Guidance on forces driving futures
June 3, 2014
Quizzes are not customary on this page, but the subject at hand seems best explained by asking a question. Here it is: In the event, you, the reader, had to account for the dramatic rise in your food company’s ingredient costs in recent years, how would you rank the following as the cause for boosting grain? The choices are: Poor weather threatening production; global economic slowdown; supply-demand shocks; political turmoil that might cause military intervention; expanded activity by commodity index traders; cash inventory accumulations, and increased speculative trading. Ranking these by the power of their influence on prices is a difficult task, requiring considerably more than off-the-cuff market observations.
The best study available of these types of influences is sponsored by the Economic Research Service in the U.S. Department of Agriculture. It covers a period that for most current market participants had enough wild fluctuations to merit attention. Focus is on the dramatic rise in prices in 2008 and continuing into 2011. Similar study was applied to market moves starting in the late 1990s.
What this E.R.S. study primarily aimed at was determining whether any merit existed in the increasing clamor that speculation was driving food prices higher and higher. These assertions, from both domestic and international sources, most often claimed speculators were running ahead of realities, and that this force was magnified by commodity index traders. The latter are the managers of commodity index funds made up of baskets of agricultural and non-agricultural products meant to facilitate investing in commodities as an asset class. As investors and the trading public were attracted and volume grew, charges were made that passive purchases to create these baskets accounted for the dramatic rise in prices. The assertions were accompanied by pleas for increased regulation and new trading rules.
The study says “baloney” to such complaints. It finds that the memorable wheat price spike in February 2008 would have been only 1% less “in the absence of shocks attributable to financial speculators like commodity index traders.” It goes on to note that in the period between 2006 and 2011, when speculators were believed to have had the maximum market impact, their trading added barely 5% to 6% to the rise of wheat prices. In dismissing the pleas for new regulations imposing trading limits on speculators, the E.R.S. study declares that futures markets are efficient in responding to fundamentals.
In coming to that conclusion, the study assigns specific weight to the factors it credits with driving strength in wheat prices. Net supply shocks, which comprise crop shortfalls in various nations as well as export limits, stood as the primary driver in February 2008 when prices peaked. In the absence of net supply shocks occurring that year, the study finds that prices on the Chicago Board of Trade would have been 53% lower, in Kansas City 40% lower and in Minneapolis, where the sharpest advances occurred, 62% lower. Turning to what the study calls precautionary demand shocks, which simply mean suddenly aggressive building of inventories in response to rising futures, it finds that without these prices in Chicago would have been 11% lower, in Kansas City 20% lower and in Minneapolis 36% lower.
Besides dismissing any serious impact from speculative trading, the E.R.S. found no support for the contention that grain prices are often influenced by fluctuations in other commodities, notably crude oil. During the 2006-08 period, the impact of “comovement” (the economic name for this factor) was put at less than 1%. Oil prices at their most erratic could be measured as accounting for fluctuations of 67 cents per bushel, which was insignificant in relation to wheat prices upturns of as much as $8 per bushel.
By using advanced mathematics, the E.R.S. has not only provided the answer to the opening quiz by crediting supply-demand as the major driver of grain prices, but has provided a guide to help analyze moves in essential food ingredients.