Devil or Angel? The Role of Speculation in the
Recent Commodity Price Boom (and Bust)
By
Scott H. Irwin, Dwight R. Sanders, and Robert P. Merrin
Power Point Presentation for the
International Agricultural Trade Research Consortium
Analytic Symposium
“Confronting Food Price Inflation:
Implications for Agricultural Trade and Policies”
June 22-23, 2009
Seattle, Washington
Devil or Angel? The Role of
Speculation in the Recent
Commodity Price Boom (and
Bust)
Scott H. Irwin, Dwight R. Sanders,
and Robert P. Merrin
Outline
• Bubble logic
• Conceptual errors
• Inconsistent facts
• Empirical evidence
• Changing fundamentals
• Lessons from history
A New Type of Commodity Speculator
• Commodity Index Investors
– Desire portfolio exposure
to returns from a basket
of commodities
– Long-only
• Popular Indexes
– GSCI
– Dow Jones-AIG
– Reuters/Jeffries-CRB
• Investment Types
– OTC index funds
– Exchange-traded funds
– Exchange-traded notes
Investors
$
Swap
Dealer
$
$
Long
Futures
Positions
Index
Notional Value of Commodity Index Trading
on U.S. Futures Exchanges (CFTC)
946
Investment (bil.$)
1,000
750
500
250
118
133
161
Dec-07
Mar-08
Jun-08
0
All Futures
Jun-08
It Has to be a Bubble!
• A ‗titanic‘ wave of money
invested in commodity
futures markets
• Overwhelmed ‗normal‘
supply and demand
fundamentals
• Greatly magnified upward
trend in commodity prices
• Final result: A bubble
It Has to be a Bubble!
• A ‗titanic‘ wave of money
invested in commodity
futures markets
• Overwhelmed ‗normal‘
supply and demand
fundamentals
• Greatly magnified upward
trend in commodity prices
• Final result: A bubble
So it‘s becoming increasingly
clear that there are very few
people left in academia and
economics-land that think
that commodities were
anything but a bubble. In
fact it appears the only
economists left attacking the
bubble theory are the ones
being paid by Wall Street to
defend their actions.
---Accidental Hunt Brothers
Blog, October 15, 2008
The World According
to Mr. Masters
Conceptual Error #1: Money Flows are not the
Same as Demand
• Futures markets are zero-sum
games
• If long positions of index funds
are new ―demand‖ then the
short positions for the same
contracts are new ―supply‖?
• Simply observing that large
investment has flowed into the
long side of commodity futures
markets at the same time that
prices have risen substantially
does not necessarily prove
anything
Conceptual Error #1: Money Flows are not the
Same as Demand
• Futures markets are zero-sum
games
• If long positions of index funds
are new ―demand‖ then the
short positions for the same
contracts are new ―supply‖ ?
• Simply observing that large
investment has flowed into the
long side of commodity futures
markets at the same time that
prices have risen substantially
does not necessarily prove
anything
―…for every long there is a
short, for everyone who
thinks the price is going
up there is someone
who thinks it is going
down, and for everyone
who trades with the flow
of the market, there is
someone trading against
it.‖
Tom
Hieronymus
Conceptual Error #2: Index Futures Positions
Distort both Cash and Futures Prices
• Futures contracts are financial transactions that only
rarely involve the actual delivery of physical
commodities (i.e. ―side bets‖)
• To impact the equilibrium price of commodities in the
cash market, index investors must take delivery and/or
buy quantities in the cash market and hold these
inventories off the market
• Absolutely no evidence that index fund investors are
taking delivery and owning stocks of commodities
Conceptual Error #2: Index Futures Positions
Distort both Cash and Futures Prices
• Futures contracts are financial transactions that only
rarely involve the actual delivery of physical
commodities (i.e. ―side bets‖)
• To impact the equilibrium price of commodities in the
cash market, index investors must take delivery and/or
buy quantities in the cash market and hold these
inventories off the market
• Absolutely no evidence that index fund investors are
taking delivery and owning stocks of commodities
Conceptual Error #3: Hedgers are Benign RiskAvoiders and Speculators are Harmful Risk-Seekers
• Hedging and speculation are best
described as a continuum
• Index funds entered a dynamic and
ever-changing ―game‖ between
commercial firms and speculators with
various motivations and strategies
• Commercial firms tend to have an
informational advantage
• Index funds add liquidity and may
improve competition in commodity
futures markets
Inconsistent Fact #1: Speculation is not Excessive
Compared to Hedging (2006:I-2008:I Averages)
Long
Hedging
Corn
2006
2008
Change
Soybeans
2006
2008
Change
Wheat
2006
2008
Change
328,362
598,790
270,428
Short
Long
Hedging Speculation
---# of contracts--654,461
558,600
1,179,932
792,368
525,471
233,768
Short
Speculation
208,043
182,291
-25,752
126,832
175,973
49,141
192,218
440,793
248,575
183,105
351,379
168,274
107,221
74,844
-32,377
57,942
70,084
12,141
213,278
240,864
27,585
251,926
300,880
48,954
92,148
121,578
29,430
Source: Sanders, Irwin, and Merrin (2008a)
Inconsistent Fact #2: Price Increases Did not Occur in
All Commodity Futures Markets Included in Popular
Indexes (January 3, 2006 – April 15, 2008)
150%
100%
50%
gs
Ho
Le
an
ed
er
Ca
tt
le
le
Fe
Liv
eC
att
n
tto
Co
Wh
ea
t
t
KC
BT
Wh
ea
il
CB
OT
ea
nO
So
yb
ea
ns
yb
-50%
So
rn
0%
Co
Jan 2006 - Apr 2008 Change (%)
200%
Inconsistent Fact #3: Price Increases Occurred in
Commodity Futures Markets not Included in Popular
Indexes or Markets Without Futures
January 2006
April 2008
Change
$8.27/lb.
$22.17/lb.
+168%
Nearby Fluid
Milk Futures
$12.65/cwt.
$17.29/cwt.
+37%
Apples Fresh
Use (cash)
$0.26/lb.
$0.41/lb.
+58%
Edible Beans
(cash)
$19.30/cwt.
$34.40/cwt.
+78%
Nearby Rough
Rice Futures
Inconsistent Fact #4: Inventories did not Increase
for Storable Commodities
40
Ending Stocks/Use (%)
Inventory
Increase
Ending Stocks as a Percent of Use, 2001/022007/08
S
PB
PE
35
30
25
20
15
10
5
0
2001/02
D
Q
2002/03
2003/04
2004/05
Corn
Soybeans
2005/06
2006/07
2007/08
Wheat
“So my challenge to people who
say there’s an oil bubble is this:
let’s get physical. Tell me where
you think the excess supply of
crude is going.”
This Time is Different!
•
•
•
•
Facts build a persuasive case against bubble hypothesis
But, evidence is ―circumstantial‖
Bubble proponents can argue ―this time is different‖
Direct evidence on the relationship between speculator
positions and price changes is needed
This Time is Different!
•
•
•
•
Facts build a persuasive case against bubble hypothesis
But, evidence is ―circumstantial‖
Bubble proponents can argue ―this time is different‖
Direct evidence on the relationship between speculator
positions and price changes is needed
Solution: Granger causality tests
―If event X causes event Y, then event X
should precede event Y in time‖
n
Rt
t
m
i
i 1
Rt
S
i
j t j
j 1
t
Granger Causality Test Results for CFTC Trader Categories,
Positions Do Not Lead Weekly Returns, 1995-2006
m
Rt
t
n
i
Rt
j
PNLt
j
t
P-values for Hypothesis Test:
Commercials
Non-Commericals
j=0,
i 1
i
j 1
j
Non-Reporting
Wheat CBOT
0.01
0.18
0.54
Wheat KCBOT
0.03
0.24
0.71
Wheat MGE
0.63
0.15
0.76
Corn
0.35
0.79
0.33
Soybeans
0.83
0.05
0.78
Soybean Oil
0.24
0.30
0.94
Soybean Meal
0.70
0.93
0.61
Lean Hogs
0.05
0.34
0.08
Live Cattle
0.75
0.83
0.48
Feeder Cattle
0.10
0.16
0.23
Source: Sanders, Irwin, and Merrin (2009)
―Changes in supply and
demand fundamentals
cannot fully explain the
recent drastic increase
in food prices.‖
Source: Robles, Torero, and von Braun (2009)
Granger Causality Test Results for CFTC CIT Category,
Positions Do Not Lead Daily Returns, 2004-2008
n
Rt
t
m
i
Rt
i
i 1
Corn
Soybean Oil
Soybeans
Wheat CBOT
Wheat KS
FeederCattle
LeanHogs
LiveCattle
Cocoa
Coffee
Cotton
Sugar
j
CITt
j
t
j 1
P-values for Hypothesis Test: j
2004-2005
2006-2008
Nearby
Next
Nearby
Next
0.89
0.75
0.92
0.77
0.29
0.13
0.70
0.37
0.92
0.30
0.37
0.93
0.48
0.86
0.11
0.75
0.23
0.55
0.83
0.46
0.77
0.17
0.59
0.19
0.33
0.85
0.33
0.11
0.02
0.07
0.04
0.34
0.00
0.18
0.02
0.07
0.43
0.03
0.06
0.25
0.26
0.06
0.46
0.88
0.07
0.02
0.42
0.74
Source: Aulerich, Irwin, and Garcia (2009)
Changing Fundamentals?
For at least the last 50 years the
primary determinant of the
fundamental value of corn has
been the value placed on corn
by livestock feeders
“The price of feed is
determined by livestock feed
demand, feed production,
exports, and food and
industrial uses. The lines of
causation are from consumer
demand through the livestock
sector to feed prices.”
―Master Model of Midwestern
Agriculture,‖ Hieronymus,
Good, and Hinton (1980)
US Corn, Ethanol for Fuel Use, 1975/762008/09*
3,500
3,000
2,500
2,000
1,500
1,000
500
0
1975/76
Source: USDA
1982/83
1989/90
1996/97
Marketing Year
US Corn, Ethanol for Fuel Share of Total Use,
1975/76-2008/09*
2003/04
35
*2008/09 Projected
30
FSI/Total Use (%)
Ethanol (million bushels)
4,000
25
20
15
10
5
0
1975/76
Source: USDA
1982/83
1989/90
1996/97
Marketing Year
2003/04
*2008/09 Projected
Weekly Ethanol and Corn Prices at Iowa Plants,
January 27, 2007 – June 12, 2009
8.00
3.00
2.50
2.25
5.00
2.00
4.00
1.75
3.00
1.50
Corn (left-scale)
2.00
1/
26
3/ /07
23
5/ /07
18
7/ /07
13
/
9/ 07
7
11 /07
12 /2/0
/2 7
8
2/ /07
22
4/ /08
18
6/ /08
13
/
8/ 08
8
10 /08
11 /3/0
/2 8
8
1/ /08
23
3/ /09
20
5/ /09
15
/0
9
Corn Price ($/bu.)
Ethanol (right-scale)
6.00
1.25
Ethanol Price ($/gal.)
2.75
7.00
Relationship between Weekly Corn and Ethanol Prices at Iowa
Plants, September 7, 2007 – June 12, 2009
8.00
Corn Price $/bu.)
7.00
y = 2.2963x - 0.0131
2
R = 0.8829
6.00
5.00
4.00
3.00
2.00
1.25
1.50
1.75
2.00
2.25
Ethanol Price ($/bu.)
2.50
2.75
3.00
We Have Been Here Before: Lessons from History
Abraham Lincoln: ―For my part, I wish every one of them
[speculators] had his devilish head shot off.‖
Vladimir Lenin: ―For as long as we fail to treat speculators the
way they deserve—with a bullet to the head—
we will not get anywhere.‖
Harry Truman: ―…the cost of living in this country must not be a
football to be kicked around by grain gamblers.‖
U.S. Congress: ―Speculative activity in the futures markets
causes such severe and unwarranted
fluctuations in the price of cash onions as to
require complete prohibition of onion futures
trading in order to assure the orderly flow of
onions in interstate commerce.‖
Proportion of Open Interest Held by Index Traders in
Grain and Livestock Futures Markets, Jan 2006-Jun 2008
30%
30%
CIT/Total OI
20%
15%
Lean Hogs
25%
Wheat
Soybeans
20%
Live Cattle
15%
10%
10%
Feeder Cattle
Corn
Source: Sanders, Irwin, and Merrin (2008a)
“Perma-longs”
Mar-08
Jan-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Jan-07
Nov-06
Sep-06
Jul-06
May-06
Mar-06
Mar-08
Jan-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Jan-07
Nov-06
Sep-06
Jul-06
May-06
Mar-06
Jan-06
5%
5%
Jan-06
CIT/Total OI
25%
Index Trading in NYMEX Crude Oil Futures
12/31/2007
Notional Value (bil. $)
Net Long Position (# contracts)
Total Futures Equivalent Open
Interest (# contracts)
Index Position/Total Open
Interest
39.1
3/31/2008
41
6/30/2008
51
408,000
398,000
363,000
2,508,971
2,885,101
2,837,447
16%
Source: CFTC Staff Report on Commodity Swap
Dealers and Index Traders (2008)
14%
13%