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

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 The Profitability of I llinois Agriculture: Profitability at a Crossroads

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- Investors only returns from a basket of commodities $ – Pension funds and institutional π investors Popular Indexes Swap – GSCI Dealer – Dow Jones-AIG – Reuters/ Jeffries-CRB $ π $ Investment Types – OTC index funds – Exchange-traded funds Long Index – Exchange-traded notes Futures Positions 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 of 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 “…for every long there is a short, for everyone who thinks the games price is going up there is  If long positions of index funds someone who thinks it is going are new “demand” then the down, and for everyone who short positions for the same trades with the flow of the contracts are new “supply” ? market, there is someone trading against it.”  With equally informed market participants, there is no limit to the number of futures contracts that can be created Tom Hieronymus at a given price level 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 Ending Stocks as a Percent of Use, 2001/02- 2007/08 Inventory 40 Increase 35 Ending Stocks/Use (%) S 30 25 P B 20 15 10 P E 5 0 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 Corn Soybeans Wheat “So my challenge to people who D say there’s an oil bubble is this: let’s get physical. Tell me where Q you think the excess supply of crude is going.” 2 0 0 9 I llinois Farm Econom ics Sum m it

I nconsistent Fact # 2 : Speculation w as not Excessive Com pared to Hedging ( 2 0 0 6 :I -2 0 0 8 :I Averages) Long Short Long Short Hedging Hedging Speculation Speculation Corn ---# of contracts--- 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 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 ) 200% Jan 2006 - Apr 2008 Change (%) 150% 100% 50% 0% Soybean Oil CBOT Wheat Live Cattle Feeder Cattle Lean Hogs Corn Soybeans KCBT Wheat Cotton -50% 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 35% 800 CIT % Open Interest (left scale) 30% 700 Cents/Bushel 25% 600 20% 500 15% 400 10% 300 5% 200 Futures Price (right scale) 0% 100 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 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 35% 1800 CIT % Open Interest (left scale) 30% 1600 25% 1400 Cents/Bushel 20% 1200 15% 1000 10% 800 Futures Price (right scale) 5% 600 0% 400 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 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 60% 1400 CIT % Open Interest (left scale) 50% 1200 40% 1000 Cents/Bushel 30% 800 20% 600 10% 400 Futures Price (right scale) 0% 200 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 2 0 0 9 I llinois Farm Econom ics Sum m it

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

I m plications  High price volatility may Harvest Delivery Forward Basis for Corn in South limit the forward Central Illinois, 2003-2009 contracting opportunities Date 0 offered by grain 1/1 2/1 3/1 4/1 5/1 6/1 7/1 8/1 -10 merchandisers 2003-2007 Average -20  Shorter time horizons Cents/Bushel -30  Weak basis levels 2009 -40  More erratic basis -50 2008 behavior -60 -70 -80 2 0 0 9 I llinois Farm Econom ics Sum m it

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 70 y = Change in Basis (cents/bu.) 60 Dec 2001- Dec 2005 y = -0.87x - 0.61 50 R 2 = 0.87 40 30 20 10 0 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 -10 Mar 2006-May 2008 -20 y = -0.62x - 6.63 -30 R 2 = 0.28 -40 x = Initial Basis (cents/bu.) Note: September 2005 observations omitted 2 0 0 9 I llinois Farm Econom ics Sum m it

Alternatives to Forw ard Contracting  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 2 0 0 9 I llinois Farm Econom ics Sum m it