Could the world’s food supply be the next speculative bubble?

Speculators are always looking for places to speculate. The clarion call of the big money and the adrenalin thrill of the kill don’t always happen on an actual killing field for the very rich. They frequently happen with some carefully placed shorts and momentum. They do have the same results as a hunting party. Something dies. In this case, it could be the world’s hungry.

I know that wasn’t exactly a profound way to open a thread but I didn’t know how else to begin a conversation on food inflation and this UK Guardian headline: “Commodity prices soar as spectre of food inflation is back; Speculation and rumour could be the driving force behind sudden market rise in food prices”. It sounds like one of my dry economic topics when I put it this way. But, really you need to notice this.

I’ve talked about how incenting farmers to grow biofuels instead of food in a world where the population is still growing faster than it should is a dangerous bet. It may be that a few some ones are taking that bet since it’s been raised by a Russian Drought and an Indian Plague. Witness one of the few markets where we’re seeing asset prices rise above a normal rate of return. No, it’s not really the stock market that’s been floating around the same numbers for months now. It’s not the housing market or the commercial real estate market that still appears to have some downward momentum. The new asset bubble appears to be in commodities. It also seems centered in food.

The price of wheat, oil and copper soared this week but the picture looks much less clear this time. Old-fashioned supply and demand is still at work, but there are fears that wild rumours and speculation are driving up prices.

Wheat prices, which are up 40% over the last month, reached a two-year high as concerns about a drought in Russia and rotting stocks of grain in India exercised markets in London and Chicago. Claims that a major crop failure in Australia, following an invasion of locusts and a wet summer in Canada, could lead to a worldwide shortage, have pushed up prices in recent weeks to levels not seen since 2008.

The rise in futures contract prices traded on the major markets also follows a United Nations report in June that warned food prices could rise as much as 40% over the coming decade, amid growing demand from emerging markets and for biofuel production

The World Development Movement said reports pointing to a long-term upward trend in prices and the recent weather-related farming crisis had proved fertile ground for speculators who bet on rising prices.

Tim Jones, policy adviser to the WDM, said figures from US commodity futures trading commission showed the majority of contracts on foodstuffs over the past six weeks, including wheat, had bet on rising prices.

“There is strong evidence that speculators have seen an opportunity to drive up prices. But the damage caused by their activities is higher prices for everyone and people in developing countries can ill-afford to pay the cost,” he said.

One of the strong signals that the speculators have switched to creating a food asset bubble is this tidbit. “The CFTC figures showed there was a 35% increase in contracts since June betting on a rise in prices.” That means commodity futures traders are betting on price movements. Food inflation (the rise in food prices) should be solidly linked to those pesky real things that shift demand and supply curves like drought (Russia does have one), plagues of locusts, or lots of hungry babies. Is this the case in the current run up of food prices?

There are temporary reasons behind high food price inflation—drought, petroleum products price hikes, mismanagement of trade policies, transportation dislocations, debt waivers, speculation and so on. Per se, inflation numbers are also not really the point. There is no reason to expect that food price inflation will remain at 12.47%, which it was for week ending July 10. Such numbers are function of the base last year and will undoubtedly soften when the kharif crops arrive post-September. While short-term declines in prices of individual agro-commodities are possible, does one really believe that food price inflation will disappear?

It will moderate from double digits to 7% or thereabouts, but 7% is still inflation. And that 7% will remain, because there are medium-term causes behind the increase in food prices—NREG (which continues), increase in rural incomes (there is no reason to presume public expenditure in rural sector will taper off), increase in urban incomes, changes in consumption patterns and warped incentives through procurement prices and hikes in these (that isn’t going to be reversed either). We are talking about increasing demand imposed on an inelastic supply. (Increases in production and productivity have been marginal.)

These kinds of things make a market ripe for speculation. This is from The UK Guardian.

But critics maintain that spikes in prices of global commodities are increasingly driven by speculators. They said the effects of a block on Russian exports by the Russian government were overplayed. Russia sends most of its wheat exports to Egypt, Syria and other middle eastern countries, which can access grain from other sources.

Reports that large amounts of India’s wheat stockpile could rot were premature, they said. Also, while India is the world’s second largest rice and wheat producer, it only exports a fraction of its output and would have little impact on global supply.

“Fears have been piqued that we may be heading back to the 2007-8 food crisis,” notes Sudakshina Unnikrishnan, an analysts at Barclays Capital. “In our view, market fundamentals are less compelling this time around with many of the key factors that propelled prices in that period missing.”

While India and Russia are expected to have very bad harvest, the EU and the US are expected to have abundant wheat. So, some of these price increases do not make sense in terms of traditional economics which leads us to speculators that like to create momentum and ride it to big profits.

So, what to do? When speculators in futures markets start destabilizing a market and introducing increased volatility and momentum that is likely to hurt the underlying market, the answer is limit the trade. New financial reform laws allow Congress to do that and they should consider it right now before we have a mess in the food markets the same way we’ve got a mess in the housing markets. Fortunately, the capital markets appear to have stabilized. This would not limit farmers who hedge for risk management purposes. It would limit big traders, like Cargill and most definitely hedge funds who are only in it for the kill. There are so many big players these days that I’m beginning to think that speculators do more than just ‘add liquidity’ to the market. They seem capable of creating and driving momentum which is not what we want happening in markets. Believe me, the world’s food supply is nothing you want to leave to adrenaline and testosterone. Volatility in prices may give a few of those guys a thrill, but for the rest of the world who worries about food on the table, that’s a deadly game.