Different ways of explaining price swings

by Morton Sosland
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It is a given that commodity markets like those endured by food companies this year prompt intensified searches for guidance as to what has happened and where it may lead. Preferred sources for help in understanding inexplicable price moves usually center on the purchasing staff within each company. While the impression this year is few were caught naked without prudent positions, the implications for ingredient costs intensify the hunt for explanations. The choices cover a wide range as evidenced by opinions voiced by two out-of-the-ordinary analysts who not only differed sharply in their early-year outlooks, but cited the same force — excessive speculative trading — as driving commodity prices both up and down.

The bear cited is Ruchir Sharma, managing director and head of the global emerging markets equity team at Morgan Stanley Investment Management. Mr. Sharma is also a columnist for leading newspapers, and it was in a column written last spring, before grain and other markets began their astounding climb, that he expressed his pleasure with what he said was “the end of the ‘commodity supercycle.’” He expressed the view that climbing prices prior to 2012 had been driven by an unrealistic belief that demand from China and emerging markets would continue growing for one or two more decades. Instead, he said commodity prices in the past 200 years have been governed by cycles of one decade up, two decades down. High prices, Mr. Sharma declared last spring, cut demand and brought commodity gains to their end.

His analysis of speculation’s role focuses on the “new industry of investment funds that allow even lay people to trade in commodities.” Spawned by what he calls “commodity mania,” these funds saw a doubling in size in recent years. “Speculators rule the markets and many are suffering as prices fall,” he contends, adding that “their loss is a gain for consumers around the world.”

Contrasting with Mr. Sharma’s bearishness is Yaneer Bar-Yam, who said at the same time that a dramatic rise in commodity prices was likely this year. Mr. Bar-Yam, founder and head of the New England Complex Systems Institute, is known for his use of mathematical models to predict economic and social developments. In reaction to the decline in food prices in early 2011, he predicted another peak within about a year, as affirmed by what happened this year. Not only did he forecast that the 2012 peak would surpass that of prior years, but he warned it would be severe enough to lead to widespread social unrest and even revolution.

The Bar-Yam views attracted enough interest that he was invited to speak at the World Economic Forum in Davos, Switzerland, last winter. There he expanded on his theme that the upward move in food prices is mainly driven by two forces. One is the large-scale conversion of corn into ethanol and the other is expanded speculation in commodity markets. Even though his price predictions are based on quantitative models meant to explain complex system behavior, he asserts that the worrying food price upturn of this year could be reversed by decisions to cut back the American ethanol mandate and to impose trading restrictions to limit speculation.

Anyone who contends speculation has no effect on food prices is disingenuous, Mr. Bar-Yam says. He claims to have an analytical model clearly showing that the wild moves in food prices are not explained by supply and demand alone. “Rather,” he says, “the ethanol quota and the explosion of financial speculation account for much of the volatility.”

So there we have totally opposite opinions on the market’s course, but both centered on one cause, excessive speculation. Overlooked in these studies is the hugely important role of speculation as providing a broad enough market that price swings are actually moderated by its presence and that a market without speculation is a market that moves violently. That too is proved by history.
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