You’re in a grocery store and that loaf of bread in your hand is now a buck fifty when you could swear it was a dollar a few months ago. It’s certainly more than last year. But if you think it’s bad in your local supermarket, it’s far more serious in the global marketplace. Most American foods are highly processed so the commodity price of the corn in say a bag of Tostitos is less a factor than the transport, marketing and packaging. (and this is the food culture we seek to export). But when the price of hard red spring wheat climbs on the MGEX, price of bread in Iran or Nigeria rises in correlation. Are commodities traders to blame for this?
Now that food has become a securitised asset class, traded as ETFs and ETNs to investors seeking diversification as well an inflation hedge, is Wall St. going to lead the world’s hungry down the same path it led the American homeowner? Does the image of Wall Street profiteers making a killing by killing starving Africans while tucking into a business lunch at Le Cirque nauseate you? If so, please follow me below the orange torsade croustillante
While food prices are harder to track than say gasoline, which is plastered in big letters on signs everywhere, we’ve seen food prices climb sharply this year. February’s Producer Price Index showed food prices, particularly vegetables, climbing 3.9 per cent, outpacing energy. That’s the most food has gone up in a month since 1974. And in the developing world, food prices have risen even more sharply. In the Middle East, where bread prices doubled in the last eight months, the price of bread may have been what triggered revolution in Egypt and Tunisia. In this article, Robert Samuelson describes the looming crisis-
Global food demand is colliding with strained supply. High prices or shortages could destabilize poor countries and trigger global scrambles for scarce foodstuffs. The present price surge is the second in three years. In 2008, run-ups in rice and wheat triggered protests and riots in about two dozen countries
The food crisis of 2008 is an important case in point as the emergence of commodities trading in wheat was implicated as a central factor. Fred Kaufman, in The food bubble: How Wall Street starved millions and got away with it, focuses on a critical development in commodities market that set the stage for speculative manipulation of food prices. The prime actor in this scheme was, you guessed it, Goldman Sachs.
Let's start with the familiar mortgage derivatives and their effect on the real estate market. By offsetting CDOs with CDSs, Goldman Sachs was able to game the mortgage derivatives market both rising and falling. It turns out that analysts at Goldman Sachs had devised an equally ingenious way to game the commodities market that produced profit for the firm whether the spot price of commodities went up or down.
First step was creating commodities index funds which maintained a continuous series of rolling ‘long orders’, promises to buy an amount of say wheat or copper at a fixed price at a certain date in the future. These funds appealed to investors looking for an inflation hedge (or in today's case, a hedge against a falling dollar) and Kaufman notes the downside risk:
In fact, the structure of commodity index funds ran counter to our normal understanding of economic theory, requiring that index-fund managers not buy low and sell high but buy at any price and keep buying at any price.
There is no profit-harvesting mechanism within these funds: no intention to buy or sell the underlying commodity, in contrast to the traditional traders who occasionally took delivery of the product. So these fund managers were obligated to keep rolling over an expiring contract into another one, to maintain a perpetual long position on the commodities represented. But the spot price of wheat, for example, rises and falls due to unpredictable events from floods to weevils, so who bets on something that must always go up?
Kaufman explains how Goldman Sachs figured that angle out:
The strategy, standard practice for most index funds, relied on “replication,” which meant that for every dollar a client invested in the index fund, Goldman would buy a dollar’s worth of the underlying commodities futures (minus management fees). Of course, in order to purchase commodities futures, the bankers had only to make a “good-faith deposit” of something like 5 percent.
Goldman Sachs made money not only from the usual transaction fees, but also from the time value of the investor’s money. They only had to wager the deposit. The remaining 95 per cent could be parked in a low risk instrument like a T-Bill to make income for the firm. As Kaufman summarizes:
The bankers had figured out how to extract profit from the commodities market without taking on any of the risks they themselves had introduced by flooding that same market with long orders. Unlike the wheat producers and the wheat speculators, or even Goldman’s own customers, Goldman had no vested interest in a stable commodities market.
Of course the resulting commodities bubble popped along with most other asset bubbles in 2008, sending the price of all commodities plummeting, but this corrective comeuppance for the unfortunate investors was by no means definitive evidence that speculation in derivatives is a zero-sum game.
Assuming every winning investor in a commodities play has an equal and opposite loser, who cares? Well, the toxic effects of speculation on commodities prices arise from the fairly recent practice wherein financial traders can buy derivatives in huge amounts of commodity for very little cost compared to the underlying value of the pysical commodity itself. This means that a small swing in demand can amplify prices well beyond traditional market wisdom. These assets become portfolio dominoes- in other words instability becomes contagious across asset classes and products: in the case of commodities derivatives, if a lot of call options are exercised for any number of reasons, then prices can soar as traders try to meet their commitments. As a result, the price of a bushel of corn can swing significantly despite a situation of stable supply and consumption.
What about the conventional free-market wisdom which holds that for everyone who makes a profit someone else must make an equal and opposite loss?
Derivatives are truly a zero sum game if only two parties are involved and if the price fluctuations do not affect others. In the case of food and other commodities the price changes affect those that ultimately take delivery of the product, the consumer, regardless of the outcome between the buyer and seller of futures. It is the consumer who loses collaterally since market volatility leads to shortages and price gouging. And there are winners as well outside the buyer/seller frame. As with the mortgage meltdown, Goldman Sachs emerged from 2008 the winner despite negative investor outcomes. Wall St. wins, while the consumer loses.
This free-market argument holds that speculation merely brings risk forward. In the case of food that means high prices are paid today to forestall tomorrow’s food shortages. In simplest terms, “The solution to high prices is high prices”.
So let’s assume that a food shortage is inevitable- today’s speculative run-up in prices would be seen as a good thing. Higher prices through speculation pull future shortages into the present by serving as an incentive for farmers to plant more, become more efficient, etc. in order to rebalance demand with increased supply.
This Adam Smith paradigm runs out of gas when you take into account that demand for food is 'inelastic', and more so the poorer the consumer. While we Americans might respond to higher prices by buying cheaper products (which for us often mean less processing and packaging as opposed to less commodity), a poor consumer in the thrid world is faced with going without. In the third world, higher food prices don't alter consumer behavior, they cause starvation and riots. And in the very long run, growth in food production is limited while the consumers of food are ever increasing. In the face of dwindling resources, a market-based approach is potentially catastrophic. Resource scarcity, be it of oil or fresh water, both of which are necessary to produce food, falls outside the mind-set of market economics which is rigged onto the flimsy armature of perpetual growth. Besides, Adam Smith never foresaw a tiny market dog wagged by a massive derivative tail.
I’m more of the opinion that we’ve never experienced free market. Chomsky and Zinn make this argument. They contend that economic history shows not a single developed nation in the world has ever followed the rules of free market capitalism. Every single industrialized nation rose out of protectionism. Free market capitalism is something we prefer to preach to the developing world as opposed to practice.
So what to do about all this speculative mischief? One solution would be to restrict certain types of derivative trading to those that have a structural need to insure against market fluctuations: the farmer using a crop futures contract to guarantee income against a possible decline in prices, a cereal processor who uses grain options to guarantee raw material for its factories, or an airline that uses oil futures to stabilize ticket prices. In these situations derivatives have a very valuable role.
Another solution would be to reverse the trend of lowering barriers to entry by requiring traders to deposit bonds relative to the value of the underlying commodities. Right no the opposite is happening as financial innovators seek to make exposure to commodities more accessible by lowering margins through financial instruments like CFDs (Contracts for Difference).
Another important step in disentangling banks and monetary gamesters from food supplies would involve pressuring the International Monetary Fund to stop their policy of forcing nations in their thrall, mostly in Africa, to grow cash crops. In the interest of corporate recolonization, the IMF and WTO coerce farmers into growing monocultures such as cotton, cacao, or coffee as opposed to subsistence crops. (if I were truly cynical I would add coca and opium to this list). The cash is used justify more debt and to purchase food grown ‘more efficiently’ from (dumped by) industrialized exporters. In the resulting boom/bust cycle, the market often drops, leaving the farmer both impoverished and stuck with an inedible crop that cannot be saved until prices recover.
Recovering prices lead us to a new development in food speculation- the reality of hoarding food. The potential for mass storage is accepted as a major difference between oil and soft commodities such as grain. It’s interesting to note that oil tanker demand goes up sharply during periods of rising oil prices. This is because tankers are filled up by suppliers and traders for the purpose of warehousing the cheap oil in anticipation of higher prices. Can this be done with grain?
Paul Krugman opined this in column that food is immune to speculation driven shortages
since there is no accumulation of physical inventories. Yves Smith refutes his argument in this response but more to point, Dave Kane in his blog post supplies links citing evidence of grain storage facilities owned and operated by commodities traders Gavilon
and Goldman Sach’s commodities trading rival Glencore (a company to watch in the financial/food future)
Food hoarding may very well be the next trend in creating trading profits at global consumer expense. It's a depressing thought that these huge grain silos are being built not to feed people but to starve them.
The Bigger Picture:
Assuming the bad effects of speculation on food prices, is it fair to say that speculation ‘causes’ starvation? I don’t think so. While it’s emotionally satisfying to blame a moneygrubbing powerful elite corp of profiteers for our troubles, the predicament we’re currently facing is much more broadly based than that.
Suppose that we, by some miraculous policy solution, have sidelined the speculators. Investors and bankers have now agreed to stop fooling around with the things we eat and have reverted to customary shenanigans with abstract credit and debt. Will food prices settle down, will markets regain an even keel? In a word, no. Speculators certainly aggravate the problem, but there is a greater and graver situation that will lead to increased food prices and starvation in the future. Talk about curbing speculation is academic without addressing these issues.
The first is population growth. Every day over 220,000 new food consumers are created. This is the demand that threatens to overwhelm the supply.
The second is the success at which American corporations have globally promoted an animal-protein based diet as indicative of success and status. Already China consumes double the meat the US does, and this is historically unprecedented. It bears noting that it takes sixteen pounds of consumable grain to produce one pound of beef.
As for beef being cited as an example of an animal protein that can be produced from non-consumable grass, here’s an excerpt from an interview with Michael Pollan. More on this topic can be found here.
Here's another framing of the effects of increasing livestock production on the global economy: it takes 100 gallons of oil to grow a single cow. Which leads us to the third and most essential cause of rising food prices. It’s that other speculative commodity, the one with the huge numbers displayed at service stations. Farming or agriculture in the modern world has evolved into a function of turning oil into food. There are 10 calories of hydrocarbon energy in every calorie of food we eat.
After water, fossil fuels are the major resource input in food production. From diesel machinery for tilling, planting and harvesting, to fertilizers and pesticides, to mechanized processing and transport, fossil fuels are the reason why monoculture factory farms have been able to outproduce and outcompete smaller enterprises on both a local and global level.
Oil into food is now a two-way street. Thanks to billions of dollars in taxpayer subsidy, corporations such as ConAgra and ADM reap profits by transforming corn into ethanol, all under a shabby political banner of 'energy security'. The tragic statistic is that the share of grain production dedicated to fuel ethanol production has doubled over the last four years to 28.7%.
Given the US role as a major grain exporter, ethanol production creates a corn supply destruction. This has driven up the price of all grains worldwide . In fact 2011 will be the first year that more grain will used for domestic ethanol production than exported to the rest of the world.
As far as the travesty of ethanol production goes, a political solution seems unlikely: Given ten producing states with two senators apiece, there’s a well-entrenched legislative bloc that is committed to supporting increased ethanol production, despite its clear moral hazards.
Here’s a great summation by environmentalist Lester Brown:
But whereas in years past, it's been weather that has caused a spike in commodities prices, now it's trends on both sides of the food supply/demand equation that are driving up prices. On the demand side, the culprits are population growth, rising affluence, and the use of grain to fuel cars. On the supply side: soil erosion, aquifer depletion, the loss of cropland to nonfarm uses, the diversion of irrigation water to cities, the plateauing of crop yields in agriculturally advanced countries, and -- due to climate change -- crop-withering heat waves and melting mountain glaciers and ice sheets. These climate-related trends seem destined to take a far greater toll in the future.
Like our looming situation with peak oil, the spectre of a worldwide decline in food production has it’s naysayers and as with energy the proposed solutions are more technological than social. In the case of food production, much hope is invested in genetically engineered crops or GMO (genetically modified organism) seeds. Without question, these GMO crops, marketed by corporations such as Monsanto, have increased yields worldwide. The caveat to all this technological salvation is we are just now beginning to understand some of the underlying health risks to GMO foods. Adding to this concern is the increase in the extent of genetic insertion: In just one decade of marketing GMO corn seed, Monsanto has gone from adding one genetic trait to eight.
Others point to yield gaps between American farmers and their third world counterparts, in which American farms can out-produce by up to a magnitude of 10 to 1. The devil is in the details and the demon here is not GMO technology, although that’s a factor, but in the sheer amount of fossil fuel input that drives this productivity- the oil for diesel powered tilling, planting and harvesting machinery, natural gas for fertilizer and pesticides, more fuels for mechanized processing and transport. In other words, we can't frack or drill our way out of potential food scarcity.
We’re at a crossroads between energy use and food. As the cycle of energy/food/wealth spins toward natural depletion of perhaps all three, we need to change our way of living so that others may live at all. Our predilection to drive cars anywhere and everywhere, combined with our preference for meat-based proteins and heavily processed and packaged foods, are setting the stage for massive human suffering. We’ve shown our willingness as a nation to wage war to secure our oil reserves. We've shown our willingness to turn real products into financial abstracts for the sake of propping up the financial industry which props up our consumer culture. That’s the non-negotiability of the American way of life that we have all bought into.
Will we be just as willing to starve whole populations to the same end?