A good piece in the New York Times today, “Price Volatility Adds to Worry on U.S. Farms,” describes how the runup in agricultural crop prices is making life harder for farmers.
The recent upswing, and the entry of speculative capital, has led to a sharp increase in volatility (note that that’s the reverse of what theory says you ought to expect. More liquidity is purported to lower volatility). And that has created new problems, Crop insurance is more expensive when prices are erratic. Worse, grain elevators refusing to buy crops in advance, forcing more farmers to hedge themselves, which is particularly risky since they might not have enough cash on hand to meet margin calls.
Aside: would a forward sale to a grain elevator be counted as inventory by the elevator company? If so, some of the apparent inventory tightening might be an accounting phenomenon (although the US may not be a big enough player in the commodities in which this is happening for that factor to have much impact).
Aside from the difficulties that the farmers are facing, the article does contain signs that speculation is overwhelming fundamental activity. One big warning sign mentioned in passing: trading has outgrown the delivery system. If I read this correctly, it means that the volume of futures contracts is so large relative to the actual deliverable commodity that arbitrage (via taking physical delivery) won’t force convergence of futures prices to cash prices at contract maturity.
The article notes that some farmers who cannot sell to elevator companies and are frustrated with the ways the options and futures markets are misbehaving are doing deals outside the exchanges, directly with sponsors of commodity funds such as AIG. AIG buys the commodity, the farmer stores it for a fee, and the farmer buys it back later at a pre-set price.
Again, does the inventory held with the farmer by a commodity index fund get recorded anywhere?
Paul Krugman asked in a post yesterday, if speculative activity had anything to do with the commodity run-up, where were the inventories? Others had commented that speculators were carrying inventories without describing a mechanism. Looks like we’ve found one.
From the New York Times
Fred Grieder has been farming for 30 years on 1,500 acres near Bloomington, in central Illinois. That has meant 30 years of long days plowing, planting, fertilizing and hoping that nothing happens to damage his crop.
“It can be 12 hours or 20 hours, depending,” Mr. Grieder said.
But Mr. Grieder’s days on the farm in Carlock, Ill., are getting even longer. He now has to keep a closer eye on the derivatives markets in Chicago, trying to hedge his risks so that he knows how much he will be paid in the future for crops he is planting now. And the financial tools he uses to make such bets are getting more expensive and less reliable.
In what little free time he has, Mr. Grieder attends Illinois Farm Bureau meetings to join other frustrated farmers who are lobbying officials in Chicago and Washington to fix a system that was designed half a century ago to reduce uncertainty for food producers but is now increasing it.
Mr. Grieder, 49, is shy about complaining amid so much prosperity. Prices for his crops are soaring on the updraft of growing worldwide demand, and a weak dollar is making the crops more competitive in global markets.
But today’s crop prices are not just much higher, they also are much more volatile. For example, a widely used measure of volatility showed that traders in March expected wheat prices to swing up or down by more than 72 percent in the coming year, three times the average volatility for that month and the highest level since at least 1980. The price swing expected in March for soy beans was three times its monthly average, and the expected volatility in corn prices was twice its monthly average.
Those wild swings in expected prices are damaging the mechanisms — like futures contracts and options — that in the past have cushioned the jolts of farming, turning already-busy farmers into reluctant day traders and part-time lobbyists.
One measure of the farming industry’s frustration is the overflow crowd expected at a public forum on Tuesday at the Commodity Futures Trading Commission in Washington. Interest is so high that the commission, for the first time ever, will provide a Webcast of the forum, which it says is being held to gather information about whether crucial markets for hedging the price of crops “are properly performing their risk management and price discovery roles.” The Webcast link is available on the commission’s Web site, www.cftc.gov.
The additional costs that stem from volatility in grain prices — higher crop insurance premiums, for example — are not just a problem for farmers. “Eventually, those costs are going to come out of the pockets of the American consumer,” said William P. Jackson, general manager of AGRIServices, a grain-elevator complex on the Missouri River.
Prices of broad commodity indexes have climbed as much as 40 percent in the last year and grain prices have gained even more — about 65 percent for corn, 91 percent for soybeans and more than 100 percent for some types of wheat. This price boom has attracted a torrent of new investment from Wall Street, estimated to be as much as $300 billion.
Whether new investors are causing the market’s problems or keeping them from getting worse is in dispute. But there is no question that the grain markets are now experiencing levels of volatility that are running well above the average levels over the last quarter-century.
Mr. Grieder’s crop insurance premiums rise with the volatility. So does the cost of trading in options, which is the financial tool he has used to hedge against falling prices. Some grain elevators are coping with the volatility and hedging problems by refusing to buy crops in advance, foreclosing the most common way farmers lock in prices.
“The system is really beginning to break down,” Mr. Grieder said. “When you see elevators start pulling their bids for your crop, that tells me we’ve got a real problem.”
Until recently, that system had worked well for generations. Since 1959, grain producers have been able to hedge the price of their wheat, corn and soybean crops on the Chicago Board of Trade through the use of futures contracts, which are agreements to buy or sell a specific amount of a commodity for a fixed price on some future date.
More recently, the exchange has offered another tool: options on those futures contracts, which allow option holders to carry out the futures trade, but do not require that they do so. Trading in options is not as effective a hedge, farmers say, but it does not require them to put up as much cash as is required to trade futures.
These tools have long provided a way to lock in the price of a crop as it is planted, eliminating the risk that prices will drop before it is harvested. With these hedging tools, grain elevators could afford to buy crops from farmers in advance, sometimes a year or more before the harvest.
But that was yesterday. It simply is not working that way today.
Futures, for example, are less reliable. They work as a hedge only if they fall due at a price that roughly matches prices in the cash market, where the grain is actually sold. Increasingly — for disputed reasons — grain futures are expiring at prices well above the cash-market price.
When that happens, farmers or elevator owners wind up owing more on their futures hedge than the crops are worth in the cash market. Such anomalies create uncertainty about which price accurately reflects supply and demand — a critical issue, since the C.B.O.T. futures price is the benchmark for grain prices around the world.
“I can’t honestly sit here and tell you who is determining the price of grain,” said Christopher Hausman, a farmer in Pesotum, Ill. “I’ve lost confidence in the Chicago Board of Trade.”
David D. Lehman, director of commodity research and product development for the C.B.O.T.’s owner, the CME Group, said: “We know that the current global environment is creating challenges for many of the traditional users of our markets, and we are very concerned. But there are a lot of things that are changing and there is no silver bullet, in terms of a solution.”
Many farmers and people in related businesses blame the tidal wave of investment pouring in from hedge funds, pension funds and index funds for the faulty futures contracts and rising volatility. But those institutional investors’ money actually adds liquidity to the market, which in theory should reduce price volatility, Mr. Lehman noted.
In any case, at current levels of volatility, options trading becomes riskier, and therefore more expensive — too expensive for many farmers like Mr. Grieder, who now has to hedge with the recently less reliable futures contracts.
That exposes him to the risk of having to put up more cash — to maintain his price protection — whenever a weather threat, shipping disruption or a fresh surge of money from Wall Street suddenly pushes up grain prices.
“If you’ve got 50,000 bushels hedged and the market moves up 20 cents, that would be a $10,000 day,” he said. “If you only had $10,000 in your margin account, you’d have to sit down and write a check. You can see $10,000 disappear overnight.”
On an unusual day, he said, he might get four phone calls a day from his broker seeking additional margin. “But usually, the margin calls come in the mail, in a little blue envelope,” he said. “You don’t have to open it to know what it is.”
When it arrives, he sometimes has to rely on his bank to advance him the margin he needs to keep those hedges in place — a worrisome requirement even for a successful farmer in an economy already struggling with a credit squeeze.
“The nightmare scenario is when you have to make margin and you’re looking out your back door and seeing, maybe, a crop problem,” he said. “Everybody has a story about a guy they know getting blown out of his hedge” by unmet margin calls.
Farmers used to leave the market-watching to traders who work for big grain elevator companies. But with some of those companies now refusing to buy crops in advance because hedging has become so expensive and uncertain, farmers have to follow and trade in those markets themselves.
“This is something the farmer didn’t have to worry about before,” said Curt Kimmel, a commodity broker at Bates Commodities, the advisory service Mr. Grieder uses. “It’s a cruel and unforgiving market.”
John Fletcher, a grain elevator operator in Marshall, Mo., started pressing the C.B.O.T. to address the flaws of futures contracts almost two years ago — even before his futures hedge on a million bushels of soybeans failed to fully protect him last September, hitting him with a cash loss of $940,000.
Mr. Fletcher does not blame the big institutional investors stampeding into the market. “But they have contributed to the problem by making these markets so much larger — so large that they have outgrown their delivery system,” he said. “And that has detached the futures market from the cash market.”
Frustrated over the flawed futures contract, Mr. Fletcher is voting with his feet. Last year, he entered into a contract with A.I.G. Financial Products, a leading sponsor of commodity index funds, which allows him and the index fund to hedge their risks without using the C.B.O.T.
Instead of using futures or options, A.I.G. simply buys the commodity directly from Mr. Fletcher, who stores it for a fee and buys it back six months later. His storage fee is lower than the one built into the C.B.O.T. contract, so A.I.G. pays less for its stake in the market. And he has a hedge he can rely on.
“I did a deal with them for corn a year ago, and this year I’m doing a deal on soybeans,” he said.
But private deals like these do not provide pricing data to other farmers and to the rest of the food industry, which has long relied on the Chicago Board of Trade as the best measure of supply and demand. If such bilateral contracts become more common, it will be harder for everyone in the industry to anticipate costs and potential profits — which could also push prices up.
This growing uncertainty about prices and hedging “just makes the market less efficient,” said Jeffrey Hainline, president of Advance Trading, an agricultural advisory and brokerage service in Bloomington, Ill. “And anything that makes these markets less efficient increases the cost of food.”
Robert E. Young II, chief economist for the American Farm Bureau Federation, has held meetings on this topic around the Farm Belt over the last month and has gotten an earful from distressed food producers and elevator owners, he said.
“I tell people, ‘You are not going to market the 2009 crop the way you marketed the 2007 crop. You may never market grain that way again.’ ”
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Why don’t the CBOT raise margin requirements on traders active in the grain and food future markets?
COMEX did that to the Hunt brothers et al. in 1980; kinda took care of the problem, didn’t it?
Like Yves wrote recently: costs to society overrules investors’ pet needs. The last thing we need now are unstable food prices.
Interesting details.
How are the “official” inventory numbers for different commodity types measured? (e.g., in the IMF report cited by Krugman). Krugman at least seems to put a lot of trust in published inventory numbers despite ongoing discussion such as on this blog about where there might be “hidden” inventory.
I have not yet seen a systematic discussion of unmeasured or undermeasured inventory locations and potential quantities (especially with respect to storable commodities such as metals and oil). But I agree this article highlights possibilities for agricultural commodities.
Might there also be an incentive for those speculators that choose to hold physical inventory to keep a low profile (i.e., unmeasured inventory) due to perceived risk of regulatory backlash due to soaring prices, or is a low profile not feasible?
“But those institutional investors’ money actually adds liquidity to the market, which in theory should reduce price volatility, Mr. Lehman noted.”
Right! Shows where economic “theory” is nowadays. Out there stumbling through the corn fields with its hands in its pockets and a big idiot grin on its face.
“So we bid on three different Citizens securities that day. We got one bid at an 11.33% interest rate. One that we didn’t buy went for 9.87%, and one went for 6.0%. It’s the same bond, the same time, the same dealer. And a big issue. This is not some little anomaly, as they like to say in academic circles every time they find something that disagrees with their theory.”–Warren Buffet
And from the NY Times article:
“Increasingly — for disputed reasons — grain futures are expiring at prices well above the cash-market price.
“When that happens, farmers or elevator owners wind up owing more on their futures hedge than the crops are worth in the cash market.
It sounds to me as if markets are in total confusion and disarray, not unlike the fog of war, where there is a total breakdown in reconnaissance, intelligence and communication.
From Tolstoy’s “War and Peace”:
“But in the disposition it is said that the action thus begun, subsequent orders will be issued in accordance with the enemy’s movements, and it might therefore be supposed that all necessary dispositions would be issued by Napoleon during the battle. But this was not and could not have been done, for during the whole engagement he was so far away that, as appeared later, he could not know the course of the battle, and not one fo his orders during the conflict could be executed.”
Know very little about commodities futures, but I rather doubt your reading of the consequences of too many futures wrt underlying. Suppose there are only x units of a commodity to deliver, but there are y futures outstanding, where y > x. One would still expect the futures price (F) to converge to the underlying price (U) on the day of expiry, because the convergence argument doesn’t depend on x or y. For instance, if one was the buyer of a future and F > U on the expiry, then one could sell the future and buy the commodity and make a riskless profit. etc. On the other hand, if y > x, then there is a much greater chance of a squeeze, in one direction or the other, and so where F and U are when they converge would seem reasonably volatile.
Two comments…
1. The example of the farmer with the AIG contract is puzzling. What’s described is more like a repo than a hedge, since the farmer has apparently agreed to repurchase the grain in six months. So he still has almost the same market exposure.
2. The wikipedia article on futures mentions nonconvergence fairly prominently. The discussion suggests that CBOT restrictions on who is eligible to physically settle contracts is at least partly responsible. Somebody has to be there with the freight cars to enforce convergence, and it might take a lot of freight cars if the open interest is large going into delivery.
This is just more incompetent reporting on commodity trading.
Written testimony of Jeffrey Harris, Chief Economist of the Commodity Futures Trading Commission, before the Senate Committee on Energy and Natural Resources (April 3, 2008): http://www.cftc.gov/stellent/groups/public/@newsroom/documents/speechandtestimony/opaharris040308.pdf
Moe Gamble
Moe,
With all due respect, I take what regulators say in front of Congress with a handful of salt, as the recent testimony on the JP Morgan/Bear deal attests. They are always and ever doing a good job, and can always catch the bad guys.
In particular, I nearly gagged on the first page when Harris implied that CFTC supervision was able to prevent manipulation. John Dizard in the Financial Times has written of one known practice, “date rape” which the powers that be seem unwilling or unable to stop.
Per our comments on his story, which can also be found in a February 2007 post:
Dizard calculates the collective losses to investors (organizations like pension funds, endowments, and insurers) on the monthly roll of the GSCI (required because the index uses futures contract that expire every month) at 150 basis points on $100 billion of funds, or $1.5 billion. And who is on the other side of these trades? Dizard believes Goldman is at the top of the list.
Read that figure again. 1.5% a month. That’s massive. On a supposed low cost, efficient index, investors are incurring costs above what they’d pay to be in a hedge fund (and it would have to be a hugely successful one at that for them to face charges of that magnitude, while here, the costs are incurred, whether the investor profits or not).
And these frictional costs are on top of explicit management fees.
Commodities trading volumes are up considerably from a year ago, hence there is every reason to believe the magnitude of “date rape” and similar practices has increased correspondingly.
I will note that this sort of manipulation does not support the “speculative cash has pushed commodities well above their fundamental price” thesis.
So lets go back a few years and consider something Robert Mabro of the Oxford Energy Institute had to say re. volatility in the crude markets:
These are significant [price] movements amounting sometimes to a 30% variation in a matter of few weeks.
Does any of that matter?
Ask any trader and the answer will be almost invariably ‘no’. The alleged economic rationale is that we are considering a market which sends signals about the allocation of resources. That would be perfectly correct if these price changes caused rapid adjustments in supply and demand. But they do not because the commodity traded is not physical oil but either a claim on future oil or a price differential which is no a commodity at all.
The signals that the industry needs are about investments in capacity. One could argue that the prices quoted for long term swaps provide these signals, and indeed long term prices fluctuate much less than short term ones. But investments do not depend only on the view taken about prices in the long term, they are strongly influenced by the cash flow available to companies and the cash flow is a function of current prices.
Volatility generates uncertainty and uncertainty inhibits or confuses the investors.
(Does Oil Price Volatility Matter? June 2001)
‘The alleged economic rationale’ is an efficient market artifact which fails to hold and all the more so when, as Steven Briese has written, index traders are able to evade exchange and/or CFTC position limits through use of swaps dealers.
That this large, bullishly oriented group of funds is flourishing is partly a result of a regulatory anomaly. In recognition of the fact that the commodity markets are too small to absorb an excess of speculative dollars, the Commodity Futures Trading Commission, in conjunction with exchanges, imposes position limits on speculators. But the agency has effectively exempted the index funds from position limits.
[…]
The speculators, now so bullish, are mainly the index funds. To see how their influence on the market has become outsized, just look at how they operate. Nearly $9 out of every $10 of index-fund money is not traded directly on the commodity exchanges, but instead goes through dealers that belong to the International Swaps and Derivatives Association (ISDA). These swaps dealers lay off their speculative risk on the organized commodity markets, while effectively serving as market makers for the index funds. By using the ISDA as a conduit, the index funds get an exemption from position limits that are normally imposed on any other speculator, including the $1 in every $10 of index-fund money that does not go through the swaps dealers.
The purpose of position limits on speculators, which date back to 1936, is clearly stated in the rules: It’s to protect these relatively small markets from price distortions. An exemption is offered only to “bona fide hedgers” (not to be confused with “hedge funds”), who take offsetting positions in the physical commodity.
The basic argument put forward by the CFTC for exempting swaps dealers is that they, too, are offsetting other positions — those taken with the index funds.
( http://commitmentsoftraders.org/?p=32#more-32 )
Commodity prices have been financialized, i.e. have been disconnecting from fundamentals, something noted early 2006 by Citi’s Alan Heap but evident to all who cared to look.
This is no longer simply a broken system but one that, in its fashionable grubbiness, kills.
Juan,
That was enormously helpful. You ought to post the same over at Krugman, since he has some sway.
It also confirms my and others’ suspicions: some of the run-up in commodities is warranted, but a lot is due to people looking for an inflation/dollar collapse hedge. And the currency and bond markets are so much bigger than the commodities markets that parties fleeing the above for safety can create distortions pretty easily.
Once prices are disconnected from fundamentals, they can soar to astonishing heights, making those who sat it out look like morons. But mean reversion (more often, a correction beyond the mean) eventually prevails, and timing an exit is difficult. But then again, if your rationale is hedging, as opposed to speculation, that concern is less relevant.
Yves,
Thanks and you may also find this 8 February, 2008, article from AgWeb of interest:
The great wheat “squeeze” of ‘08.
http://www.agweb.com/Blogs/BlogPost.aspx?PID=b12091a2-0e10-4003-bd6b-ab24b1406077
Aren’t the specs on a futures contract tied directly to the underlying cash market? By definition alone, the whole idea of a futures contract is that the buyer accepts the underlying delivery or the contract is marked-to-market to the cash, either way its based on the cash sale at the expiry of the futures contracts. How can expired contracts be more than the cash price when in the contract itself, presumably, the specs are based on the cash price? In this context, I fail to make sense of the NYT article: its all contractual.
binary,
No, a futures contract does not require delivery; in fact, per ichabod’s comments above, only a subset of traders on the CBOT are permitted to take delivery. Most index traders are assumed not to take delivery.
An earlier NYT article discussed how disparities between futures settlement prices at contract expiration and cash prices in certain ag markets were a growing and perplexing phenomenon. That clearly can’t happen if enough players are arbitraging.
Love your blog Yves…Long time lurker… anyhoo
Don’t know if you spotted this over at econbrowser, here’s the link:
http://www.econbrowser.com/archives/2008/04/commodity_arbit.html
Wonder what happened at the forum…
Does this post add anything valuable to the “if there is speculation where are the inventories” discussion? (at least for storable commodities.)
http://theroxylandr.wordpress.com/2008/04/08/how-commodity-speculation-works/
Basically it suggests that when futures prices are higher than cash market prices (due to speculative interest), commodity buyers will simply buy the physical commodities early to lock in the price rather than buying the futures contract… which would contribute to closing the gap between cash and futures prices. If as Juan’s link suggests the prices have only been out of line with fundamentals since Sep 2007, this seems even more feasible.
The explanation seems logical, if not quantified. But I don’t know if those inventories would be counted among the inventories that Krugman claims just aren’t there. My apologies if this is not a valuable comment, I’m still learning this stuff.
hbl,
Sorry that there is no link but from what Alan Heap, Global Commodity Research, Citigroup, wrote 25 January, 2006, the process began well before Sep last.
His report, co-authered with Thomas Price, was titled: Beyond fundamentals – the funds phenomenon, from which a few excerpts:
Long-only funds are joining hedge funds and CTAs – investing in commodity markets.
Fund investments began to surge in early 2004.
Commodity markets have always been strongly influenced by speculation. For example, surging investor demand contributed to the 1994-95 boom. In this cycle though, funds deployed are perhaps double the previous high.
Since early 2004, when this investment cycle began, funds invested have tripled.
All commodities are involved
All classes of commodities – base and precious metals, energy and softs (agricultural goods), have enjoyed substantial price gains.
The increased fund investment and price increases are occurring against a fundamentally robust environment… (But Juan would mention that, even as global growth was fairly strong, China’s consumption of crude oil fell flat in 2005, picking up again in ’06)
New players
Long standing investors in commodity markets (hedge funds, CTAs, etc.) are being joined by long-only funds (mutual funds, pension funds, etc.) who are implementing an asset allocation shift away from more traditional sectors.
The growth in investment has been facilitated by new instruments, principally indices and others such as ETFs. Funds of funds are also an increasingly important means of siphoning money into a mix of investment instruments. However, direct investments on the commodity exchanges are also increasing.
Fund flows dwarf those of commodity markets Commodity markets are tiny compared to markets of conventional asset classes. Funds are making only small asset allocations (3-5%) into commodities, but much greater flows could occur.
And, apparently, greater flows did occur as trend following behavior and reallocation decisions became trend generating.
At that point in early 2006, A. Heap estimated a total of US$200 billion to be invested in commodity markets. Without checking, it’s my recollection that S. Briese and Bianco Research’s Greg Blaha speak of roughly the same amount today, not as a total but only the Index Fund portion, most all of which is buy side.
Sure they no doubt use different different methodologies, nevertheless…
The difference between expiring futures and the cash market is most probably a sign of players that are physically incapable of receiving actual delivery. The price difference is actually a price for not having to pay for storage of the commodity. The same for the AIG deal. AIG is paying Fletcher for a possibility of going long on the grains without actually having to take hold of it.
The same can be seen in the negative rent for gold. There are so many players going long without actually being able to securely store the stuff. They take care of it by paying somebody else for storing it for them.
Commodity lending is a kind of “virtual inventory”. When speculative hysteria goes to these lengths, the popping of the bubble can not be very far ahead.