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October 5, 2011

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October 5, 2011

Food and Finance: a little less speculation, a little more action please…

October 5, 2011
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Some good sense on a polarised topic from Ruth Kelly, Oxfam economic policy adviser and co-author of a new paper on Ruth kellyspeculation and food prices.

When they work properly, financial markets are great at greasing the cogs of the food system. Why, then, are so many people blaming speculation for recent food price spikes?
First here’s how markets ought to work. People all along the food supply chain use them to hedge their risk. At the moment food prices are exceptionally high and rising and, as they rise, they are shooting up and down in a completely unpredictable way. So for a premium, speculators guarantee a future price for those buying and selling food, taking a gamble that prices on the market will be higher than the price they have guaranteed so they can pocket the premium without having to cough up – if things go the other way, the speculators may lose but they are big enough to take that risk.
There are other benefits. Since there is very little public information about physical markets in agricultural commodities, buyers and sellers of food rely on financial markets to help them determine the right price. Each speculator comes with a little bit of information that they share by buying and selling, bringing the price of agricultural derivatives very close to the price producers should be charging for food.
Better still, financial markets allow agricultural assets to be turned into cash quickly and easily. This is crucial in a market where assets FAO prices oct 11can only be sold in bulk at harvest, leaving participants with major cash flow problems. Having a bunch of savvy speculators monitoring market dynamics and in response, buying or selling agricultural derivatives, brings liquidity, moving money around while the crops are still in the ground to help the market work more efficiently.
That’s why financial markets are great when they work. But right now, they’re broken: the deals that are being done have lost their grip on the reality of food production and distribution. Even analysts who think that there is no link between speculation and food price volatility admit that the way the markets are working at the moment is making people very nervous. And nerves breed panic and panic inflates bubbles and bubbles eventually burst.
First, socially useless speculation, where agricultural derivatives are bought and sold irrespective of the price, with other speculators following like sheep, can lead to a situation where everyone is buying and no-one is selling and prices keep on spiralling upwards. Instead of bringing liquidity to the market, this type of speculation sucks it out.
Add this to the growing presence of investors with so much money that they can single-handedly move prices independently of supply and demand, at least in the short term. When such speculators pile in on one side of the market with little regard for price, those relying on financial markets to give them the right price may as well be plucking prices out of the air.
And as prices of commodity derivatives shoot out of control and become increasingly volatile, it becomes more and more expensive to hedge risk. Those who rely on financial markets to guarantee prices for their physical crops must pay higher and higher premiums for the privilege. These days, only very large businesses can afford to hedge their risk, leaving smaller producers and traders, who are already more exposed to risk than big agribusiness, without protection. And the increased costs are passed on to consumers.
Expert opinion is evenly divided on another key accusation – whether speculation contributes to volatile food prices. Different researchers make the same data say different things, depending on their underlying assumptions and methodologies. And in any case, the data is full of holes. Nonetheless, the fact that there is so much debate means that there is at least a strong case to answer. Because the risks of letting current practices continue, if the critics are right and they are indeed exacerbating food price volatility, are much higher than the risks of acting to make financial markets more transparent and efficient, a precautionary approach should be taken to regulating socially useless speculation.
inflation and speculationThe first step is to get a better idea about what is actually going on. Publishing comprehensive data will help prevent panic and herding, and allow a better assessment of whether there is a link between speculation and food price volatility. But transparency is not enough. The second step is to regulate markets by limiting certain types and volumes of speculation, to try to prevent huge amounts of money spent by very big players from skewing prices and causing panic. The risks of doing nothing far outweigh the risks of regulating.
Decisions are already being made at the G20, in the EU and in the US. Those with a vested interest in continued volatility are lobbying hard. Those hit the hardest by volatility – small-scale producers whose livelihoods depend on receiving reliable prices for their produce, consumers in the poorest countries who spend up to 75 percent of their income on food – have a much weaker voice. That is why it is so important to listen and to take action over the next few months and beyond. The right reforms will go a long way to making financial markets work for the people who contribute to feeding everyone on our planet.


  1. I find this a difficult subject – you are no doubt right, but when you write in your paper:

    “Take the case of a medium-scale farmer in S Africa who plants a crop of corn in late 2011. This farmer doesn’t know what will happen to prices between late 2011 and early 2012, when the corn will be ready to harvest. If prices remain stable, she will be able to make a small profit, but if they go down, she will lose the money she has invested in seeds, fertiliser, irrigation, storage, etc. To protect herself, she goes to her financial broker to buy a „put option‟ which gives her the option, but not the obligation, to sell at 2011 prices in 2012, in return for a fixed premium. However, if prices are too unstable and the premium is too high, she may not have the cash up front, or it may be too expensive for it to be worthwhile to protect herself against the risk of falling prices.”

    Why does she need to speculate? Cannot the farmer enter instead a forward contract, which is not traded by speculators? The farmer agrees a price with the buyer, which in present times would be attractive. Then she can rest easy, knowing exactly what she will get, and can concentrate on good agronomy etc. to make sure she delivers, maybe with some insurance in case of a crop loss?

    Futures in general are surely a good thing because they send a signal from the future (e.g. ‘food supply could be tight’) and helps the farmer respond by applying more inputs thus helping to solve the problem.

  2. You are right to say that farmers can buy forward contracts rather than hedge risk using derivatives (which can include forwards, options, etc.) and so the example in the paper was a simplification. But forward contracts are increasingly unavailable. Most of the research about how food producers engage with agricultural derivative markets has been done in the US, and this paper is a good reference:
    More or less, the argument the paper makes is as follows. Traditionally, US farmers have been able to buy ‘forward’ contracts from a local grain storage facility, or ‘elevator’ to lock in a price for future delivery. They can purchase insurance to be able to pay a penalty if their crops fail. The grain elevator goes to a financial broker to buy a ‘future’, i.e. one type of agricultural derivative, which allows them to sell at, e.g. 2011 prices in 2012. As prices of agricultural derivatives rise and fall they have to pay ‘margin calls’ to maintain the right to sell at 2011 prices – sometimes they make money and sometimes they lose money on these margin calls. However, as agricultural derivatives prices became more volatile in 2007-8, these margin calls become more and more expensive; a typical grain elevator in Nebraska, for example, could be faced with a $3–5 million margin call each day when the futures market makes limit moves higher. In response, the price that grain elevators in the US were able to guarantee to farmers shot down. In March 2008, many grain elevators simply stopped offering forward contracts. If the price guaranteed by the forward contract fails to cover farmers’ costs, or if they are unable to purchase forward contracts, farmers could in theory deal directly with agricultural derivatives markets. However, the challenges that grain storage facilities face with regard to the increasing cost of margin calls (or other down payments for different types of derivatives) can be even more serious for medium-scale farmers, who would have much bigger cash flow problems than a large grain elevator and would be much more exposed to risk if she lost money. The amount of money they would have to put up front, depending on the size of their crops, could be about $ 40,000. Farmers with larger operations, more working capital, and more familiarity with the futures market will likely find agricultural derivatives hedging to be a reasonable alternative to forward contracting. Other farmers, unable to access agricultural derivatives markets, may remain completely exposed to price risk.

    We agree that futures in general are a good thing helping, as you say, with price discovery. Unfortunately, it looks like markets are no longer playing this very useful function – which is why we need regulation.

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