Speculation & Price Volatility Are Unrelated

www.agrinews-pubs.com
Tom Doran
2010-01-12

BLOOMINGTON, Ill. — There is very little evidence that the recent boom and bust in commodity prices was driven by a speculative bubble, according to an agriculture marketing specialist.

Scott Irwin, University of Illinois professor of agricultural and consumer economics, refuted the claims that speculation – particularly by “long-only” index funds – created the recent market volatility.

“Lots of people think that speculators are responsible for both run-up and the price volatility,” Irwin said at a recent Illinois Farm Economics Summit presented by U of I.

“Of course, a lot of attention focused on the energy markets, but also almost as much on our food markets,” he said. “When you get that kind of headline attention to an issue, congressional hearings at least in our commodity markets, typically follow.”

Irwin said there have since been numerous hearings in Washington regarding the role of commodity market speculators in market prices.

The main concern is that speculative buying by index funds in commodity futures created a “bubble,” with the result that commodity prices far exceeded fundamental values at the peak, according to Irwin.

He said the case for index funds causing the bubble “really doesn’t hold up under careful, close scrutiny.

“So what are some of the problems with what seems like a sensible argument? The first is money flows are not necessarily the same as demand,” he said.

“Futures markets are zero-sum games. If long positions of index funds are new ‘demand,’ then the short positions for the same contracts are new ‘supply.’

“The essential point is futures contacts are financial contracts and, at least in theory, there’s no limit on the number of contracts that are created at any given price.”

Tom Hieronymus, who was a University of Illinois educator, researcher and counselor in futures market, once said, “For every long there is a short, for everyone who thinks the price is going up there is someone who thinks it is going down, and for everyone who trades with the flow of the market, there is someone trading against it.”

A related point in terms of the bubble argument is that index futures positions distort both cash and futures prices, when, in fact, they are only trading in the futures markets.

“Futures transaction are purely financial transactions,” Irwin said. “Think of them as financial side bets on the physical market that only rarely involves the actual delivery of physical commodities.

“To impact the equilibrium price of commodities in the cash market over all but very short term intervals, index funds would have to take delivery and/or buy qualities in the cash market and hold these inventories off the market. There is absolutely no evidence that index funds took the delivery of commodities.”

Irwin pointed to some facts that are inconsistent with the index futures argument.

“Inventories did not increase for storable commodities,” he said. “In fact, during the time period of the most rapid increase in prices, of which index funds were supposedly responsible for, inventories were actually going down, not going up. So this is blatantly inconsistent with the argument that index funds were behind the run up of prices.”

A second inconsistent fact relates to the definition of “excessive speculation.”

“Most of the statistics that have appeared in the media or at congressional hearings view speculation or the size of dollar on the position themselves in isolation,” the economist said.

“But we know over 50 years of research in commodity markets that it really isn’t useful to look at the level of speculation in the commodity futures market without also considering the size of the hedging demand positions in the same market. These things tend to work together.”

Comparing 2006 to 2008, he said there are very large increases in both long speculation and long hedging, “but what I find most fascinating is large commercial hedgers are taking the other side of all those contracts.”

“So the bottom line is there is no evidence at any time that the level of speculation that was increasing due to the rising index fund involved in our commodity markets got out of line relative to the positions that hedgers were taking,” he said.

The third inconsistent fact Irwin noted was that price increases were not even or relatively equal in all the markets that the index funds were known to take large positions.

While there were rises in prices of the grain complex from 2006 to 2008, livestock prices were slightly down or up.

“It turns out livestock had the highest concentration of index fund positions over this time period,” Irwin said. “So it doesn’t make sense that the index fund were behind the run up in prices that you would see prices skyrocket in the grain market but not the livestock markets.

“Despite those arguments, the debate does continue. It is ongoing in Washington, D.C., right now.”

Even if commodity futures were not driven by speculative forces farmers still must deal with an environment of highly volatile prices.

Prospects for large ranges in annual price movements suggest that producers may find more value in the use of futures options contracts to protect profitable price levels, but also capture higher prices should they occur, according to Irwin.

“In addition, expectations for large ranges in prices may continue to limit the forward pricing opportunities offered by grain merchandisers,” he said. “Those limitations may take the form of shorter time horizons for forward contracting production and/or in weak basis levels for forward contract bids.

“Fewer pricing opportunities from merchandisers may require producers to manage price risk directly with the use of futures and options contracts.”

Direct use of futures and the related risk of margin requirements have obvious cash flow and credit implications for producers.

In some instances, merchandisers may continue to offer a full array of pricing alternatives, but require producers to participate in the margining of the underlying futures and options positions.




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