The real reason for spikes in food prices

By Yaneer Bar-Yam and Greg Lindsay
October 25, 2012

Spikes in grain prices are regularly blamed on oil shocks, droughts and emerging markets’ hunger for meat. The real culprit in the three bubbles-and-busts of the last five years, however, isn’t the weather. It’s financial speculation.

The Midwest drought this summer, the worst in a half-century, produced a bumper crop of profits for derivatives traders like Chris Mahoney, the director of agricultural products for Glencore, the world’s largest commodities trading firm. Mahoney noted during one August conference call that tight grain supplies and the resulting arbitrage opportunities “should be good for Glencore.”

They’ve been a disaster, however, for the world’s poor.

More than 40 percent of grain futures can now be traced to financial institutions, which nearly doubled their commodity bets over the last five years — from $65 billion to $126 billion.

During that time, food prices have bubbled and burst twice — leaving millions of people to go hungry and stoking global unrest — before climbing to new heights this summer. Corn prices soared 65 percent between June and July alone, the same month the World Bank’s food price index recorded its highest rise ever, breaking the previous record set in February 2011.

What’s fueling this stunning price fluctuation is financial speculation. Our research team at the New England Complex Systems Institute built mathematical models to test possible explanations for the price spikes of 2007-2008 and 2010-2011 — including all the above, in addition to the rise of ethanol production. We could replicate a rise in prices but couldn’t explain the bubbles and crashes. When we added speculation, the model fit precisely.

When it comes to food, our faith in markets is contingent on their ability to match supply and demand at prices that benefit farmers, while ensuring the greatest number of people can afford to eat. Speculation in grain futures knocks these prices out of equilibrium. During past bubbles, for example, bountiful harvests piled up in silos because grain was too expensive for consumers to buy. This grain accumulation eventually bursts the bubbles after a year or more – the time elapsed between harvests.

While Americans will likely only feel a pinch of drought-fueled speculation this year – the Department of Agriculture projects a 3 percent-4 percent rise in food prices next year – the situation is more dire in the developing world. Those living on less than a dollar per day already spend most of their income on food.

The price bubble of 2007-2008 led to food riots in more than 30 countries, including Mexico’s “tortilla riots” and the overthrow of Haiti’s government, before prices peaked again in February 2011, during the Arab Spring.

The current bubble is behind the fresh protests in Haiti, where food prices have gone up 40 percent since the election of President Michel Martelly last year. In eastern India, mobs robbed government granaries.

Hunger and revolutions have always gone hand-in-hand, of course — the latter is what happens when you let them eat cake but the people have no bread. But at which point do prices pass the point of no return?

Our research has found that food riots are most likely to occur when the Food Price Index, compiled by the United Nations Food and Agriculture Organization, rises above 210.  It’s currently 216.

Recognizing the dangers of food speculation, six European banks – including Commerzbank, Germany’s second largest – this summer removed agricultural products from their commodity funds altogether. Wall Street, however,  has not been so accommodating.

Last month a federal judge vacated tough new rules designed to rein in commodity speculation that would have taken effect Oct. 12. The rules would have closed loopholes and instituted new position limits that would cap the number of derivative contracts a commodities trader could hold, in the hopes this would dampen volatility and prices.

But Judge Robert L. Wilkins channeled Wall Street’s objections when he questioned whether these rules were appropriate or necessary. In his decision he quoted Michael V. Dunn, a former commissioner of the Commodity Futures Trading Commission, who had doubted whether “excessive speculation is affecting the market.” Dunn once declared, “at best position limits are a cure for a disease that does not exist, or at worst it’s a placebo for one that does.”

CFTC Chairman Gary Gensler has vowed to push ahead with the rule – including the possibility of appealing. Commissioner Bart Chilton meanwhile has proposed drafting an “interim final rule” that would appease Wilkins’ objections and could be instituted quickly. “Position limits are simply too important,” Chilton said earlier this month in a speech at the U.N. Food and Agriculture Organization headquarters in Rome.

They are. But if the rule that’s eventually passed is to be more than the placebo Dunn fears, it will be necessary to close the loopholes added to the bill to appease derivatives traders – who instead sued to have it overturned.

The proof will be in seeing if speculation actually decreases. Current volumes are three to five times higher than what’s necessary for the smooth functioning of the markets, according to our research. At a time when the U.S. corn harvest is expected to be less than annual consumption, we can’t afford to gamble with our food.

PHOTO: Corn fields in Lexington, Kentucky. REUTERS/John Sommers II


2 comments

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Speculation is driven by issues ranging for economic stability to weather to the basic value of the dollar. Speculation is not the driving force on cost. Speculation is the result of instability in both the production of the product and market forces. The degree of speculation depends on these fundamental influences. While it feels good to blame speculators for our problems they are hardly the root cause.

Posted by Willie12345 | Report as abusive

Thanks Willie, I was wondering how speculators could support speculating on food. Speculating isn’t the result of anything that’s happened yet, that’s why it’s called speculating and not reflecting. The root cause of speculating is a realization that there is money to be made by investment firms. There is no realized shortage of food and as such, there should be no fluctuations in price.

Posted by dbauer2000 | Report as abusive