I haven’t much time free today to write (travelling). Over the last several months I have been asked by many readers to explain how banks and hedge funds manipulate commodity prices to their advantage. This has been a recurring theme over the last several years and these activities were a principle reason why inflation rates increased in the period leading up to the crisis. Major international organisations like World Development Movement have associated these speculative forays with rising starvation. Their The Great Hunger Lottery report shows how such speculation on food has impacted on the poor around the world. Hunger and starvation escalated between 2007 and 2008 with over 1 billion people considered chronically malnourished at the time they prepared the Report. The major players in creating this havoc are Goldman Sachs, Bank of America, Citibank, Deutsche Bank, HSBC, Morgan Stanley and JP Morgan. In my view, this speculation creates no widespread good and should be declared illegal. We should ban financial speculation on food prices.
There is a branch of econometrics called intervention analysis. A famous article in the field – Box and Tiao (1975) ‘Intervention Analysis with Applications to Economic and Environmental Problems’, Journal of American Statistical Association, 70(1): 70-79 – defines the task of intervention analysis as:
Given a known intervention, is there evidence that change in the series of the kind expected actually occurred, and, if so, what can be said of the nature and magnitude of the change?
Intervention analysis has been used to study the impacts of traffic laws; decriminalization; gun control laws; air pollution control laws; changing political realignments; terrorist measures and much more.
It always follows a standard pattern – define a postulated event (for example, a change in law), define a reaction event, assess the impact (including testing for causality). It gets quite complicated in a time series setting but that is the nub of it.
So when I see a time series like this one – in the graph that follows – I am interested to know what happened to cause those two humps. The graph is of Australian retail sales – the red line is trend and the blue line is the seasonally adjusted series.
The two humps occurred in December 2008 and February/March 2009. What happened then? The two large fiscal stimulus packages were introduced by the federal government and were targetted to consumers and sharply tapered (for example, the December intervention was a cash handout).
More advanced study of that data would formally attribute (that is, find statistical significance) the jumps in the time series to the policy change.
This would substantiate a case that fiscal policy was effective in positively changing the level of economic activity at that time which go against the mainstream macroeconomics story that fiscal policy is largely ineffective and should give way to monetary policy. The crisis has taught us that the exact opposite to what the mainstream have argued for years is the case.
So what would we think when we saw a graph like this?
The graph shows the FAO Food Price Index (using their monthly time series data) from January 2000 to April 2011. Prior to 2000 the series was slowly increasing but without any large jumps.
So how do we explain that sort of jump?
I raised this issue because many readers have been writing in asking me about price manipulation in international commodity markets – which is aka how financial markets caused a jump in world starvation and death. Many readers are somewhat uncertain of the way that the financial markets achieved their ignominious feats in this regard.
It came up again in the last few days, when an Australia was one of the first ever charged by authorities for price manipulation of international commodity markets. In this case, it was the – US Commodity Futures Trading Commission – which began proceedings for “Price Manipulation in the Crude Oil Market” on May 24, 2011 against some companies and some individuals for violations of the Commodity Exchange Act. You can see all the details of the enforcement action – HERE.
The action alleges that:
… during the relevant period defendants traded futures and other contracts that were priced off of the price of West Texas Intermediate light sweet crude oil (WTI) … defendants conducted a manipulative cycle, driving the price of WTI to artificial highs and then back down, to make unlawful profits.
So how is it alleged that they did that?
The CFTC say that between January and March 2008 the “defendents” made profits exceeding $US50 million by:
First, they purchased large quantities of physical WTI crude oil during the relevant period, even though they did not have a commercial need for crude oil. They purchased the oil pursuant to their scheme to dominate and control the already tight supply at Cushing to manipulate the price of WTI upward and to profit from the corresponding increase in value of their WTI futures and options contracts (WTI Derivatives) on NYMEX and IntercontinentalExchange (ICE). Next, once WTI reached artificially high prices and they had taken profits from their long WTI Derivative position, defendants allegedly engaged in additional trading activity – selling more WTI Derivatives short at the artificially high prices. Finally, defendants allegedly strategically sold off their physical holdings of WTI, mostly all on one day, to drive the WTI price back down and to profit from their short WTI Derivatives position.
Cushing (Oklahoma) is a major crude oil delivery point.
It isn’t rocket science is it. These geniuses just get some cash together buy up big and create an artificial shortage. But before they do that they take out some forward contracts (their “long” positions) which allow them to profit from rising prices for assets they hold. Then they take out further contracts which were basically bets that the price would fall.
So in the same act of taking the profit from liquidating their long positions (made profitable by the shortage they had created) they also profitted from the short positions (the bets that the price would fall) they had taken. Why? Because in liquidating their extensive holdings of the physical commodity they caused the price to plummet.
That is why the CFTC called it “a manipulative cycle”.
For readers who are not sure of all this terminology here is a quick explanation.
A long position arises when you already hold an asset and profit is gained by selling the asset when the price rises.
Similarly, a long position in a futures contract or similar derivative means that the holder of the position will profit if the price of the futures contract or derivative goes up. Note that it is important to consider the value of the option, not the value of the underlying instrument, as the value of a put option will increase when the value of the underlying instrument decreases. This is in contrast to short selling.
A short position arises when you take out a forward contract to sell a commodity at a specified price (that is, to deliver the commodity as some specified future date at that price) but you currently do not own that commodity. You are thus speculating that the price will fall in the period prior to the delivery and so you can come in and buy at the lower spot price (the price in the market on any particular day) and pocket the difference.
Short selling may also involve borrowing a commodity (asset) and selling them at the current price (which drives the price down). The short seller then uses the proceeds of the original sale to buy back the commodity (at the lower price) and then is able to close the debt down (delivering the commodity) and pocketing the difference.
There are all sort of variations on the same theme.
So while it is alleged that these scammers were making huge daily profits, the rest of us were having to pay significantly more for petrol at the bowser and industry costs rose (causing a minor spike in inflation). The global financial crisis interrupted that price cycle.
But the same sort of behaviour is also rife in food commodity markets and then the consequences are lethal.
The following graph is taken from the individual food price indexes compiled by the FAO. I made the vertical scales on each row the same for the graph sequences (so row 1 has the same scale for Meat, Dairy and Cereals; and row 2 has a same scale for Oils and Sugar).
These indexes are sub-components of the overall index in the graph shown above.
You get another perspective of the price manipulation when you examine the monthly percentage change in prices for the overall Food Price Index as depicted in the next graph (from February 2000 to April 2011).
The rapid serial escalation in prices (starting around April to May 2007 and finishing in February 2008) followed by a serial plunge in prices is a classic sign that commodity price manipulation is occurring.
Some might argue that these movements just occurred because of the famous agricultural hog cycle which economists explain using the cobweb model. It is easy to understand and basically is a series of supply lags and overshoots in response to demand changes which drive prices in a cycle.
But while rice when up around 206 per cent between May 2007 and May 2008 – see FAO Rice Price Monitor – while the rice production was still fairly robust – there was not a farm shortage that is.
So the standard explanations from economists regarding the cobweb cycle do not hold. Instead it was the actions of the banks and hedge funds that were behind the price hikes.
There is evidence emerging that when the housing market collapsed in the US (early 2007), the speculators (our trusty banks etc) started to move their focus into primary commodities like food.
This Report – Commodity Speculation and the Food Crisis – prepared for the World Development Movement by Indian economist Jayati Ghosh is very interesting reading.
She says that:
It is now quite widely acknowledged that financial speculation was the major factor behind the sharp price rise of many primary commodities, including agricultural items over the past year … there is no evidence that actual volumes of commodity transactions mirrored these price movements.
This is supported if you follow the FAO Global Food Monitor on a regular basis.
The OECD have argued the contrary position (as you would expect) emphasising that the price jumps were about “fundamentals” or as Ghosh termed it “real if temporary changes in demand and supply, such as sudden supply shocks in particular areas, as well as the associated impact on panic buying or bans on selling such as export bans in the world trade market”.
In a consulting paper they released April 2010 Report – The Impact of Index and Swap Funds on Commodity Futures Markets – you will see a pale defence of the proposition that speculators did not cause any problems in food markets. You can also see the Annexe – Speculation and Financial Fund Activity – to this document which explains the econometrics used. There are serious problems with the modelling but that would take me to long today to explain.
The data does not suggest sudden physical shortages occurred other than those artificially created by hedge funds. At the time this was happening I was in the US and told (by those who know) that a growth industry in Texas was physical storage capacity.
The US Senate Committee on Homeland Security and Governmental Affairs held a hearing – Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation? in May 2008 which provided a wealth of evidence to support the view that speculation had manipulated the commodity price cycle.
The evidence from financial market insider Mike Masters is very telling.
The mainstream argue that speculation actually smooths out prices and reduced volatility. This works because, allegedly, speculators buy low and sell high which means that commodity volumes shift in a way that reduces price variability. Speculation in futures markets also is meant to to work in this way.
This UK Guardian article (January 23, 2011) – Food speculation: ‘People die from hunger while banks make a killing on food – interviewed Masters and quoted him as saying:
When you looked at the flows there was strong evidence. I know a lot of traders and they confirmed what was happening. Most of the business is now speculation – I would say 70-80% … Let’s say news comes about bad crops and rain somewhere. Normally the price would rise about $1 [a bushel]. [But] when you have a 70-80% speculative market it goes up $2-3 to account for the extra costs. It adds to the volatility. It will end badly as all Wall Street fads do. It’s going to blow up.
In the following blogs – Operational design arising from modern monetary theory and Asset bubbles and the conduct of banks – I mooted some ideas that should be applied to banking reform.
Those reforms would outlaw any speculative behaviour in food markets.
I have run out of time today and have to catch a flight home.
So … that is enough for today!
The Saturday Quiz will be back tomorrow sometime.