Speculation and food prices

Large investment agencies
In the past decade large investment agencies have become active on agricultural futures markets. For them these investments are part of a diversification strategy of their investment portfolio. It enables them also to reduce inflation risk: if there is inflation, prices of agricultural goods will increase, and the real value of their investment is not eroded.

Index funds
An index fund bundles many small investments and aims to replicate the movements of an index of a specific financial market (the value of the investments is expressed as a ‘basket’ of commodities). The large investment agencies such as index funds that invest in agricultural futures markets are not interested in buying or selling actual, physical goods; they are interested in the value of their investment. Therefore, before the delivery date for the futures contract is due, they will terminate their contracts, or switch their obligations to the next futures contract. This is why they do not have an effect on the real markets. The fact is, you can make as many futures contracts as you wish, as long as there is a counterparty. The demand and supply of futures markets is therefore not the same as the demand and supply of agricultural products.

Price signal
Because the futures price is based on expectations about the future, the futures markets function as an important price signal for other investors and traders. There is discussion about the ability of large index funds to appraise the future correctly. If they do not, then they can give the wrong price signal through their buying or selling behaviour, which may lead to too high (or too low) futures prices. However, index funds can lose large sums of money if they wrongly predict future prices, and therefore it is in their interest to guess futures prices as accurately as possible.

In addition, several scientific analyses have been done, that draw opposing conclusions. Some analyses conclude that there is a relationship between large scale speculative investments and higher prices, while other do not find this to be true.

A much cited source is the compilation of literature by Markus Henn of WEED. He cites no fewer than 94 sources that, according to him, all conclude that speculation on futures markets has led to higher prices. This seems to be overwhelming evidence. However, it is easy to find fault with this source.

A number of source that Henn cites actually concludes the opposite. Many sources are not scientific, but are statements based on an opinion, not evidence. In addition, a number of quantitative (scientific) studies are of inferior quality.

This is the reason why LEI has compared the most prominent studies and reviewed their quality. The list includes a several non-scientific publications as well as a number of qualitative scientific analyses that have been evaluated on the logic of reasoning. The quantitative analysis were reviewed on the methodologies used.

Correlation confused with causality
The first is by confusing correlation (the large volume of speculation and high prices occur simultaneously) with causality (large volume of speculation leads to higher prices). This is the same as concluding that in an area with many storks and many babies, babies are therefore delivered by storks. In such a case, a third variable is often missing, that can explain both.

Causality not explained
The second is by doing a statistical analysis to show causality without a sound theory that explains that relationship. One can, for instance, show that Christmas cards cause Christmas. Without a clear theory how Christmas cards and Christmas are related, such an analysis has little use. The same applies to speculation and high prices: it is more evident that increasing prices lead to more investments in futures markets.

Speculation leads not by definition to long-term higher prices
LEI concludes on the basis of 25 studies, that the studies of best quality more often conclude that there is no link between speculation and higher prices. The studies that conclude the opposite are more often of less quality or very flawed.

The studies of best quality that conclude there is a link, state that speculation push up or down futures prices only a few hours or days, after which the market adjusts. This means that speculation can lead to more (small and short) volatility, but not, by definition to long-term higher prices.