Sunday, June 12, 2011

Commodity costs subject to the whims of investors

As cotton prices soared last year to record highs, you probably thought farmers such as Ron Rayner were grinning all the way to the bank.

Instead, they were gritting their teeth, as do many buyers and sellers who have to deal in what has become a highly volatile commodities market tossed about by the whims of speculators.

Sell your crop too early, and you lose out on a chance to make more money if the price keeps rising. Wait too long, and the price may fall.

Speculation is believed to be a major reason why consumers, for the second time in three years, are seeing high prices for commodities such as crude oil, cotton and wheat - which in turn drives up the costs of gasoline, clothing and food.

What made cotton prices leap last year from about 65 cents a pound to more than $2 wasn't just that China had run short of cotton and began buying more. Once prices began rising, investors eager for anything offering a decent rate of return jumped into the cotton futures market - which operates similar to the stock markets - and drove up prices even higher. Many of them had no intention of actually buying bales of cotton.

Supply and demand, of course, always play a key role in price fluctuations. Droughts and freezes can be counted on to boost crop prices. But when trading in goods is far greater than the amount of commodities produced, it signals a massive amount of speculation. And many professional traders use sophisticated mathematical processes known as algorithms to analyze markets and suggest times to buy or sell, further feeding the trend.

"The markets are supposed to be based on supply and demand," said Randall Werner, owner of Advanced Commodity Trading in Scottsdale. "But once they get into a frenzy and into the media, you always have these bandwagon speculators that want to jump on late. That pushes the prices up even higher."

2007 and 2008 brought worldwide food shortages and soaring gas prices. Ever since, debate has simmered over how much of that was caused by normal supply and demand and how much was aggravated by investors with no need to buy barrels of oil or bushels of wheat. Studies backed up both sides.

But a variety of Arizona insiders in the oil and agricultural industries have no doubt that speculators - notably hedge funds - are driving up commodity prices, or at least making the markets for commodity futures excessively volatile and difficult to nail down a selling price.

"They (speculators) never take hold of the product," said Andrea Martincic, executive director of the Arizona Petroleum Marketers Association. "You got people trading and saying they are taking possession of all these barrels of oil, but in reality, they aren't. They are just . . . jacking up the price for all those who do."

Arizona gas prices have risen about one-third over the past year and food prices about 5 percent in the first quarter compared with a year earlier, according to AAA Arizona and the Arizona Farm Bureau.

In April, President Barack Obama tapped the attorney general to look at whether oil markets were being manipulated by financial speculation.

Meanwhile, the Commodities Futures Trading Commission, which oversees commodity trading in the U.S., is reworking its rules to try to minimize the impact of financial speculators without shutting out farmers, ranchers and others who need those markets. It also has stepped up enforcement actions against people who illegally manipulate or try to manipulate markets.

The issue is not only complicated but contentious. The commission has received about 12,000 public comments.

Risky business

Arizona cotton farmers' plight offers a good example of the impact of commodities futures trading.

Rayner said many Arizona farmers sold their 2010 crop, harvested around November, when the price was in the 75-85 cent range.

"When you have incredible volatility in the market, that makes it tough for either side to use the market because you have so much risk involved," said Rayner, a Buckeye farmer and chairman of Calcot Limited, a Bakersfield, Calif.-based cooperative in Arizona and three other states. Calcot has had warehouses in Glendale for more than 80 years.

A cooperative is a group of growers who band together to jointly sell their products, enabling them to get the same price for the same quality. Rayner said he has sold his cotton through Calcot because it assures him more steady prices.

The risk for producers is not only selling your crop too early but having to pay higher charges, because of the way exchanges work. For example, say a farmer locks in a price at $1.35 a pound with a futures contract, and the price keeps rising. Every time the price rises - say, up to $1.50 a pound - the farmer (the seller) has to pay more money to the exchange to compensate the buyer for the rising price. That is what is known as a margin call. If the futures-contract price goes down, the buyer has to come up with the margin money.

Futures explode

Commodity futures markets have been around for more than a century, primarily to help farmers and ranchers sell products and minimize their financial risks and, in turn, to help commodity buyers, such as food processors, minimize their risks.

The first agricultural exchanges such as the Board of Trade in Chicago were created as far back as the mid-1800s, and today, farmers and ranchers can't do business without them.

It enables them to hedge, or lock in, a price for their products, whether cotton, soybeans or calves. If they find a buyer, they will sign a "forward" contract agreeing to sell the product upon harvest or, in the case of calves, when they reach a certain weight.

Since the 1970s, the futures markets also have branched into sophisticated financial products linked to foreign currencies, interest rates, stock indexes and real estate. In the past decade, the volumes traded on these exchanges has exploded as individual and institutional investors - including hedge funds - discovered they could be profitable.

Commodity trading has become global, with about two dozen commodity exchanges in the world. There are more than 100 commodities traded. They are not just the obvious ones such as crude oil, wheat and corn, but also hides, rubber, soft logs, fertilizers, steel-wire rods and coconut oil.

The face value of commodity derivative contracts tripled between June 1998 and June 2003 and then rose 19-fold in the next five years, peaking at $13 trillion in June 2008, the Federal Reserve Bank of St. Louis Review reported in February. That growth was far greater than the amount of commodities produced, indicating a massive amount of speculation.

The bank attributed that to investors, both individual and institutions, moving out of derivative investments based on real estate because of subprime-mortgage problems and into investments such as futures and options based on commodities. In finance, a derivative is a financial instrument whose value depends on other, more basic, underlying variables.

Now commodities have become hot again. Volumes on the Chicago-based CME Group Inc., which operates the country's largest commodities market, rose 47 percent to a record 1.2 million contracts a day in the first quarter compared with a year earlier. About 80 percent of CME's trading is done electronically.

Repeat of 2008

In many ways, 2011 started off looking a lot like 2008, with rising gas and food prices. Now that experts have had a few years to study what happened then, they are finding more evidence that speculation probably worsened the situation.

The food shortages of 2008 initially were caused by droughts in grain-growing countries a year earlier that reduced stocks of grain. Corn prices also rose in 2008 in part because about a third of the U.S. corn crop went to ethanol production, leaving less for human consumption and animal feed.

Corn prices tripled between 2006 and 2008 to $6 from $2 a bushel. That in turn raised the price of animal feed and indirectly, prices of beef, pork and dairy products, creating consumer stresses and making food too expensive for many people around the globe.

The world also experienced a shock in 2008 when oil prices soared because of rapidly growing demand in emerging countries such as China and India. Arizona gas prices remained above $4 a gallon for six weeks that summer. But then they dropped steeply as the recession deepened, then rose to end up nine months later about $1 a gallon cheaper.

Rising food prices again are front and center in 2011, in part because of droughts and freezes. Recovering economies have been clamoring for more food, cotton, copper and oil.

The average cost for gasoline in Arizona increased about 93 cents a gallon, or about 34 percent, before the Memorial Day weekend compared with the same time a year earlier. The cost to fill a 15-gallon tank hit a record $55.33, according to AAA Arizona.

Several experts also believe that volatility is aggravated when traders use algorithms to analyze markets and suggest times to buy or sell. If a drought in Russia, for example, drives wheat supplies down and prices up, the computer algorithm would suggest it's a good time to buy, and traders will get bullish.

"They (computer models) have certainly contributed to the big spikes in commodities," said Eric Wilkey, a grain dealer in Casa Grande.

He has no doubt that speculators are driving up prices and making the markets volatile. Ideally, when the futures market determines that the price for wheat harvested in the fall will be a set price, farmers should be able to get that price when they go to sell. In other words, the cash and futures markets should be about the same. But that's not happening.

"The difference between the cash market (price paid today) and the futures market tends to get wider and wider," Wilkey said. "That to me is an indication that people (buyers) do not want the physical commodity. They want the speculative value of the contract."

The Petroleum Marketers Association of America also contends investors drove up futures prices for oil several months ago after unrest in the Middle East and North Africa - even as there really was no shortage of oil.

Several academic studies have examined the unusually sharp increase and decline in crude-oil prices in 2008 and 2009. In one of the latest, released in March by the Stanford University Graduate School of Business, management professor Kenneth Singleton said there was growing evidence that the "financialization" of commodity markets and investor involvement was affecting the direction of prices.

Skittish on the farm

On Arizona farms and ranches, the people who need to use futures markets to reduce their risks and help ensure the highest prices possible say that speculators have complicated their lives and are keeping them chained to computers more than they would like to be. While they welcome higher prices, they don't like the hassle it takes to get them.

Cotton prices in particular have risen to record highs, prompting a frenzy in the futures markets that has driven up the index price 145 percent over the past year, according to

Arizona's cotton crop last year was estimated by Rayner to be valued at about $208 million, not counting sales of cotton seed.

For the past six years, cotton demand was low, Rayner said, and farmers cut back on their plantings. But last year, China exhausted its supplies and began buying.

"In the fall, prices started skyrocketing when people realized the current crop in the world would be the sixth year in a row where worldwide consumption would exceed production," Rayner said.

He said Arizona land planted in cotton this year probably would grow to about 195,000 acres this year, compared with 145,000 acres in 2010.

One of the requirements of futures exchanges is that sellers have to keep putting in more money when prices rise, and that became very expensive last year, Rayner said. The futures market was so difficult to use that the cooperative at times switched to fixed-price contracts.

"It (volatility) has got everybody a little gun-shy right now," Rayner said. "So that's one of the reasons Calcot is offering growers a fixed-price contract. It takes a little longer to do it because you have to find a mill on the other side that's willing to buy it."

Paul Bush, Arizona vice president for the co-op, said the high prices eventually will affect consumer prices. Cotton-price hikes usually take six to eight months to show up in the prices of products, such as clothes and sheets.

"I don't think we have seen the full brunt of these prices at the consumer level yet and we probably won't until maybe the fall or sometime in the third or fourth quarter," he said.

The dairy industry also is affected to some extent, though milk prices are mainly set by the federal government, said Mark Hocking, chief financial officer for United Dairymen of Arizona.

But in recent years, a trade has developed in milk-powder futures and options. Investors with no intention of actually buying the products have been driving up prices, he said.

The futures market also is keeping cattle rancher Bas Aja on edge. He is executive vice president of the Arizona Cattle Feeders' Association and owns a ranch in northern Arizona with his parents.

He said fickle investors who jump in and out of the market for beef futures make it difficult to find cattle buyers. Neither buyers nor sellers know whether prices will rise or fall by the time calves have reached the required 500 pounds. The effects also are felt in the cash market, where sellers have not locked in futures contracts.

"The big guys (speculators) decide, 'You know, I made enough money,' and pull out," he said. "And boom, the price drops and you, who actually own the livestock, would just lose value. Speculative trading does drive up prices, but it also presents really volatile risks for producers, and that's probably what's most unsettling now."

Potential fixes

Not only has the Obama administration begun to look for evidence of price manipulation, but the exchanges from time to time boost the amount of money required to invest, said Scottsdale commodities trader Werner.

The NYMEX exchange recently tripled the amount required to buy silver and caused a huge sell-off, he said. He predicts that if crude oil is priced too high, the exchanges could do the same with that commodity.

The agricultural community, Wilkey said, is pinning its hopes on the Dodd-Frank Act that Congress passed last year to make public trading more transparent and reduce speculation. The law requires the Commodities Futures Trading Commission to produce new rules that limit the role of speculators.

"We'll have to see whether those effects are realized and whether we have less speculation," Wilkey said.

by Betty Beard The Arizona Republic Jun. 12, 2011 12:00 AM

Commodity costs subject to the whims of investors

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