Last month an article was published on www.foreignpolicy.com (http://www.foreignpolicy.com/articles/2011/04/27/how_goldman_sachs_created_the_food_crisis?page=full) , written by Frederick Kaufman explaining how speculators on Wall St are responsible for current rise in food prices. I pointed some flaws in that article but wasn’t able to explain my point due to lack of time and space allowed on facebook comments section (A friend of mine shared that article on his page). Although a simple question that can refute the idea that Wall St is responsible for current rise in food prices is “Although speculation has been going on for decades (CBOT was established in 1848) then why current rise in food prices coincides with expected inflation due to zero bound interest rate and a devalued dollar?”
Just to make it clear, Mr Fredrick is not against speculation. He contends that the fact that Wall St is profiting from futures markets is what makes our food more expensive. He argues that if only companies taking real deliveries were trading in futures market then prices will be lower than what we see currently when there are several speculators speculating in futures market with no intention to get deliveries. I’ll explain in this note that although they are making profits, it is not increasing the cost of food for us. I will prove that prices of food would be the same regardless of Wall St making these profits or not. We’ll see that if Wall St doesn’t make this profit then the very companies taking these deliveries will drive these prices to the current level. Also Wall St has been profiting from these markets for a very long time as opposed to 1999 as Mr Fredrick mentioned in his article. So, let’s see how speculation works.
To begin with let’s start with a world where there is no speculation. I’ll use corn as an example, which is widely traded in different commodity exchanges, in the US. You can replace corn with virtually any commodity traded in commodity exchanges and you'll have the same result and that includes oil which is not harvested and instead drilled. Let’s say there was a harvest on May 1st and on that day we have following demand for corn
People like you and me who want to eat corn,
Hog bars who want to feed their hogs
Companies like Kellog for their corn flakes and lot of other cereals
Other companies who take corn deliveries for their products (for example manufacturers of high fructose corn syrup)
Archer Daniel Midland who wants to convert corn into ethanol
Alcohol producers like Miller who distill corn and make drinking alcohol
All these people want to buy corn today. Let's suppose that nobody thought of future and all of this corn is sold today for $1 per bushel of corn. In the absence of futures market all this corn will be sold in spot market for a price based on demand and supply on that day (May 1st in our case).
Now assume some future date, let’s say August 5th where corn will be required but not available until next harvesting season. Since it’s future, the market for August 5th 2011 does not exist, except in our minds. On August 5th, just like May 1st there will be some demand for corn. It would be again by people like you and me and companies who use corn in their products as mentioned above. If you think that companies would have bought for the whole year then you should add storage cost to your calculations, because as we’ll see below, Wall St benefits in futures markets through storage costs only. That is the only opportunity to make money.
Now assume that someone accidentally dropped a bushel of corn on May 1st during the delivery. How much could you sell that bushel for now on August 5th when there is no corn?
Without putting a number, we know it’s going to be very high. Assume either Kellog or Miller or ADM will bid up the price to $10. That’s a reasonable assumption given there is only one bushel against such a high demand.
Now go back to May 1st and think like a businessman (a "Greedy Capitalist Pig", a “Memon”, what ever you want to call it). What can you do on May 1st to profit on August 5th 2011.
You can store some of that corn and not sell it and then sell it in August when there is no harvest but demand is still there. In this case you can decide to not sell for $1 today on May 1st and instead store it and then sell it in August for $10 and make an extra $9 profit (I'll come to the storage cost in a minute and yes it will be considered).
What you just did is called Speculation and people who do this are called speculators. They don't buy corn to consume it, instead they buy it to make a buck because this speculator thinks that he can make a profit by selling it in future when there will be some demand but no supply. Now remember that this guy is taking a risk when doing this speculation. In the real world the demand on the day of the delivery may not be what he is estimating it is. There is certain cost when getting into speculation. For example
Now assume that the whole world is stupid to not think of future (remember hearing as a kid that we'll run out of oil...) and now we have seen that if the whole world is stupid enough to not think about future, we can profit of their stupidity. All we have to do is store some of that corn and sell it in future when there is no corn. So we buy that corn today for $1, store it (assume zero storage cost for simplicity) and sell it for $10, 4 or months later.
Your actions will have an impact on prices today. Since you and several other speculators start buying corns not in order to consume but to store and make profit by selling it later, you are a new type of buyer beside all those consumers in our example above and you'll increase today's demand thereby driving prices up in spot market today.
So basically potential for profit drew new type of buyers, driving up the prices in our spot market, let's say $3 per bushel. Some of the consumers who were able to buy corn earlier at $1 will not be able to afford this corn anymore at $3 and will be out of the market.
So, speculators enter the market to make a potential buck, driving up prices in spot market and reducing our ability to consume corn today. But guess what else happens??
Now all these speculators supplying corn in August, we don't run out of corn in August because all these speculators are willing to supply that corn to us in August. Guess what will happen to prices of corn in August now. It is NOT going to be $10 a bushel anymore because there are several million bushels available now as opposed to that one bushel that someone accidentally dropped. All this happened because there was a potential to make a buck and some "greedy capitalist" or "memon" decided to profit from this situation.
So where does this speculation stop. Before you read further, think where the process will stop. At what point do speculators say, anymore speculation and we lose. Take a minute and think.
The process stops when spot market price + storage cost equals expected price in futures market. Now it doesn't matter if speculators exchange goods or not. It doesn't matter if buyers in futures market include Archer Daniel Midland, Miller, or anyone who is not even interested in the product. Whether you take deliveries or not, storage cost is going to be the same for everyone. If you are ever lucky enough to see a difference between "spot market price + storage cost" and "futures market price" (and trust me you won't) but if you do, then sell your car, your house, your first born and do this. Buy from spot market and sell it in futures market. Because there is no risk of loss. By the way, there are people who do this and they are called Arbitragers.
So future price will always equal current price + storage costs + other transaction costs and whether it's Kellog or a Greedy Capitalist Pig on Wall St, they all have to incur this cost. So whether one takes delivery or not, price is going to be the same. And therefore presence of these speculators makes absolutely no difference except this profit is going to someone other than these companies.
Let me give you another example that should be revealing. Let's say you live on a desert island. A boat arrives on this island delivers a month of food supply that you store in some cave. You consume at a rate roughly that will allow you to be able to have food until the end of the month. What happens if you heard on a weather radio that there is a hurricane coming which will close your supply boat which wont be able to deliver your food on time (Let's a 2 week delay). How would you react to this? I'll guess you'll start eating less. Speculators perform a similar service. They get you and me to slow down the rate of consumption today, so we can have food for tomorrow. They do that by driving current prices up. So you go to the grocery to find higher than expected prices and go "must me those damn speculators". They are doing exactly what you would do on a desert island.
So, if speculators don’t drive current prices up, then the companies taking deliveries will have to incur storage costs and we’ll end up with precisely same prices. Except this time Mr Fredrick will lament “big corporations” than Wall St.
*******************************
If you find reading this interesting so far then feel free to read some more interesting details below, otherwise I believe I have proved my point.
*******************************
Notice few interesting things that have happened due to this speculation
We don't run out of corn in August.
We have reallocated the corn from today when its relatively plentiful, to future when its relatively scarce.
We have moved the corn from a time period where it has less value to a time period where it has more value and in doing that speculators have actually increased the value of stock of corn. We have maximized the value of stock of corn. Corn was not as much valuable. But speculators have increased its value (from $1 to $3 in our case).
So speculators in their motive of making profit have performed some interesting functions (described above). They have also given farmers an incentive to grow more corn. If farmers were getting $3 a bushel as opposed to $1 a bushel, they'll produce more corn next year which will drive prices below $3 given same demand.
Speculation plays fairly an important role in a capitalist system. It serves so many purpose that a special market, called futures market has been created for this purpose. Now what is the motivation to create this market? Let's see what happens in our case of corn. A bushel of corn weighs about 42 lbs. A speculator first has to buy a bushel of corn, find a place to store it and then haul it to that storage location. He will have to store, dry it periodically so it doesn't deteriorate and then take it out of the storage and find a buyer and deliver it. It's a pain in the butt. That's what it is. Now that is only if you want to speculate on one bushel. But if you want to speculate on any sizable quantities of corn, then you'll need a fleet of trucks and drivers and these transaction costs are going to be very high.
Futures market is just the right market to reduce all these transaction costs. It makes it easier for people to speculate.
We have a spot market where corn is sold and corn exists. Then we have a futures market where corn doesn't exists except in our brain. But corn is not being sold in these futures markets. What is being sold here is a piece of paper called a futures contract. In a futures contract for corn there will be a future specified promise of delivery and grade of corn. For example a contract for 1 bushel of corn to be delivered on August 5th 2011 for $5. This price that we agreed today is called August corn futures price and you'll pay it when I deliver that corn on August 5th. Now, I have just sold a futures contract and you have just bought a futures contract. Now the question is why would we engage in such a transaction?? The reason is that I believe that price of corn on August 5th is going to be less than $5 (I am taking a position called "short") and you believe that the price of corn is going to be greater than $5 (you are taking a position called "long"). Let's assume that price of corn in the spot market on August 5th is $6 (you were right and I was wrong), then all I have to do is buy corn at $6 right there from the spot market and deliver it to you. Chances are you don't care about the corn either. Both of us will mutually agree that I pay you the difference which is $1 and clear the contract. No deliveries, nothing. We just cleared our contract as Mr Fredrick said and one guy on Wall St also made a buck. Although it caused the prices to increase in spot market on May 1st, it did reduce the price on August 5th. In reality this future and this spot is everyday and if anything, this speculation serves an important purpose and prevents prices from a seesaw effect. That's why futures trading is a pure gamble. Although we can estimate but no one knows the real spot price in future. For example, people who were trading oil futures before Middle East crises, probably did not expected a low supply due to current Libyan crises. So those who sold contracts before middle east crises, probably end up losing a lot of money. So Wall St is losing money too. Notice how prices are affected by real supply and demand shocks rather than you and I betting in futures market. Similarly current food prices are a result of expected inflation and a devalued dollar. If you have not checked recently, then check the price of gold. It's over $1500 an ounce and all because of expected low value of dollar rather than bunch of traders on a trading floor.
In reality a contract for corn would require a minimum of 5000 bushels. Anybody can buy and sell these and you don't have to own corn to sell a futures contract. All you have to do is deliver it on the promised day. There are clearing houses and markets make sure everyone complies. One such market is CBOT (Chicago Board of Trade).
Just to make it clear, Mr Fredrick is not against speculation. He contends that the fact that Wall St is profiting from futures markets is what makes our food more expensive. He argues that if only companies taking real deliveries were trading in futures market then prices will be lower than what we see currently when there are several speculators speculating in futures market with no intention to get deliveries. I’ll explain in this note that although they are making profits, it is not increasing the cost of food for us. I will prove that prices of food would be the same regardless of Wall St making these profits or not. We’ll see that if Wall St doesn’t make this profit then the very companies taking these deliveries will drive these prices to the current level. Also Wall St has been profiting from these markets for a very long time as opposed to 1999 as Mr Fredrick mentioned in his article. So, let’s see how speculation works.
To begin with let’s start with a world where there is no speculation. I’ll use corn as an example, which is widely traded in different commodity exchanges, in the US. You can replace corn with virtually any commodity traded in commodity exchanges and you'll have the same result and that includes oil which is not harvested and instead drilled. Let’s say there was a harvest on May 1st and on that day we have following demand for corn
People like you and me who want to eat corn,
Hog bars who want to feed their hogs
Companies like Kellog for their corn flakes and lot of other cereals
Other companies who take corn deliveries for their products (for example manufacturers of high fructose corn syrup)
Archer Daniel Midland who wants to convert corn into ethanol
Alcohol producers like Miller who distill corn and make drinking alcohol
All these people want to buy corn today. Let's suppose that nobody thought of future and all of this corn is sold today for $1 per bushel of corn. In the absence of futures market all this corn will be sold in spot market for a price based on demand and supply on that day (May 1st in our case).
Now assume some future date, let’s say August 5th where corn will be required but not available until next harvesting season. Since it’s future, the market for August 5th 2011 does not exist, except in our minds. On August 5th, just like May 1st there will be some demand for corn. It would be again by people like you and me and companies who use corn in their products as mentioned above. If you think that companies would have bought for the whole year then you should add storage cost to your calculations, because as we’ll see below, Wall St benefits in futures markets through storage costs only. That is the only opportunity to make money.
Now assume that someone accidentally dropped a bushel of corn on May 1st during the delivery. How much could you sell that bushel for now on August 5th when there is no corn?
Without putting a number, we know it’s going to be very high. Assume either Kellog or Miller or ADM will bid up the price to $10. That’s a reasonable assumption given there is only one bushel against such a high demand.
Now go back to May 1st and think like a businessman (a "Greedy Capitalist Pig", a “Memon”, what ever you want to call it). What can you do on May 1st to profit on August 5th 2011.
You can store some of that corn and not sell it and then sell it in August when there is no harvest but demand is still there. In this case you can decide to not sell for $1 today on May 1st and instead store it and then sell it in August for $10 and make an extra $9 profit (I'll come to the storage cost in a minute and yes it will be considered).
What you just did is called Speculation and people who do this are called speculators. They don't buy corn to consume it, instead they buy it to make a buck because this speculator thinks that he can make a profit by selling it in future when there will be some demand but no supply. Now remember that this guy is taking a risk when doing this speculation. In the real world the demand on the day of the delivery may not be what he is estimating it is. There is certain cost when getting into speculation. For example
- When I buy this corn today and intend to store and sell it in August, then I'll be incurring storage cost.
- There are transaction costs that I have to incur as a speculator. I have to spend time to find sellers today and then go out and find buyers in August.
- While I store the corn and not sell it right away, I forgo the interest my dollar could earn. By storing corn, my dollar is tied up in this corn and I am unable to make interest on that dollar.
- I may spend money insuring the corn against natural disasters like tornadoes or floods so I have insurance cost.
Now assume that the whole world is stupid to not think of future (remember hearing as a kid that we'll run out of oil...) and now we have seen that if the whole world is stupid enough to not think about future, we can profit of their stupidity. All we have to do is store some of that corn and sell it in future when there is no corn. So we buy that corn today for $1, store it (assume zero storage cost for simplicity) and sell it for $10, 4 or months later.
Your actions will have an impact on prices today. Since you and several other speculators start buying corns not in order to consume but to store and make profit by selling it later, you are a new type of buyer beside all those consumers in our example above and you'll increase today's demand thereby driving prices up in spot market today.
So basically potential for profit drew new type of buyers, driving up the prices in our spot market, let's say $3 per bushel. Some of the consumers who were able to buy corn earlier at $1 will not be able to afford this corn anymore at $3 and will be out of the market.
So, speculators enter the market to make a potential buck, driving up prices in spot market and reducing our ability to consume corn today. But guess what else happens??
Now all these speculators supplying corn in August, we don't run out of corn in August because all these speculators are willing to supply that corn to us in August. Guess what will happen to prices of corn in August now. It is NOT going to be $10 a bushel anymore because there are several million bushels available now as opposed to that one bushel that someone accidentally dropped. All this happened because there was a potential to make a buck and some "greedy capitalist" or "memon" decided to profit from this situation.
So where does this speculation stop. Before you read further, think where the process will stop. At what point do speculators say, anymore speculation and we lose. Take a minute and think.
The process stops when spot market price + storage cost equals expected price in futures market. Now it doesn't matter if speculators exchange goods or not. It doesn't matter if buyers in futures market include Archer Daniel Midland, Miller, or anyone who is not even interested in the product. Whether you take deliveries or not, storage cost is going to be the same for everyone. If you are ever lucky enough to see a difference between "spot market price + storage cost" and "futures market price" (and trust me you won't) but if you do, then sell your car, your house, your first born and do this. Buy from spot market and sell it in futures market. Because there is no risk of loss. By the way, there are people who do this and they are called Arbitragers.
So future price will always equal current price + storage costs + other transaction costs and whether it's Kellog or a Greedy Capitalist Pig on Wall St, they all have to incur this cost. So whether one takes delivery or not, price is going to be the same. And therefore presence of these speculators makes absolutely no difference except this profit is going to someone other than these companies.
Let me give you another example that should be revealing. Let's say you live on a desert island. A boat arrives on this island delivers a month of food supply that you store in some cave. You consume at a rate roughly that will allow you to be able to have food until the end of the month. What happens if you heard on a weather radio that there is a hurricane coming which will close your supply boat which wont be able to deliver your food on time (Let's a 2 week delay). How would you react to this? I'll guess you'll start eating less. Speculators perform a similar service. They get you and me to slow down the rate of consumption today, so we can have food for tomorrow. They do that by driving current prices up. So you go to the grocery to find higher than expected prices and go "must me those damn speculators". They are doing exactly what you would do on a desert island.
So, if speculators don’t drive current prices up, then the companies taking deliveries will have to incur storage costs and we’ll end up with precisely same prices. Except this time Mr Fredrick will lament “big corporations” than Wall St.
*******************************
If you find reading this interesting so far then feel free to read some more interesting details below, otherwise I believe I have proved my point.
*******************************
Notice few interesting things that have happened due to this speculation
We don't run out of corn in August.
We have reallocated the corn from today when its relatively plentiful, to future when its relatively scarce.
We have moved the corn from a time period where it has less value to a time period where it has more value and in doing that speculators have actually increased the value of stock of corn. We have maximized the value of stock of corn. Corn was not as much valuable. But speculators have increased its value (from $1 to $3 in our case).
So speculators in their motive of making profit have performed some interesting functions (described above). They have also given farmers an incentive to grow more corn. If farmers were getting $3 a bushel as opposed to $1 a bushel, they'll produce more corn next year which will drive prices below $3 given same demand.
Speculation plays fairly an important role in a capitalist system. It serves so many purpose that a special market, called futures market has been created for this purpose. Now what is the motivation to create this market? Let's see what happens in our case of corn. A bushel of corn weighs about 42 lbs. A speculator first has to buy a bushel of corn, find a place to store it and then haul it to that storage location. He will have to store, dry it periodically so it doesn't deteriorate and then take it out of the storage and find a buyer and deliver it. It's a pain in the butt. That's what it is. Now that is only if you want to speculate on one bushel. But if you want to speculate on any sizable quantities of corn, then you'll need a fleet of trucks and drivers and these transaction costs are going to be very high.
Futures market is just the right market to reduce all these transaction costs. It makes it easier for people to speculate.
We have a spot market where corn is sold and corn exists. Then we have a futures market where corn doesn't exists except in our brain. But corn is not being sold in these futures markets. What is being sold here is a piece of paper called a futures contract. In a futures contract for corn there will be a future specified promise of delivery and grade of corn. For example a contract for 1 bushel of corn to be delivered on August 5th 2011 for $5. This price that we agreed today is called August corn futures price and you'll pay it when I deliver that corn on August 5th. Now, I have just sold a futures contract and you have just bought a futures contract. Now the question is why would we engage in such a transaction?? The reason is that I believe that price of corn on August 5th is going to be less than $5 (I am taking a position called "short") and you believe that the price of corn is going to be greater than $5 (you are taking a position called "long"). Let's assume that price of corn in the spot market on August 5th is $6 (you were right and I was wrong), then all I have to do is buy corn at $6 right there from the spot market and deliver it to you. Chances are you don't care about the corn either. Both of us will mutually agree that I pay you the difference which is $1 and clear the contract. No deliveries, nothing. We just cleared our contract as Mr Fredrick said and one guy on Wall St also made a buck. Although it caused the prices to increase in spot market on May 1st, it did reduce the price on August 5th. In reality this future and this spot is everyday and if anything, this speculation serves an important purpose and prevents prices from a seesaw effect. That's why futures trading is a pure gamble. Although we can estimate but no one knows the real spot price in future. For example, people who were trading oil futures before Middle East crises, probably did not expected a low supply due to current Libyan crises. So those who sold contracts before middle east crises, probably end up losing a lot of money. So Wall St is losing money too. Notice how prices are affected by real supply and demand shocks rather than you and I betting in futures market. Similarly current food prices are a result of expected inflation and a devalued dollar. If you have not checked recently, then check the price of gold. It's over $1500 an ounce and all because of expected low value of dollar rather than bunch of traders on a trading floor.
In reality a contract for corn would require a minimum of 5000 bushels. Anybody can buy and sell these and you don't have to own corn to sell a futures contract. All you have to do is deliver it on the promised day. There are clearing houses and markets make sure everyone complies. One such market is CBOT (Chicago Board of Trade).
