It never fails. Each time commodity prices rise, there are calls for more curbs on speculation.
The latest instance was last summer’s run-up in food prices as a result of the severe drought in central parts of North America.
There are many factors that affect grain prices, but a basic one is the stock-holding behaviour of the world grain processing industry. This industry has moved to almost exclusively receiving just-in-time shipments of their raw material. They don’t like to have capital tied up in grain storage facilities and inventory and as a result buy grain as needed to keep costs down.
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But what happens when there isn’t much product in inventory and an apparent shortage? For example, what if inventories are already low and a U.S. Department of Agriculture report forecasts a lower crop? Grain processors become concerned about security of supply and buy a little extra just in case. Some may call this hoarding, but I would call it prudent risk management to make sure their plants stay open.
Whatever it is, the effect is to increase prices, and the lower the inventories and the more just-in-case buying, the higher prices will rise.
An interesting aspect of all the price spikes in recent years is that they occurred during the growing season and were relatively short-lived because, invariably, the shortages turned out to be overstated.
In other words, the harvest was better than expected or higher prices curtailed demand.
How do just-in-case buyers respond when production and inventories exceed expectations? Naturally, they buy less because they had already made their purchases and now return to their normal just-in-time behaviour. Reduced demand obviously lowers prices.
Some blame speculators, but serious analysts see the market simply doing its job of rationing lower supply. Many people note that commodity price volatility has risen along with more speculation, and draw a link between the two. This confuses correlation and causation.
Researchers at the University of Illinois have shown that increased speculation was overwhelmingly a result of higher volatility. They argue strongly that lawmakers should tread lightly on controlling speculation: the worst possible outcome is to regulate a market into too little liquidity.
The real reason for greater volatility in food prices is the trend toward lower grain inventories. This is caused by burgeoning demand in emerging economies as well as from the biofuel industry, which farmers are struggling to keep up with. Speculation can have a short-term impact on prices, but the evidence is clear that fundamentals drive markets in the long run.
It is not helpful to address agricultural issues with superficial thinking. According to the simple view, curbing speculation would have avoided high prices.
Exactly how would reining in speculators insulate us from the inevitable price effects of the worst drought in a century? And how are farmers going to take advantage of higher prices if there are no speculators to take the opposite side of the farmers’ or grain handlers’ hedges?
They would be latent sellers left without buyers. The worst problems and the most volatility are in commodity markets with too little speculation to provide the liquidity that hedgers need.
Perhaps more importantly, what if policy-makers actually heed the argument against speculators? In a world with real problems, how much harm can be done with bad solutions — in this case, by potentially jeopardizing the liquidity needed in a well-performing market.
With only two to four weeks of grain inventory and the specter of very high food prices and starvation in vulnerable economies, the focus should be on ensuring people have enough to eat without resorting to revolution and terrorism.
Larry Martin is the author of the Macdonald-Laurier Institute’s report Are Higher Commodity Prices driven by Speculation or Fundamentals? and a principal in Agri-Food Management Excellence Inc. This article was distributed by Troy Media. It has been edited for length.
