May 25, 2008

Is Institutional Speculation Driving Up Food Prices?

Michael W. Masters testifies before the Senate on speculation in the commodity markets.Last week, Michael W. Masters testified before the Senate Committee on Homeland Security and Governmental Affairs on the effects of institutional speculation on commodity markets.

You have asked the question “Are Institutional Investors contributing to food and energy price inflation?” And my unequivocal answer is “YES.”

These institutional investors, which he calls index speculators, include corporate and government pension funds, sovereign wealth funds, university endowments and other institutional investors. Over the last five years these index speculators have poured large sums of money into the commodity markets, increasing demand and pushing prices higher.

Today, Index Speculators are pouring billions of dollars into the commodities futures markets, speculating that commodity prices will increase. Chart One shows Assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March 2008, and the prices of the 25 commodities that compose these indices have risen by an average of 183% in those five years!

And the problem with this sort of trading is that it because this is long term investing, it essentially removes large stockpiles of the commoddities being invested in.

Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell.

And this is effecting the food supply by removing large quantities of key commodity from the market.

Let’s turn our attention to food prices, which have skyrocketed in the last six months. When asked to explain this dramatic increase, economists’ replies typically focus on the diversion of a significant portion of the U.S. corn crop to ethanol production. What they overlook is the fact that Institutional Investors have purchased over 2 billion bushels of corn futures in the last five years. Right now, Index Speculators have stockpiled enough corn futures to potentially fuel the entire United States ethanol industry at full capacity for a year. That’s equivalent to producing 5.3 billion gallons of ethanol, which would make America the world’s largest ethanol producer.

Turning to Wheat, in 2007 Americans consumed 2.22 bushels of Wheat per capita. At 1.3 billion bushels, the current Wheat futures stockpile of Index Speculators is enough to supply every American citizen with all the bread, pasta and baked goods they can eat for the next two years!

And this speculation has also had an effect on the price of oil and ultimately the price we pay at the pumps for gasoline.

In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculators' demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

Source : Testimony of Michael W. Masters (PDF)

This goes a long way to explaining some questions that I have had about the current food price situation. Looking at and comparing recent crop production numbers of not only corn but other crops as well indicated to me that supply is not the issue. So that only leaves demand as the driver of food price inflation and honestly it is hard to see how demand could have increased at such a pace without some form of artificial demand being created.

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