Kris Douma. Mn Services: Food crisis and commodities: are investors to blame?

Pension fund addresses public concern after media coverage on agricultural commodities investing.

Commodity investment is under scrutiny. Many blame commodity derivative investors especially in agricultural products as the cause of the recent food crisis. These investors include financial institutions such as banks, pension funds or hedge funds who do not necessarily have direct business needs for commodities but invest in them nevertheless. These commodity investors are often labeled as ‘speculators’. In light of this issue, UNPRI published a comprehensive document of best practices in commodity investments for responsible investors. The best practices span across commodity-exposed assets: from derivatives and physical commodities to farmland. In addition, Mn Services conducted its own research to address public concern regarding commodity investment. We came across several facts and findings that are complimentary to the UNPRI publication. This article aims to improve the understanding of commodity investment especially in agricultural derivatives. The key question seems to be if the apparent correlation between spot prices and commodity derivatives can be explained by some sort of causal relation between developments on the commodity derivatives market and the spot market. The fact that there is correlation should not come as a surprise. After all, it is one of the reasons why investors entered the arena in the first place. The question should be what the potential causal relations are and in which directions the arrow points.Before we continue, it is worthwhile to explain what we refer to as ‘commodity investment’. In general, financial institutions invest in commodities in the form of derivatives investments. This means that they hold futures contracts which are based on the underlying physical commodities. Most of these contracts are settled/reversed before they expire, without any physical deliveries taking place. This article addresses this type of investment in particular, which corresponds to the ‘Investments in commodity derivatives’ section of the UNPRI best practices document. Originally, commodity derivative markets were set up to accommodate the need of producers/consumers to hedge their price risks. With derivative contracts, the price risk is transferred from the producers/consumers to the financial players, who are often referred to by the public as ‘speculators’. In this case, speculators act as liquidity providers. Financial institutions look for exposure to commodities because commodities are considered to have low correlations with other assets (therefore reducing the overall risk of the portfolio) and are hedged against inflation. Over the past few years, commodity investment by financial institutions has increased significantly. Barclays Capital noted that assets under management for this asset class reached USD375 billion in 2010. At the same time, commodity prices including agricultural prices, soared in 2008 and in early 2011.
This has triggered the accusation that speculation in commodity investment by financial institutions has led to the food crisis, marked by the significant increase in the prices of agricultural products such as wheat, corn, and rice. Since then, various articles have been written and academic research has been carried as to whether or not commodity investment has caused the food crisis. Many of these studies focus on the correlation between the futures prices from commodity derivative investment and the development of spot prices. The US Permanent Senate Committee on Investigations (2006) attributed the rise in commodity prices to the role of speculators (i.e. financial institutions, hedge funds and pension funds) because the change in demand and supply itself failed to justify the price increase. Wahl (2008) argued that the nature of passive index investment, which tends to be pro-cyclic, contributed to the food market price bubbles in 2003-2007. The research conducted by Greely and Currie from Goldman Sachs using new data (2008) estimated that speculators have contributed to USD 9.50/bbl increase on average during 2008 oil price ramp-up. It is important to understand that correlation does not necessarily imply causality. Two variables can move together and be perfectly correlated without having a causal relationship. Having established the portion of the oil price increase attributed to speculators, Greely and Currie continued by providing alternative explanations, in which speculators were responding to the price change of commodities (rather than driving them) or both prices and speculators were concurrently driven by new information in the market (2008, pp 16). In this scenario, speculators are not the cause of the rise in commodity prices but simply the effect.Part of the new evidence blaming speculators largely for rising commodity prices came from Kenneth Singleton (2011). Taking the oil market as an object of study he showed that index investors and managed money accounts were responsible for the rise and fall of the oil price in 2008. This is one of the few academic studies that presents the causality link between derivative investment and commodity prices using statistical techniques. However, his study was widely criticized by the IEA for failing to take fundamental factors into account in the models. On the opposite side, many researchers did not find statistical evidence of causality between the inflows of investment into commodity futures and the rise in commodity prices. Scott and Sanders (2010) found that the positions of index traders did not influence market returns on commodity futures markets (namely agricultural futures market); hence index traders did not cause the food price bubble. Moreover, they showed that the inflows of index fund investment were associated with the declining market volatility phenomenon. Based on Working’s speculative index, Sanders, Irwin and Merrin (2008) estimated that the presence of long-only index funds was actually beneficial to balance the short hedging activity. An empirical study conducted by the IMF (2006) even showed that the financial inflows into the commodity market were actually caused by the development of the spot market and not the other way around: recent development in commodity prices encouraged more speculators to gain more exposure towards commodities. Mn Services conducted research to test the causality relationship between commodity spot price developments and speculative activities, using weekly data from wheat and corn markets for the period from 1998 – mid 2011.
We defined speculative activities as the weekly changes in open interest of non-commercial investors (as a percentage of total open interest). Granger causality tests that we ran led to the conclusion that there was no evidence of causality running from speculative activities to corn and wheat prices. We then expanded the scope of the research and looked at fundamental factors as the possible drivers of wheat and corn prices. The factors taken into account were exchange rate, supply, production cost, consumption and stock-to-use ratio. The regression indicated that at least the changes in supply and production cost have immediate effect and were incorporated directly into prices. Faced with arguments from both sides, we agree that deeper analysis is needed to further reveal the causality relationship. On top of statistical analysis, we think it is also important to understand the mechanisms in which derivative investments may have direct influence on physical market especially in agricultural products.
One of the ways in which speculators could have direct influence on physical prices is by hoarding the physical commodities. Unfortunately, the extent to which hoarding activity is taking place in agriculture is quite difficult to measure. We could however look at the stock-to-use ratio as a measure of relative inventory level. On the corn market, the aggregate stock-to-use ratio has been declining since 2001, which does not suggest massive hoarding. However, we cannot conclude that hoarding does not happen solely on the base of this evidence. To find out, one would need to trace the ownerships of the agricultural warehouses and check the activities for indications of hoarding. The same low stock-to-use ratio applies to rice and wheat although for the latter the stock-to-use ratio seems to have improved recently.This relatively low level leaves only a limited buffer to respond to changes in demand and supply, which may have caused prices to fluctuate more. On top of that, the cost-of-carry relationship signals that in order for arbitrage opportunities to exist, the cost of carrying the inventories have to be low enough. In this case, arbitrageurs are bound by the storage costs and insurance costs of carrying the commodities. Then there is the question whether the surge in demand in commodity derivatives has to be accompanied by demand in the physical products. Rationally, it should. But remember that the value of futures contracts is aggregated from different maturities and most of these contracts are closed before they expire. Therefore, no physical delivery actually takes place. Of course it is possible for futures contract holders to receive physical delivery. If a large amount of participants suddenly demand the physical products, it will definitely cause disruption in the spot market. Financial parties that write commodity futures could potentially mitigate this risk by not taking positions on the physical market or not allowing asset managers to take physical delivery. In this case, investors (financial institutions) play an active role in preventing commodity products being stored by parties who do not have economic use for these products. Volatility is another element being used to draw the causality from the futures market to the spot market. Excessive speculative activities in the futures market could cause futures market to be very volatile. This highly volatile futures market may induce exchanges to post more margin requirements, which would mean higher hedging costs for the producers/consumers/trading houses. This costs might then be incorporated into the spot prices.
Although some researchers point out to the contrary (Scott and Sanders (2010); Irwin and Sanders (2010) showed that the inflows of index traders have not generated volatility), we realize that this is a plausible scenario that needs to be investigated. To overcome excessive speculation and maintain an orderly marketplace for the futures market, derivatives exchanges have implemented daily price limits (the highest a certain futures price could go up or down in a day). Recently, CFTC also passed order limits in 28 commodities to avoid markets becoming too concentrated: for commodities close to delivery date the positions are restricted to 25% of deliverable supply. In addition to that, UNPRI recommends financial institutions to limit the amount of investment in small illiquid markets to prevent dominant speculators driving the price formation in a certain futures market. The debate on the impact of commodity derivatives investment on food prices is far from ended. The fact that this issue concerns people’s basic needs (food products) will keep drivingopinion from both politicians, investors and academicians. Limitations in previous empirical research will also lead to further refined studies which might in turn reveal more information than is now available. In the meantime, certain situations exist in which financial institutions could have direct influence on the physical prices as explained in the previous paragraphs. In the context of commodity derivatives investment, UNPRI lays the responsibility mainly in the hand of regulators. However, they also consider investors to play an important role in addressing ESG issues. This can be achieved by incorporating best practices into the investment implementations. Financial institutions should also be prepared to further investigate the issue, with a particular focus on actual hoarding behavior in the physical market, either through commodity producers and traders or through financial institutions that write the futures. Until then they should take a precautionary approach and adhere to the UNPRI recommendations on responsible investment in commodities.
Kris Douma is Head of Responsible Investment and Marissa Maradona is an Investment Researcher at Mn Services.