Speculation and Price Volatility: I m plications for Farm er - - PowerPoint PPT Presentation

2 0 0 9 I llinois Farm Econom ics Sum m it

The Profitability of I llinois Agriculture: Profitability at a Crossroads

Speculation and Price Volatility: I m plications for Farm er Marketing

Scott I rw in sirw in@illinois.edu University of I llinois

2 0 0 9 I llinois Farm Econom ics Sum m it

2 0 0 9 I llinois Farm Econom ics Sum m it

2 0 0 9 I llinois Farm Econom ics Sum m it

2 0 0 9 I llinois Farm Econom ics Sum m it

A New Type of Com m odity Speculator

Commodity Index Investors – Desire portfolio exposure to long-

• nly returns from a basket of

commodities – Pension funds and institutional investors 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 π π $

2 0 0 9 I llinois Farm Econom ics Sum m it

The W orld According to Mr. Masters

2 0 0 9 I llinois Farm Econom ics Sum m it

Unpacking the Bubble Argum ent

• Supplies of physical commodities are constrained in the

short-run

• Unleveraged futures positions of index funds are effectively

“synthetic” long positions in physical commodities, and hence, represent new “demand”

• If the magnitude of index fund “demand” is large enough

relative to physical supply, prices and price volatility can skyrocket

• Bottom-line: index fund investment is “too big” for the size
• f existing commodity futures markets

2 0 0 9 I llinois Farm Econom ics Sum m it

Conceptual Error# 1 : Money Flow s are not Necessarily the Sam e as Dem and

• 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” ?

• With equally informed market

participants, there is no limit to the number of futures contracts that can be created at a given price level

“…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

2 0 0 9 I llinois Farm Econom ics Sum m it

Conceptual Error# 2 : I ndex 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 over all but very short time intervals, index funds must take delivery and/ or buy quantities in the cash market and hold these inventories off the market

• Absolutely no evidence that index funds took delivery of

commodities

2 0 0 9 I llinois Farm Econom ics Sum m it

I nconsistent Fact # 1 : I nventories did not I ncrease for Storable Com m odities PE PB Inventory Increase Q S D

Ending Stocks as a Percent of Use, 2001/02- 2007/08

5 10 15 20 25 30 35 40 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 Ending Stocks/Use (%) Corn Soybeans 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.”

2 0 0 9 I llinois Farm Econom ics Sum m it

Long Short Long Short Hedging Hedging Speculation Speculation Corn 2006 328,362 654,461 558,600 208,043 2008 598,790 1,179,932 792,368 182,291 Change 270,428 525,471 233,768

• 25,752

Soybeans 2006 126,832 192,218 183,105 107,221 2008 175,973 440,793 351,379 74,844 Change 49,141 248,575 168,274

• 32,377

Wheat 2006 57,942 213,278 251,926 92,148 2008 70,084 240,864 300,880 121,578 Change 12,141 27,585 48,954 29,430

• --# of contracts---

I nconsistent Fact # 2 : Speculation w as not Excessive Com pared to Hedging ( 2 0 0 6 :I -2 0 0 8 :I Averages)

2 0 0 9 I llinois Farm Econom ics Sum m it

I nconsistent Fact # 3 : Price I ncreases Did not Occur in All Com m odity Futures Markets I ncluded in Popular I ndexes ( January 3 , 2 0 0 6 – April 1 5 , 2 0 0 8 )

• 50%

0% 50% 100% 150% 200% Corn Soybeans Soybean Oil CBOT Wheat KCBT Wheat Cotton Live Cattle Feeder Cattle Lean Hogs Jan 2006 - Apr 2008 Change (%)

2 0 0 9 I llinois Farm Econom ics Sum m it

The Debate Continues

• Conceptual problems and

inconsistent facts build a reasonably strong case against bubbles in commodity prices

• Unpersuasive to those who

think this was a unique market episode

• Temporal relationship

between index fund investment and commodity price movements just seems so obvious!

2 0 0 9 I llinois Farm Econom ics Sum m it

Testing the Bubble Hypothesis

2 0 0 9 I llinois Farm Econom ics Sum m it

Com m odity I ndex Trader Percentage of Total Corn Open I nterest and Nearby CBOT Corn Futures Price, January 2 0 0 4 - August 2 0 0 9

100 200 300 400 500 600 700 800 0% 5% 10% 15% 20% 25% 30% 35% Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Cents/Bushel CIT % Open Interest (left scale) Futures Price (right scale)

2 0 0 9 I llinois Farm Econom ics Sum m it

Com m odity I ndex Trader Percentage of Total Corn Open I nterest and Nearby CBOT Soybean Futures Price, January 2 0 0 4 -August 2 0 0 9

400 600 800 1000 1200 1400 1600 1800 0% 5% 10% 15% 20% 25% 30% 35% Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Cents/Bushel CIT % Open Interest (left scale) Futures Price (right scale)

2 0 0 9 I llinois Farm Econom ics Sum m it

Com m odity I ndex Trader Percentage of Total Corn Open I nterest and Nearby CBOT W heat Futures Price, January 2 0 0 4 -August 2 0 0 9

200 400 600 800 1000 1200 1400 0% 10% 20% 30% 40% 50% 60% Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Cents/Bushel CIT % Open Interest (left scale) Futures Price (right scale)

2 0 0 9 I llinois Farm Econom ics Sum m it

2 0 0 9 I llinois Farm Econom ics Sum m it

• High price volatility may

limit the forward contracting opportunities

• ffered by grain

merchandisers

• Shorter time horizons
• Weak basis levels
• More erratic basis

behavior

I m plications

• 80
• 70
• 60
• 50
• 40
• 30
• 20
• 10

1/1 2/1 3/1 4/1 5/1 6/1 7/1 8/1 Cents/Bushel Date

Harvest Delivery Forward Basis for Corn in South Central Illinois, 2003-2009

2003-2007 Average 2009 2008

2 0 0 9 I llinois Farm Econom ics Sum m it

Dec 2001- Dec 2005 y = -0.87x - 0.61 R2 = 0.87 Mar 2006-May 2008 y = -0.62x - 6.63 R2 = 0.28

• 40
• 30
• 20
• 10

10 20 30 40 50 60 70

• 70
• 60
• 50
• 40
• 30
• 20
• 10

10 20 30 40 x = Initial Basis (cents/bu.) y = Change in Basis (cents/bu.)

Note: September 2005 observations omitted

Predictability of CBOT Corn Basis Change to First Day of Delivery w ith all Delivery Locations Pooled, Decem ber 2 0 0 1 – May 2 0 0 8 Contracts

2 0 0 9 I llinois Farm Econom ics Sum m it

• Direct use of futures hedging
• Margin risk
• Basis risk
• Direct use of options hedging
• Initial premium outlay may be large
• Basis risk
• Basis contract + futures hedge
• Contract with a grain user (e.g., ethanol plant)
• Default risk
• Increase crop revenue insurance coverage

Alternatives to Forw ard Contracting