Data gap remains in commodity speculation row

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06 October 2011

Two conflicting reports released last month have exposed the gap in data on the impact of futures trading on the agricultural commodities spot markets as a study by IOSCO recommends position limits and increased transparency in global commodity markets.

Speculation in the agricultural commodities has been forced into the spotlight over the past five years after markets experienced high volatility and price rises. Food prices alone have risen by almost 40% this year to July, according to the UN Food and Agriculture Organisation.

The price rises are devastating for the world’s poorest, where in some cases, basic food purchases account for up to 60% of total income. A study by the World Bank found that in the last six months of 2010, 44m people were pushed into extreme poverty by rising prices.

Whether speculation is at the root of these price rises is the subject of heated debate. The debate centres on proving the causality between increased speculation and food price rises.

Two reports released last month, entitled Broken Markets: How financial market regulation can help prevent another global food crisis and The impact of speculative trading in commodity markets – a review of the evidence, were commissioned by the World Development Movement and the Futures and Options Association respectively.

The WDM report pulled no punches. Financial speculators dominate the market accounting for 60% of all holdings in the agricultural commodity markets, compared to 12% 15 years ago, the report said.

The result of this speculation has “broken the market”, leading to prices being driven “no longer by supply and demand for food, but by the sentiments of financial speculators and the performance of their other investments”.

It adds that the financialisation of the commodity markets has created inflationary pressure, increased herding and price volatility and caused the prices of unrelated commodities to move together.

The report also points to increased correlation between commodity prices that has increased with the influx of speculators into the market and basket funds that track price movements of commodities.

“Empirical research into price trends across a range of commodities found that prices of non-energy commodities, such as agricultural commodities, became increasingly correlated with oil during the mid-2000s in parallel with the huge growth in financial speculation in commodity index funds,” the report claimed.

However, while the report is strong in pointing out correlations between increased in speculation and price rises, it fails to under pin the correlations with proof of cause and effect. Its assertion that long only commodity indexes necessarily leads to price inflation fails to recognise that on every trade there is a counterparty that takes the opposite view.

The second report, which was compiled by FTI and analysed 20 white papers, found no empirical proof of a link between increased speculation and price rises. While it acknowledged the correlations found in the WDM report, it said that many analysts confuse correlation with causation.

“It has been observed that ice cream sales and the rate of drowning deaths are strongly correlated. However, this does not imply that ice cream causes drowning, rather, warm temperatures are the underlying cause of both,” the report said.

The report concludes that fundamentals are the key driver of both the spot and futures markets and, by reason of their close linkage, current supply and demand conditions as well as expectations of future supply and demand conditions determine prices.

The two reports came as the International Organisation of Securities Commissions recommended that commodity markets be subject to position limits and increased transparency in order to prevent market abuse.

Masamichi Kono, the chairman of IOSCO’s Technical Committee, said: “The Principles set out...help to ensure that the physical commodity derivatives markets serve their fundamental price discovery and hedging functions, while operating free from manipulation and abusive trading schemes.”

The leaked draft of the Markets in Financial Instruments Regulation also pointed to the introduction of position limits by competent authorities under the supervision of the new European regulator Esma (see page 12).

At the same time, the CFTC is currently finalising rules that are expected to impose position limits on commodity speculation. However, there remain concerns over the implementation of such rules. In particular how to manage position limits over longer term contracts and how position limits will be enforced across various divisions and subsidiary companies of organisations.

Detractors of position limits in commodity trading claim that they will suck liquidity from the market and hand a competitive advantage to exchanges outside the US and the Eurozone.

The impact of speculation on the commodity markets is unlikely to be proved until a more extensive data set is available to analysts. However, that is unlikely to halt the regulatory bandwagon as it runs towards increased transparency and tightened position management.

Highlights from the October issue of FOW:

News

News analysis: Data gap remains in commodity speculation row