A new investment metric for a commodities-crazed world

We hear from many pundits that the current food crisis. i.e., the swift escalation in the price of food commodities, is largely caused by speculators and hedge fund managers. How true is this? Let’s start by analysing how they might, and could, effect this increase.

To begin, we all know that any increase in price of any commodity is largely the result of supply and demand interaction. Price increases if supply cannot meet all existing demand at previous levels. We know that global population has been increasing, particularly in the Third World countries. We also know that personal incomes are increasing in these developing countries. These factors can put a partial logical cause to the current demand-supply interaction.

But in our current situation, food prices have been increasing rapidly. Too rapidly. For commodities like wheat, rice, corn, and soybean, prices were doubled in as short a time as a few months. Does this mean world population has doubled in that time? Or the average income of everybody in the world doubled in that amount of time? Likely not. But our current situation is such that it almost seems like for this year alone, we see people suddenly eating who otherwise never ate at all before this year came rolling.

Let’s now summarise how food commodities are priced. Commodities such as wheat and corn are traded on a commodity futures exchange. Futures exchanges exist because many food producers, i.e., corn farmers, wheat farmers, etc. do not want, or cannot afford, to absorb the price volatilities of the good that they produce.

A harvest season takes many months. For some farmers, harvest season may come only once a year. If you’re a farmer, you are weighed by specific, determinable expenses when deciding to plant a crop for an oncoming harvest. Corn seed prices, fertilizers cost, plus all other costs of running a farm or plantation.

Income from all the farmer’s effort and costs, however, cannot be determined with as much certainty. Because of the long lead time between planting and harvest and eventually, getting a crop to the market, many events can suddenly affect supply and demand during the interim. In that amount of time, a bumper harvest may result in much supply for what the farmer has just planted, leading to a decline in price. It is very possible, if a large enough number of farmers had decided to plant, say corn, and all of them, because of favourable weather, experience a bumper crop, corn prices may fall even below each farmer’s cost of planting it. This would wipe out the farmers.

To prevent financial ruin, many farmers prefer to sell their commodities to buyers long before they have harvested their crops. We call their agreements forward contracts, wherein farmers sell a specific quantity of a commodity, for a specific price, for delivery at a specific date in the future. A specific buyer promises to buy the farmer’s output at harvest, at whatever price that crop will have upon harvest time. In short, this buyer has now taken on the risk of a bumper crop. After all, if prices fall below what the buyer had agreed to pay for at delivery of the crops, that buyer will now be potentially in financial ruin.

This buyer may be the large food wholesaler who would be buying the farmer’s output after harvest anyway. Or he could be a purely speculative buyer, someone who’s willing to take a bet that months in the future, the price of the commodity might actually rise. For example, just when harvest time for corn comes, the buyer knows that people will suddenly develop an unrelenting appetite for popcorn, thereby increasing demand for corn in the market.

But since many buyers also want to retain financial flexibility, and since many of them are pure financial speculators who really have no intention of ending up with a harvest of corn at delivery date, they have set up the futures exchange where they can buy and sell these forward contacts with each other. In a futures exchange then, the prices for these forward contracts fluctuate depending on where market sentiment believes the price will be at upon delivery.

Many hedge fund managers have lately been interested in investing in the futures exchange. Why? Well, they mostly believe that demand for most commodities will be firm going into the future, given increasing consumption world-wide.

Other reasons are responsible for hedge fund managers’ current love affair for commodities. Stock prices worldwide are sluggish. The US dollar has been depreciating, with the depreciation eating into potential stock market profits . Investing in bonds are no good either if inflation is expected to be high, as inflation eats into the fixed income stream of bonds. So many fund managers are making an exodus out of traditional stock and bonds fare, and into commodities.

Many have gotten into commodity futures trading such that they have already dwarfed the true and eventual buyers of these commodities in the exchange – the food wholesalers – to a significant extent. In short, hedge fund managers are increasing the cost for these food wholesalers to buy the commodities on the exchange. These food wholesalers have to pass this added cost down onto the consumer eventually.

We can now see a very likely key ingredient of the recipe for today’s food crisis. Hedge fund managers as a group could be the single biggest, most powerful food hoarders the world has ever seen.

They are indeed powerful. Frequently, they are investing not just their own capital, but are in fact investing for the world’s largest pension funds, retirement funds, insurance firms, and wealthiest individuals. And they have been augmenting their investing power with leverage.

Previously, when hedge fund managers limited their investment to the stock market, we saw huge run-ups in stock prices. At the height of the tech bubble, for instance, we saw the price to earnings multiples of many tech stocks go into the hundreds. Price earnings multiple is the multiple that a company’s earning need to be multiplied to, to arrive at the price of the stock.

Given this scenario of high commodity prices, I will even venture into offering a new diabolic multiple. The price to hunger multiple. This might be the multiple whereby a certain commodity price level, where a scandalously large population of the world no longer can afford to buy food, and therefore go hungry, is multiplied to arrive at the price of the commodity.

In a bull market for stocks, a truly interested investor may end up having to buy stock at prices beyond the capability of the company’s level of earnings to earn that investor a return on his investment. In this bull market for commodities, people may have to buy food at prices where they will just end up going hungry. This is very scandalous and unforgivable in the most extreme.

What are we to do?

Why don’t food wholesalers buy the commodities directly from the farmers, by-passing the commodities exchange altogether, which is now possibly infested by too many parasitic hedge fund managers and other speculators of all sorts? Maybe some are already contemplating to. If commodity prices have indeed already been going to unreasonable levels.
Genuine food buyers, if this is indeed already the case, for the sake of the world’s poorest and hungriest, please act now!