent years that financial actors have entered into these markets, converting them into highly concentrated markets in which enormous sums of capital are traded. As posed by Wray (2008) and posteriorly by the UNCTAD (2009a; 2011) this can be understood as the “financialization of commodities”.
Within the objectives of this article, what is particularly noteworthy about the evolution of the commodities market has been the rapid emergence of index speculators, as highlighted by Masters and White (2008). While the rapid penetration of financial actors into what was a relatively “sleepy” market dominated by producers can be clearly seen as the domination of financial actors over productive ones, we will use the term horizontal speculative integration, as the commodity futures market is the single market that brings together participants in the physicals market and speculators in financial derivatives tied to the physicals (Masters and White, 2008). We also use this term in order to establish a distinction between vertical speculative integration, which we will examine later.
The rise of the index speculator can be attributed to various factors, the first and foremost being deregulation, a common element in most financial crisis in the past decades. The principal regulation limiting speculative activity in commodities futures markets was The Commodity Exchange Act of 1936, which explicitly sought to control speculative activity in commodities markets. However, beginning in the early nineties, the US Commodities Futures Trading Commission (CFTC) began to selectively lift speculative position limits, particularly for over the counter swaps transactions. These exceptions opened a loophole that primarily benefited swap dealers, as speculators who wished to avoid speculative position limits in futures markets could now only do so through swap traders (Masters and White, 2008). The commodity futures markets were more completely deregulated through the 2000 Commodity Futures Modernization Act, which included the “Enron loophole”, exempting electronic trading from US regulation. In any case, the CFTC had already opened the “London loophole” in 1999 through its decision to allow traders using the London exchanges to avoid position limits that still existed in the US (Wray, 2008).
Goldman Sachs was the first large bank to fully take advantage of these new speculative spaces, creating the Goldman Sachs Commodity Index (GSCI) in the early 1990s. As Masters and White state, “these swaps dealers have convinced institutional investors that commodities futures are an asset class that can deliver “equity-like returns” while reducing overall portfolio risk. These investors have been encouraged to make “a broadly diversified, long-only passive investment” in commodities futures indices” (Masters and White, 2008: i). Convinced of the profitability of this passive hedging strategy, institutional investors poured money into commodity indexes, which grew from $13 billion in 2003 to $317 billion in July 2008. During this time, the 25 commodities that make up these indexes grew by around 200% (Masters and White, 2008: 1). The structure of this recently formed market has been dominated by few players. On the one hand, pension funds represent about 65%-75% of institutional assets, while an estimated 85% to 90% of institutional investors seeking to allocate money to commodities choose to do so by entering into over-the-counter commodity index swaps with Wall Street Banks.On the other hand, the four largest commodity swaps dealers - Goldman Sachs, Morgan Stanley, J.P. Morgan and Barclays Bank –are estimated to control 70% of the commodity index swaps positions (Masters and White, 2008: 7, 9, ii).
The great commodities crash of 2008 has indeed shattered the argument for passive investing in commodities indexes as a speculative hedge. As the UNCTAD points out, while index speculation has not ceased, the importance of money managers (most prominently hedge funds) has increased in relation to that of index speculators post-2008 UNCTAD, 2011: 27). Indeed, anecdotal evidence since 2008 highlights the continued speculative price formation of commodities, yet another element has also risen to the fore: the increasing importance of high frequency trading (HFT), based on algorithms and traded in opaque dark pool platforms. We first briefly examine the continued dominance of a handful of speculative markets in the determination of commodity prices.
Towards the end of 2010, it was reported that JP Morgan purchased “between 50 and 80 percent” of the 350,000 tons of copper reserves, pushing copper prices to two year highs at the time (Telegraph, 2010). In a less dramatic move, in mid 2010, the London- based hedge fund Armajaro took delivery of 7 percent of annual global cacao production, forming part of a two year 150% increase in cacoa prices (Financial Times, 2010). The fact that entire markets can be swung by single participants is not a new phenomenon. The cornering of the silver market by the Hunt Brothers a few decades ago still reverberates in many actors. Yet to see such wild swings in commodity prices, many times precipitated by a single protagonist, is indeed a more recent development, and it is indeed causing consternation among many market participants. One well documented case involves the World Sugar Committee, the industry body that represents the big traders. Upon sugar reaching its highest prices in 30 years, its chairman declared that the presence of new high-frequency speculative funds “only serves to enrich themselves at the expense of the traditional market users”. (Financial Times 2011b)
As the above quote touches upon, the recent trend of greater and much more volatile commodity prices cannot be attributed solely to the increased participation of speculative actors in commodities futures markets, nor just to the actions of a few hedge funds or institutional investors. Ongoing financial innovation and the proliferation of HFT and dark pool trading platforms have greatly increased the velocity, volume and volatility of financial speculation. As highlighted by Bank of England’s Andrew Haldane,
equity market trading structures have fragmented. This has gone furthest in the US, where trading is now split across more than half a dozen exchanges, multilateral trading platforms and “dark pools” of anonymous trading... Having accounted for around 80% of trading volume in NYSE-listed securities in 2005, the trading share of the NYSE had fallen to around 24% by February 20… As recently as 2005, HFT accounted for less than a fifth of US equity market turnover by volume. Today, it accounts for between two-thirds and three-quarters (Haldane, 2011).
Yet while equity and other markets have fragmented, they have simultaneously become more interconnected. As the UNCTAD states, “the activities of financial investors have profoundly affected the relationship between commodity markets and other markets over the past decade. Portfolio restructuring, algorithmic trading and herding of market participants have spilled over from one market to the other and increased correlations between previously uncorrelated markets.” (UNCTAD 2011: 34)
As their ominous name suggests, dark pools are indeed far more opaque than traditional trading platforms, and that is precisely their function. Their creators claim that if market rivals cannot track traders’ moves, trading strategies may be better preserved. Yet increased opacity also leaves a wide berth for accidents and malfeasance, neither of which can be readily traced. Prominent examples of extreme market volatility with no apparent relation to supply and demand fundamentals include the “flash crash” in US equity markets in May 2010 and the oil flash crash a year later in May of 2011. In the latter case, oil prices fell 10% in a single day, only days after silver also experienced a historical drop (Reuters, 2011). As Haldane states, “flash crashes, like car crashes, may be more severe the greater the velocity”. (Haldane, 2011)