Tuesday, March 15, 2011

Supply, Demand, and Speculation

     Two articles in the Monday 14 March 2011 Globe and Mail business section caught my attention. One, a column by Brian Milner called Taking Stock (B1) talks about the recent rises in the commodities and futures market. The other, by Jeremy Torobin, The seed for food inflation (B3) is about the rise in food prices now underway. Reading them back to back is instructive. Torobin points out that the current value of the Canadian dollar is helping keep a lid on import prices--particularly those used in food processing. But with George Weston Ltd. announcing an average 5 percent price rise starting April first, and other major producers set to follow, it is expected that the average increase in a Canadian family food bill will be about 7 percent by the end of the year.
     The reasons for this food price inflation are the usual suspects; higher fuel prices (the disruption of Libya's 1.5 percent of global production is cited), growing population and rising incomes in the developing world (particularly China), and "diminishing supply". This last is interesting, because two pages earlier Brian Milner is quoting the U.S. Department of Agriculture as calling for bigger harvests and higher global stockpiles than previously expected. Also, other oil producing nations have announced that they will be able to pick up the slack in oil production, and China is busy buying farmland around the world (particularly in Africa) and getting into industrial food production in a big way (trying to avoid contagion from Egypt and Tunisia, among others).
     So what is driving food price inflation? The same thing that drove house price inflation--hedge funds and "other speculators who have shoved hundreds of millions into agricultural futures and swaps" (Milner, B4). Commodities have been one of the plays of choice for speculative money since the meltdown of 2008. Milner interviews Ron Lawson, co-founder of Logic Advisors, who spends a lot of time and energy following agricultural commodity markets for his clients. And Lawson is pretty blunt in his analysis:
     Supply and demand establish the balance sheet. But when participants come in with amounts of money that are multiples of the available commodity, that's speculation. We always say that the specs got more money than the trade has cotton.
     If you're a big money manager, your round lot, your loaf of bread, is $100-million. Well, with $100-million you can buy the entire open interest of a commodity contract. So when these guys come into the market, they're not doing it on a demand-supply basis. They're looking for somewhere to place money. they're looking for an investment that gives them alpha, some kind of yield that can improve their returns. They're the whale that jumps into the pond.
     The whale that jumps into the pond, indeed. And they're entering a system that is not designed to feed people, but rather to maximize profit. And a 7 percent return looks a lot better on the year end report than the battering speculative money took in the housing collapse.
     So speculative money drives up the price of agricultural (or "soft") commodities, the processors jack their prices, and we all pay for it because food is one of those weird things--a necessity that is not a right, but a commodity. Unlike, say, air.
     But what happens with all this frothing of the futures market? Right. the same thing that happened in housing; a speculative bubble. Let's give the last word back to Mr. Lawson:
I've only been doing this 30 years. There are guys who have been around longer. But one of the things I learned a long time ago is that speculating in futures is God's way of telling you you've got too much money.

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