Several weeks ago we looked for insight as to what's going on in commodity markets and were lucky to connect with Walker Todd, an attorney and economist who worked for many years in the Federal Reserve System. Below he provides a perspective that is remarkably timely in view of recent regulatory discussions.
Mr. Todd was a legal officer of the Federal Reserve Bank of New York and a legal and research officer at the Cleveland Federal Reserve Bank. He is now a research fellow at the American Institute for Economic Research. It is of relevance to this article that he grew up on a farm in Tennessee.
Commodity markets have changed because of the growing involvement of Wall Street firms such as Goldman Sachs, Morgan Stanley and others. We don't think of Goldman as a corn trader, for example, yet it has become a presence in commodities markets including the corn market.
You can see the effect of financial speculation clearly starting in 2006, when the commodities bubble accelerated. By early 2007, the US price of corn broke all-time records. A bushel of corn went from less than $2 to more than $4 and at times up to $6 and as high as nearly $8. Even when the price came down, it remained about 50% above the 2006 average.
The rise of corn prices happened in part because of natural factors like droughts in some areas and the demand for ethanol, whose futures contracts began trading that year, but those can account for only part of the price rise. Financial players coming in and pushing prices for their own reasons had to account for a significant part of the increase.
While agricultural prices fluctuate year by year as harvests vary, the growing presence of financial actors has introduced a new source of instability. These players are not effectively supervised in their commodities trading, whether by the exchanges, the Commodity Futures Trading Commission, the Securities and Exchange Commission or the Federal Reserve.
When I started working on the regulatory side of Wall Street four decades ago, a big price move like the one in 2006 might have resulted in regulators asking to see the futures contracts held by financial firms. There would have been an inquiry or investigation whether those with big net long or net short positions manipulated the market. But in the 2006-2008 price run-up, regulators did nothing.
Some 50 years ago, there was a scandal around the Maine potato futures contract. This ordinarily was a thinly traded market. A group of traders decided to corner the Maine potato futures contract, like the Hunt Brothers cornering the silver market. They sold so many contracts that the contracts outstanding exceeded the deliverable crop. That‚Äôs a kind of Ponzi scheme and regulators swore they would never let it happen again.
But as commodity index investing channeled increasing amounts of money into futures markets in recent years, it has had effects similar to the potato futures scheme.
AIG and Corn Futures
Financial players do distort the agricultural market. We saw this when the insurance company AIG came near failure in the September 2008 credit crisis. AIG was long corn futures equal to some 5% of the entire US corn crop. And that's just one financial firm.
Goldman Sachs and Morgan Stanley must have been holding contracts equal to large shares of the crop. I have seen rationally based assertions that Goldman's corn position was 50% larger than AIG's. Yet AIG was a major market maker in the corn futures index.
The Fed, after taking over AIG, had the Chicago Mercantile Exchange and Board of Trade allow block trading - normally not allowed on the exchanges - to liquidate those corn futures. In the past, everyone had to sell in regular order and during the regular session so that the transactions would be reflected in the current price. A wave of selling would tend to depress the price. Do you think a farmer caught on the wrong side of the market could call a futures exchange and have a special trading session to liquidate his position?
Think of the farmers who are on the receiving end of the market. Given the high prices in early 2007, farmers planted more corn. With the index money continuing to come in, prices remained high into the planting season of 2008. In the summer of 2008, the crunch came with higher energy prices that pushed up agricultural costs.
The crop was still bringing in $5.50 to $6.00 on the futures contracts, so despite the high costs of production farmers planted more corn. Then the price of corn collapsed below $4 a bushel during the harvest season, reaching a monthly low of $2.90 in December 2008. Farmers were squeezed between the cost of production and the falling price of the product.
Financial players had a role in this. Farmers have to make a decision about planting in the winter and spring; they can't wait for the dust to settle from index investors in the futures market. So farmers had to act on prices that did not reflect the fundamentals of the corn market, which is now distorted because financial interests have a dominant role.
Farmers have become very skeptical. Even with the demand for ethanol, which peaked in mid-2006 and mid-2008, there is much uncertainty about grain prices. One scenario is that demand will be weak and with a better-than-average harvest, there'll be a price collapse. At this writing, that seems to be the more likely scenario. The underlying problem is that, although the financial players are buying the contracts, their demand may not be an accurate gauge of the end users' demand.
The alternative scenario, which now seems less likely for 2009 but could arise in 2010 and beyond, is that at some point farmers won't plant enough corn and then we'll run the risk of skyrocketing prices. One way or the other, by the end of the summer of 2009 we could have a blowup in the grain markets.
Regulators and exchanges need to consider some key issues. Before you're allowed to take a big position in an agricultural market, shouldn't you have the capability of storing the physical commodity if you are not an end user? This question is especially relevant because you usually can play in commodity markets with a proportionately much smaller margin requirement than in stock or bond markets.
We can and probably should allow financial firms to participate in commodity markets to increase liquidity. But you might want to make them post substantially higher margins (perhaps 50%) to discourage them from using their leverage to distort market conditions.