Speculation of World Food Prices

Mon, 08/18/2008

While most solutions to the current crisis of high food prices will require substantial reworking of our global, fossil fuel-dependent system to create a more localized and organic one (see "Food Crisis"), one relatively easy solution could bring quick and significant reductions in prices. Financial speculation in commodities’ futures markets has increased dramatically in the last 3-4 years, and especially in the current year, artificially driving up prices of a host of commodities, from food crops like wheat, corn, soybeans, etc., to oil and natural gas, to metals and minerals. This marked increase was brought on by simple policy decisions and can be addressed by similarly simple policies.

The first commodities market in the U.S. was formed in 1848 when merchants joined to create the Chicago Board of Trade. Before that, selling grains was an unpredictable and chaotic task. Individual farmers negotiated with sellers and faced widely varying prices and uncertainty. With the Board, farmers agreed with a buyer to deliver grain at a specific date in the future for an agreed upon price. This is called a forward contract. In 1865, futures contracts were created. These are similar to forward contracts, but instead of being directly between a producer and a buyer, are traded on an open exchange called the futures market where others can participate. Buyers on the futures market rarely, if ever, actually receive the physical product but are able to profit off changing commodity prices.

By the late 1800s, futures markets had been created for various products, with speculators betting on whether prices would rise or fall. But the influx of investors not actually involved in agriculture or food production was a problem. A casino-type atmosphere reigned with huge amounts of money entering the market procuring easy profits. Abuses, from fraud to spreading rumors in order to alter prices to buying inside information, were used to influence the market. Large fluxes in investments also affected food prices unnecessarily.

After the Depression, several laws were passed to regulate markets in order to prevent another economic collapse. One was the Commodities Exchange Act of 1936, which for the first time put limits on speculative investors to prevent them from manipulating commodities futures markets. People directly involved in agriculture and food could still participate in the futures market in order to provide liquidity, but outside investors had severe limits placed on the manner and amount they could invest.

These limits were maintained until Ronald Reagan’s presidency. Pressure from investors and the administration’s predisposition towards deregulation led to apparently small changes in commodities laws that have large effects on food prices today. The Commodity Futures Trading Commission (CTFC) created loopholes that allowed outside investors to invest unlimited amounts in commodities.

Negative results from these loopholes were first seen when Enron took advantage and invested huge amounts in energy futures, driving up prices while creating huge profits for itself, thus naming these types of loopholes “Enron loopholes.”

Financiers did not immediately invest in the food commodities markets as they provided lower profits than other areas of investment. This changed after the stock bubble burst in the year 2000. Investors pulled vast amounts of money from the stock market, deflating the bubble. Much of that money was placed in the housing market, thus creating a bubble in that market. As the housing bubble bursts, many investors have now switched to commodities futures, and with the Enron loopholes they are able to plow immense amounts of money in these markets.

Hedge fund manager Michael Masters recently testified before Congress on this issue. He said that institutional investors (pension funds, university endowments, sovereign wealth funds, etc.) have increased their investments in commodities futures from $13 billion in 2003 to $260 billion in March 2008, and the price of 25 commodities have risen by an average of 183 percent in those five years. He explained that “commodities futures prices are the benchmark for the prices of actual physical commodities, so when… speculators drive futures prices higher, the effects are felt immediately in… the real economy.”

Futures markets tend to be rather small compared to other investment markets. In 2004, the total value of futures contracts in 25 principal commodities was only $180 billion; compared to $44 trillion invested in stock markets worldwide. So when these outside investors enter with large sums of money into the commodities futures markets, they drive up overall prices for those products. In the first 55 days of 2008, speculators placed $55 billion into these markets. Clearly these huge influxes of money are having dramatic effects on today’s rising food prices. According to Masters, “one particularly troubling aspect of… speculator demand is that it actually increases the more prices increase.” We already see this happening as investment advisors increasingly encourage clients to invest in commodities futures. These types of investments could easily increase to as much as $1 trillion if institutional investors switch a greater portion of their investments into commodities futures. This would result in catastrophic increases in food prices.

Masters draws an analogy that is helpful with these complex dynamics. “Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged.” This dynamic currently takes place in our commodities’ system, driving up food and oil prices. He estimates that with greater regulation, oil prices could drop to $65 to $70 a barrel within 30 days. Similar drops would take place in food commodities.

Luckily, members of Congress are waking up to this reality. Nine bills have already been proposed to remove the Enron loopholes and reduce speculative influence on oil and food commodity prices. It is crucial that they pass these laws as quickly as possible as every day, more speculative money floods into the commodities markets. As one wheat farmer recently stated, “We’re commoditizing everything and losing sight that it’s food, that it’s something people need. We’re trading lives.”