Determinants of agricultural commodity prices
What are the true factors of commodity price fluctuations?
STSA Research Paper
September 2015
Remedy to high prices: Investment in agriculture
Executive summary
The price spikes in 2008 have awakened the political, economic and civil society actors’ interest in food
prices and in the functioning of the futures markets. The financialisation of the commodity markets has
largely been blamed for high prices. The purpose of this summary is to take a look at a relevant question on
this matter: Is the level of prices really too high?
There is a strong academic controversy today to determine whether the price level of soft commodities
such as rice, cereals, and meat is directly influenced by the financialisation of commodity markets or not.
Empirical evidences do not help to reach a clear conclusion considering the amount of studies with
opposite results. It is indisputable that the access to food is a fundamental right and a key concern for the
sustainable future growth of our planet and peace keeping. It is a main concern shared by commodity
traders, who play a critical role in rebalancing offer and demand and in organizing the access to
commodities where there is a lack of supply. Besides, and contrary to what could be expected, a closer
look at the prices for food on real terms shows that they have not been rising in the last 20 years and are at
the same or even lower level than in 19961.
Why food prices are trending higher
Price fluctuation is driven primarily by imbalances between demand and supply. The balance is precarious
and requires yearly a good crop, a good cultivation and a good harvest in both the northern as well as the
southern hemisphere. The slightest incident will automatically provoke a deficit or surplus situation that
can temporarily impact the level of prices. The steady supply of agricultural commodities and the level of
prices will therefore depend on climatic and political conditions. Short-term weather and policy impact can
trigger panic reactions to information on stock levels of agricultural commodities and harvest quality. This
might cause a domino effect in terms of extraction limitations and mass buying of some countries as seen
during the crisis in 2008. As for long-term trends of prices, there are different drivers to take into
consideration:
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Climate change contributing to more unpredictable weather patterns;
Growth of world population up to 8.9 billion demanding an increase in global agri-production by 70%
until 20502;
Demand pattern related to the economic development of emerging countries;
Rural-urban migration and changing consumption pattern;
Farmer shortage as a result of unattractive economic conditions;
Declining acreage creating some of the lowest stocks to use ratios;
Government intervention and distortion through mandates, export bans/quotas and stock building;
Lack of investment in farming particularly, in underdeveloped countries;
Inefficient use of already limited arable land;
Significant waste in agricultural products, with an estimated 30-40% of agricultural output, pre and
post-harvest are wasted.
Investments in farming and channeled resources so as to be most effective are beneficial to higher global
output, a role that cooperatives and trading houses already undertake. In Switzerland, commodities
traders deal with physical goods and are organizing the logistic chain. In a highly competitive market the
1L’AGEFI,
“Les chiffres et malentendus de l’agro et de l’alimentaire”, April 25-27, 2014
FAO, World Agriculture: towards 2030/2050, Interim Report, (2006)
2
trader assures the agricultural products' access, their transportation and the provisioning of processing
business clients. By pooling supply purchases, sales and handling and selling expenses, cooperatives and
traders can operate more efficiently than individual farmers and it allows higher productivity through joint
investments. The remuneration of the trader depends on shifted volumes, which confers a great value on
each commodity. Therefore they are interested in a good infrastructure to avoid waste that eventually
results in a net loss. The commodities sector and farmers require enormous investment to improve current
farming techniques and efficiency throughout the supply chain, which requires a minimum level of price.
Thus, higher prices provide incentives for farmers to increase acreage, investment, yields and overall
production. It results in an increase of the offer able to bring down the price through market efficiency.
Why does liquidity matter?
The financialisation of commodity markets has been cited as one of the causes for high prices in the 2000s
without actual proof that it is the origin of this trend. Anticipating future market price fluctuation is a
common and necessary transaction to take calculated risk, which brings liquidity to the agricultural
commodities market, thus contributes to decrease volatility. Commodity markets have always offered
opportunities for profits to those who have funds to invest. Historically, investment banks saw an
opportunity to enter the commodities market supported by the incentive policies of US authorities and to
benefit from the commodity supercycle driven by the appetite of the emerging countries. More recently,
those investment banks have realised that the profitability of their investment activities in commodity
trading is not sufficient to cover their increasing capital cost.
Financial markets for derivatives (Futures, OTC) allow for price discovery and transparency by bringing
together an unknown buyer and an unknown seller. Hedging serves as a form of securing operations and is
vital for producers, trading houses and feed and food processors to prevent themselves from huge
potential losses, in particular with regards to agricultural products that are harvested at a fix moment while
sales are extending over time. "A market of derivatives, where future purchase and selling agreement are
exchanged is even necessary, as it allows operators to protect themselves against the natural volatility of
the agri-markets.”3 Non-commercial participants taking a view on the market with little interest in the
physical commodity are extremely important as they provide liquidity. Low liquidity implies that
commercial market players cannot enter or leave the market quickly, which is often the cause for seasonal
price fluctuations. It also implicates that any buying and selling has a greater effect on the price. There are
in fact examples where extreme volatility occurs in markets with no or very little traded futures contracts,
such as onions, tomatoes, limes and rice. Limiting financial markets might affect liquidity and result in an
increase of price level and volatility rather than a decrease. With Dodd-Frank Act in the US, EU regulations
EMIR, MiFID, MAD/MAR and Swiss Financial Market Infrastructure Act (FMIA), the financial markets are
already highly regulated and offer an adequate level of transparency.
In conclusion, it is evident that prices are determined by the supply and demand of commodities and that it
is essential for a merchant to be able to secure its operations using the financial market. The
financialisation of commodity markets cannot be held responsible for rise in food prices as no empirical
evidences support such relations. The financial actors provide the markets with liquidity and thus create
transparency through efficient price discovery. Both liquidity and transparency are necessary for farmers to
protect themselves from price variations. We should rather focus today on investments in rural
developments and helping farmers to produce efficiently. At the same time it is crucial to fight against
waste of agricultural commodities. As stated by Olivier de Schutter, “the solution lies in supporting smallscale farmers’ knowledge and experimentation, and in raising incomes of smallholders so as to contribute
to rural development.”4 To achieve this objective, it is fundamental to ensure a fair price for agricultural
products, which is not the case today.
3
4
Olivier de Schutter, former United Nations Special Rapporteur on the right to food, “Il faut réglementer les marches”, Global+, (2012)
Olivier de Schutter, “Eco-Farming can double food production in 10 years, says new UN report”, March 8, 2011
Determinants of agricultural commodity prices
What are the true factors of commodity price fluctuations?
Abstract
Surging food prices between 2008 and 2012 have fuelled a fundamental debate in academia and research on
the development of food prices and the roots of their sharp fluctuations. The authors of this research paper
examine the drivers of commodity prices from a macro-economic perspective and take into consideration the
role of financial markets, whose players are suspected of contributing to price volatility. As outlined in this
research paper, however, supply and demand are the most important underlying data and hence factors such
as weather, consumer behaviour, government policies, geopolitical incidents and new technologies have a
dominant impact on agricultural commodity prices. The paper explains the vital function of financial markets
in providing liquidity to the market, which is a critical prerequisite for efficient commodity markets and price
stability. What is much more at stake is to increase investment in farming in order to face the challenges of a
growing world population.
This document was produced with the input of STSA members and under the supervision of Julia Giray and
Stéphane Graber ( STSA).
Keywords: food access, sustainability, price level and volatility, population growth, urbanization,
evolution of diet, waste of food, dependence on imports, climate changes, empirical evidence, demand
and supply imbalances, future markets, market efficiency, government intervention, market distortion.
Contents
Introduction ............................................................................................................................................1
Why did food prices soar between 2008 and 2012? ............................................................................. 2
Physical Trading Houses ...................................................................................................................... 10
Role of financial markets ..................................................................................................................... 10
Synthesis and Conclusion .................................................................................................................... 14
Glossary of Industry Terminology ....................................................................................................... 16
References ............................................................................................................................................ 17
Introduction
Access to food is a key concern for the sustainable future growth of our planet. All stakeholders have been
increasingly interested in monitoring food prices since the peaks reached in 2008. The financialisation of
commodity markets has been cited by certain stakeholders as one of the causes for high prices of food.
There has also been much focus on Switzerland as a trading hub and headquarters for numerous soft
trading companies and commodity trade-financing banks.
“[…] I readily admit that
speculation is not the primary
cause or final trend to higher or
lower prices.”
Olivier de Schutter, former UN Special
Rapporteur on the Right to Food,
Global + Alliance Sud, Hiver 2012-2013
There is a strong academic controversy today over determining
whether the price level of soft commodities such as rice, cereals
and meat is directly influenced by the financialisation of
commodity markets or not. Empirical evidence does not help
to reach a clear conclusion considering the amount of studies
with conflicting results. Financial actors can cause very short
(minutes, sometimes days) fluctuations in commodity prices.
These movements are of short duration, as they are offset by
speculators taking opposite positions.
It is now essential to understand the price mechanisms operating in commodities markets. What causes
the price of food to be volatile? What is the role played by commodity trading companies and the financial
industry in the current level of prices, and what could be the potential answers for improving the situation?
So far, we have to keep in mind that the global population is growing and the demand for food has
increased substantially, largely driven by the economic development of BRIC countries. An increase in
wealth and urbanisation is resulting in demand for greater choice and a more varied diet. In particular, an
increase in meat consumption is being witnessed. The wasting of food has also increased drastically.
The recent “Arab Spring” was partly stimulated by food riots occurring throughout the Middle East and
North Africa. This was due to some extent on these regions’ dependence on imports and limited domestic
production to fulfill their domestic needs. The price of agricultural commodities at this point in time had
reached extremely high levels, which prompted concern and investigation as to why these peaks occurred.
But it is not just an issue in developing countries, it is also concerns the EU and US, who also depend on
imports for various food commodities.
Furthermore, the increase in greenhouse gas emissions is raising the
earth’s temperature. The climate change has a significant impact on
agricultural output, particularly when the demand and supply
equilibrium is so fragile.
The commodities sector and farmers require enormous investment
to improve current farming techniques and efficiency throughout the
supply chain, which requires a minimum level of price.
In the past decade commodity prices have experienced some
extreme volatility and reached new heights in certain cases. This has
resulted in much publicity focusing on the functioning of futures
markets. The futures markets allow for price discovery and
transparency, bringing together buyers and sellers to converge on a
price. There is little if any evidence that futures markets are
“In fact, there is little
empirical evidence that
investors cause more than
fleeting distortions to
commodity prices. The most
persuasive explanation for
the rises and falls of
commodities is demand and
supply.”
“Dr Evil, or drivel?” (2010), The
Economist
1
responsible for the level of prices. On the contrary, the majority of studies show the benefit of futures
markets in the improvement of market efficiency.
In conclusion, high prices are the result of underlying problems throughout the supply chain and
imbalances between demand and supply, as opposed to financial institutions driving prices higher.
Government intervention is also distorting markets, causing artificially induced price swings. The
misconception that paper markets and their actors are the cause for the high prices in commodities should
be corrected. As shown in the table below, prices are mainly determined by supply and demand.
2
Why did food prices soar between 2008 and 2012?
Since 2007, the world has seen three surges in food prices, which most analysts, policy makers and industry
executives mark as under-investment and climate change affecting global supply, alongside the demand
growth factors already mentioned5.
We saw a food crisis in 2007-8 with riots in Senegal and
Haiti, partly because large rice exporters placed bans and
hoarded important staple foodstuffs. In 2010-11 we saw a
failed crop in Russia, Ukraine and Kazakhstan after a
drought and fires, a region which ordinarily provides a
third of global wheat exports. This was followed by an
export ban by Russia causing wheat prices to spike. As a
consequence chaos erupted in the Middle-East, the
world’s largest importer of wheat.
Considering an historical perspective,
food prices are much less expensive
than 100 years before; prices have
been decreased by 50% during the last
110 years.
Economiesuisse, « Commerce des matières
premières agricoles : malédiction ou
bénédiction ? » (2013)
In 2012 the US experienced the worst drought since 1956, with a failed crop (production down at least 13%)
and high prices around the $330/Metric Ton mark. Wheat prices also soared as Russia and Ukraine
experienced crop failures again. These extreme price moves, therefore, are mainly explained by short
term weather and policy impacts.
However, when we consider the long term trend of food prices we can see that in the 20 years up to 2001,
the real cost of food has been steadily decreasing and is today cheaper in real terms than it was in 1980
(see The Economist food index graph).
“In the 20 years up to 2001, the real cost of food has been steadily decreasing”
5Javier
Blas and Gregory Meyer, “Crops lead the field for commodities,” Financial Times, February 1, 2013
3
Impact of climate change
It is very clear that in the last 20 years there have been more frequent weather events that have impacted
the global supply of agricultural commodities. Climate change appears to be contributing to more
unpredictable weather patterns that can translate into more volatile markets. After the heavy drought in
the USA in 2012, the export pace of the largest exporter of corn fell by almost 50% for the season 2012/13
according to the US Department of Agriculture (USDA) 6. The removal of such a vast amount of corn from
world supply, coupled with an increase in global demand, prices had to rise. Russia has been experiencing
poor crop years that have contributed too high wheat prices, especially as the Black Sea region is also
increasing its output of corn each year. It is expected that due to global warming the corn harvest might
decrease from 3 to 5% in the long term7.
Growth of world population & new consumption patterns
World population is projected to grow from 6.1 billion in 2000 to
8.9 billion in 2050 according to a study carried out by United Nations
Department of Economic and Social Affairs/Population Division. This
increases the demand for food enormously, and to fulfil the needs
of this population we have to increase our production. The Food and
Agriculture Organization of the United Nations (FAO) estimates
that agricultural production needs to increase by 70% by 20508.
“The world will have to
produce as much food in the
next 40 years as it has
produced in the last 8,000”
Jason Clay, Senior VP, WWF
Urbanization and the distribution of wealth across the globe are quickly changing, and this has had a huge
effect on the commodities markets due to changing demand in dietary requirements. The demand for
meat and protein-based diets has increased dramatically over the last 30 years. Growing demand for meat
requires ever greater amounts of animal feed, which in turn creates more demand for oilseeds-derived
feed and grains. Currently 40% of world grain production is used for animal feed, with that proportion set
to grow as meat features more prominently in diets. The UN estimates that the meat consumption should
increase from 37.4kg per inhabitant to 52kg by 2050, so that by middle of the 21st century half of the world
grain production would be used for animal feed.
“The global commodity super cycle over much of the past decade was largely thanks to China’s
extraordinary boom (…)”
Jamil Andilini, “Hidden benefits of China’s slower growth,” Financial Times, April 18, 2013
6USDA,
“Feed grains: U.S. quarterly supply and disappearances,”(2013)
et al., “Climate Trends and Global Crop Production Since 1980,” (2011), Sciencemag
8FAO, “World Agriculture: towards 2030/2050,” (2012)
7Lobell
4
As an example, the increasing demand for meat in China can be seen through their huge imports of beans
over the last 10 years9.
China Beans import
40000
35000
30000
000's MT
25000
20000
15000
10000
5000
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
0
Source: USDA
“By the middle of the 21st century half of the world grain production
would be used for animal feed”
In short, food production will need to double from current levels over the next 40 years to meet the
demand. Put another way, the world will need to produce as much food during the next 4 decades as has
been produced during the last 8,000 years (WWF).
However, we are not increasing our food production proportionately to the population growth rate. We
can see that in the USA alone, one of the most important exporters of agricultural commodities, where a
decreasing acreage has been planned for the 8 major crops over the last 30 years.
Figure above: US planted acreage of 8 major crops10
“A decreasing acreage has been planned for the 8 major crops over the
last 30 years”
9FAO,
“World Agriculture: towards 2030/2050,” (2012)
“USDA Long-term projections,” (2012)
10USDA,
5
Arable Land
The FAO as well as Oxfam anticipate that about two thirds of current arable land will become
unproductive by 2025, which will result in a price increase of 50 to 90% 11.
It must also be noted that the availability of new arable land is limited and investment into
underdeveloped land is currently lacking. There are vast swathes of land that are producing inefficiently,
that could increase global output enormously. This is mainly seen throughout the developing world where
farmers have little access to high yielding crop varieties, public rural infrastructures, and credit facilities,
insurance against meteorological risks, education and training.
Waste
The lack in efficiency of the supply chain is also
evident by the mountain of waste produced by
humans. This wastage implies that there is surplus
available. It is estimated that 30-40% of agricultural
output, pre and post-harvest are wasted.
“Worldwide, it is estimated that about onethird of food produced – worth around USD 1
trillion, gets lost or wasted each year.“
FAO (Food and Agriculture Organization)
In developed countries the waste occurs with the consumer or at a retail level. Contrastingly, the waste in
developing countries occurs post-harvest or in the processing stages due to storage, transportation and
harvesting limitations. This amasses to 1.3 billion tons per annum of food produced for human
consumption that is wasted12. Waste of food is also waste of energy and water used to produce the food.
Investment and education are critical factors and would allow for improved production techniques,
efficiency and distribution of this surplus.
“In a world of 7 billion people, set to grow to 9 billion by 2050, wasting food makes no sense –
economically, environmentally and ethically .“
Achim Steiner, Executive Director, UNEP
Importance of stocks
Coupled with increasing demand, declining acreage has created some of the lowest stocks to use ratios
we have experienced. Any negative effect on supply will have a more amplified effect on prices, evident
through increased volatility over recent years where stock to use ratios have been at their lowest. We can
clearly see the relationship between stocks to use ratio and price in the graphs for wheat.
11Economiesuisse,
12FAO,
«Commerce des matières premières agricoles :malédiction ou bénédiction ?, » (2013)
“Global Food Losses And Food Waste,” (2011)
6
Figure above: We can see when Stocks to Use ratio is at its lowest prices spike
Holding stocks is a necessity for agricultural commodities that are harvested only once, sometimes twice
a year. Whereas oil or minerals may be extracted at any time of the year, agricultural commodities are
characterized by seasonal production. The commodity then has to be stored, at a cost, for the rest of the
year to allow gradual consumption.
Low stocks-to-use ratios might imply that there is a shortage of storage capacity or a shortage of
commodities in current storage facilities. Thus it may seem appropriate to build more storage facilities
and to build up stocks under the condition to be efficiently managed by reducing spillage and
contamination of agricultural commodities. However, this is seldom the case and often governments
control large stocks with little transparency. This allows for hoarding for domestic food security. As a
consequence, it can distort markets with unpredictable stock releases and unknown quantities sheltered
from public knowledge, currently a problem in many parts of the world.
When there is surplus production, it is essential to store it so that in years of deficit global demand can be
fulfilled, with minimum price distortion. Currently commodity trade fulfils this function, responding to
market signals by storing commodities when prices, and therefore demand, are low relative to availability.
Conversely, the trade also advances the sale of commodities at times when prices, and therefore demand,
are high. Lack of transparency, an accusation often levelled at the trade, is a problem that governments
can play a key role to alleviate. If all governments declared their stocks, whether strategic or not, then
price distortions would not be so large and so unpredictable. Market rumors are often the cause for price
swings and create uncertainty. With greater transparency these rumors have less impact than in a market
where secrecy may be prevalent. Some stocks may be undocumented in a country due to genuine lack of
knowledge as opposed to deliberate secrecy. Many governments are not well enough informed to reach
accurate supply and demand forecasts, seen especially across Africa and Asia. Developing an international
database of supply and demand estimates would be highly beneficial to producing less distorted markets.
Government intervention in markets
One of the most distorting effects on a market can be government intervention, through mandates,
export bans/quotas and stock building. The mandating of biofuel production, to which the industry had to
respond, is a controversial topic. Between 1980 and 2011 US corn used for biofuel has risen from 1% to 37%.
By 2022 the aim is to increase ethanol production from 9 billion gallons to 36 billion gallons (from 34 billion
7
liters to 136 billion liters). This policy alone affects acreage planted, livestock farming, domestic demand,
crop allocation, export volumes and prices, with the US having such a large market share of world corn
trade.
In Brazil sugar cane is used to produce ethanol, diverting around 50% of food into energy production.
Biodiesel, which is mandated in Europe, diverts the flow of oilseed production into energy. The production
of oilseeds in Europe alone for the use in biodiesel displaces a vast quantity of wheat, corn and barley that
could be used for human consumption. 70% of all European rapeseed goes into biodiesel. The public
policies on biofuels should however emphasize the production of second – and third - generation
biofuels, which are not produced from food-grade agricultural commodities but from waste products
resulting from their use.
"It is the extraordinary distortion of global trade, where the West spends $360 billion a year on
protecting its agriculture with a network of subsidies and tariffs that costs developing countries
about US$50 billion in potential lost agricultural exports. Fifty billion dollars is the equivalent of
today's level of development assistance."
Mark Malloch Brown, former Head of the United Nations Development Program
Governments also buy excess supply that is produced to support prices for local farmers. This is evident in
the cotton market in China where the government currently has reportedly over 10 million tons of cotton
stockpiled. Governments may do this to keep farmers content with a steady income, especially where rural
populations are a big percentage of the total. It can also be seen that governments will ban exports
altogether. This can remove a large proportion of goods from world supply and so create a price spike.
Subsidies and artificial incentives have caused long-term damages to the agricultural sector throughout
the globe. Indeed it is often argued that the interventionist European and US agricultural policies of the
80s and 90s, which stimulated production through subsidies, caused dumping of sub-production cost
surpluses onto the world market. This artificially depressed price signal was a material factor in
discouraging the development of the agricultural sector in developing countries that today are so
dependent on imports.
High food prices trigger public outcry and finger pointing of the culprits. It is often the case that farmers
are heavily subsidised by government capital. Without these subsidies, food prices would be much higher
and so the consumer would pay the price through inflated food prices as opposed to taxes. Subsidies
should be awarded to farmers who are producing food on land which makes economic sense. To
subsidise farmers who are battling to produce crops on less productive land, or where costs of production
are higher, is unsustainable. The resources need to be channelled so as to be most effective, a role that
cooperatives and trading houses already undertake.
Economic factors in producing countries have also to be considered. This is currently the case in Argentina
and Brazil where local inflation and currency swings have an impact on world prices of food commodities.
These additional costs have to be absorbed by the market.
Investing in farming
Farming has lost its attractiveness as farmers have to contend with increasing production costs through
growing labour and energy costs. There is an increased use of fertilisers and pesticides to improve yields
which further adds to their input costs. Even countries like China have seen increased labour costs, with a
22% average rise in 2011. The depreciation of the dollar in the last decade has also contributed to rising
8
prices. The lack of investment in food production has limited the efficiency of the supply chain from
production through to distribution. The required investment over the coming decades is essential to
ensure that farmers generate significant yield growth. In addition processing methodologies and systems
must extract more nutrients and value from their raw materials, and significant expansion of logistics
capabilities will be required to upgrade or put in place adequate infrastructure to ensure efficient
distribution. The lack of investment for a career in farming also causes decreases in acreage.
Since 1950, an area the size of Texas plus Oklahoma (or an area almost as large as France plus Great Britain)
has been taken out of agricultural production in the United States. One reason for this decrease in acreage
can partly be attributed to the lack of incentives for a career in farming. Younger generations have
increasingly become attracted to city life with the prospects of higher income. Farmers have seen their
profits slowly squeezed as the consumer demands more for less and their input costs increase. In China
this is becoming a huge concern as people flock to the cities, leaving an ageing rural population to feed the
nation. The rural labour force will decline and China’s import demand will have to increase as a
consequence.
For farmers to really develop their practices to maximize production, governments need to offer more
funding into research organizations. Many farmers are stuck in old techniques or simply do not have
access to modern methods. The International Rice Research Institute (IRRI), which does receive
government funding, has managed to develop thousands of strains of rice through genetic engineering.
These different strains of rice have been designed to elicit optimal production under certain environmental
conditions. Many of the varieties are pest resistant and moreover grow with a lower water requirement.
Provided that it is scientifically proven to be safe for the consumer and the environment, more farmers
should have access to these new varieties of rice that have been engineered for improved yields and lower
input costs, allowing for an increased production. Many development programs are currently run by
commodity trading companies. These have not been launched for philanthropic reasons but for increased
long term production and inherent increased profits for both the farmer and the trading houses.
Development has to be sustainable so that investment is driving increased production, lower input costs
etc., and this as a consequence gives the farmer a better quality of life.
High prices provide the incentive for farmers to increase acreage, investment, yields and overall
production. Low prices, on the other hand, exacerbate the negative perception of farming stemming
from the farmers’ poor living conditions. They put at risk the long-term stability of supply in agricultural
products. In Côte d’Ivoire, a country that provides almost 40% of the world’s cocoa 13, next generations of
cocoa smallholders migrate to cities in search of a better livelihood. This is mostly due to low levels of land
ownership, which ultimately lead to less investment in farming. Higher prices are consequently necessary
to improve the attractiveness of farming. The price is what gives the farmer the planting signal to increase
productivity. Once farmers plant more and supply increases, only then can prices come down through
market efficiency.
13IFC,
“Using Market Insights to Improve local supply chains: The Case of Cocoa Smallholders in Côte d’Ivoire,” (2014)
9
Physical Trading Houses
Merchants
Commodity trading houses play an essential role between producers and consumers, buying goods at the
place of production, storing and processing them if necessary and then shipping and delivering the goods
to users. The trading houses generate added economic value in exporting and importing countries by
efficiently matching supply and demand.
As a physical trading house the primary concern is to move commodities from areas of surplus to areas of
deficit. As a merchant and global service provider of raw commodities, commodity trading houses operate
in extremely competitive markets. The primary aim is to source from an origin that is cheapest at any one
time, ship the goods, and then give the most competitive price to the consumer. Accessing the raw
material could mean sourcing from thousands of small holder farmers. This is where the role of a
cooperative is important in both delivering a marketable product and maximising profits. By pooling supply
purchases, sales, and handling and selling expenses, cooperatives can operate more efficiently - at lower
costs per unit - than farmers can individually. Investment is often very expensive for the individual farmer
but creating cooperatives allow a group to invest together, thereby increasing productivity and
efficiency.
Role of financial markets
Hedging for securing operations
The actors in derivatives markets are both commercial and non-commercial. The commercials are looking
to hedge any physical position they may be taking on the market, whereas the non-commercials are taking
a view on the market with little interest in the physical commodity. As such, they are speculating but play a
critical role serving as counterparty for commercial players.
Without the ability to hedge, it would be almost impossible to exist as physical actors (traders, industrial
companies, producers, and farmers) as commodity traders and merchants would potentially be exposing
themselves to huge losses. An example of a hedge would be a farmer producing a large volume of wheat
with the concern that the price may fall in the coming months before harvest and so wishes to lock in the
current price. In order to protect himself from a falling market, he sells futures (making him short futures).
This implies that if the price of wheat was to fall he would be able to buy back those futures at the time of
harvest at a profit offsetting the lower price he will receive for his actual wheat. Some organisations, such
as the World Food Programme, cannot hedge against rising commodity prices. In 2008 the WFP suffered
$920 million in extra cost from the inflated commodity prices. If these losses were incurred by trading
houses many would not survive.
“ Hedging helps the economy function by allowing commodities producers and consumers to
conduct their businesses with greater certainty over how much they can expect to earn from
and pay for commodities.“
CFTC (Commodities Futures Trading Commissions)
10
Financialisation of commodity markets
The financial markets play a crucial role in the determination of
the right price considering continuous adjustment of offer and
demand. It allows for the discovery of a price, by bringing
together an unknown buyer and an unknown seller. The buyer
puts in a bid and the seller places an offer and there is no trade
unless the two converge at the same bid-ask price. When a seller
enters the market he will want as high a price as possible, and a
buyer will want as low a price as possible. Price discovery is the
continuous process by which the futures market is constantly
reassessed as new information becomes available. Expectations
change from both public and private information made available
to participants. The participants will alter their market behaviour
and thus through their transactions, information leads to a
realised price. Prices are signals; they indicate how scarce or
abundant a given product in a given market currently is.
“A market of derivatives, where
future purchase and sale
agreements are exchanged, is
even necessary, as it allows
operators to protect themselves
against the natural volatility of
the agriculture markets.”
Olivier de Schutter, United
Nations Special Rapporteur on
the right to food, Global+
alliance sud, Hiver 2012-2013
Commodity markets have always offered opportunities for profits to those who have funds to invest.
Historically, investment banks saw an opportunity to enter into commodities markets supported by
incentive policies of US authorities. « Financialization » means the trend to extending existing financial
derivatives, like futures and options, to commodities, and the concomitant greater presence of financial
investors in commodity markets. In the 2000s, the financialisation of commodity markets has been
accelerated, investment banks seeing an opportunity to diversify portfolio risks and to benefit from the
commodity super cycle driven by the appetite of emerging countries led by China. This has led to a
significant rise in the number of transactions in agricultural commodity derivatives markets. Over the same
period, basic foodstuffs became more expensive and price spikes more frequent. As a result, speculative
activities have been cited as one of the causes for high prices in the 2000s without actual proof that they
are the origin of this trend. More recently, however, banks have realised that the profitability of their
investment activities in commodity markets is not sufficient to cover their increasing capital costs and one
after another are withdrawing from the sector. This reduces the liquidity of these markets and with it the
space for commercial participants to operate in this market. Small trading companies particularly suffer
from this withdrawal of liquidity provider.
Liquidity
Liquidity is a key element to ensure efficient markets by allowing
sellers to find buyers and vice-versa. Non-commercial participants
are extremely important players in these markets as they provide
liquidity. This liquidity is available for commercial participants to
hedge their physical positions and for producers to price. The
non-commercials will take a view on the market and will buy or
sell futures in the hope that the price moves as they had
“Dr Evil, or drivel?,” (2010),
foreseen. It is often thought that funds will only take long
The Economist
positions on the market, but they will also take short positions as
experienced in the sugar markets, for example. With low liquidity,
commercial market players cannot enter or leave the market quickly and it often results in seasonal price
fluctuations. Low liquidity also means that any buying and selling has a greater effect on the price, which is
not what is wanted in any market. For effective price discovery high liquidity is required. As their activity is
“Now the benefits that investors
bring – the liquidity and price
information that make for
efficient markets – barely get a
hearing.”
11
limited to futures market, the non-commercials cannot create sustained high prices. They are not likely to
take physical delivery of commodities and do not remove them from the supply chain. They can only affect
short term increases, which will eventually drop to reflect the fundamental situation in the long term.
Derivatives
The IFC permits its clients the use of financial derivative products strictly for hedging interest rate risk,
exchange rate risk and commodity risk exposure. This allows businesses in emerging markets to access the
international derivatives market in order to manage their risk exposure. In Mexico, for example, the
government finances derivative purchases by farmers, giving them the upside if prices increase, thus
reducing default risk. A similar strategy is being programmed for the cotton industry to enable mills to
benefit from the downside if prices fall. The problem so far has been that no one wants to pay for the
options premiums. However the default risk in cotton is tremendous, trades and merchants have taken
huge losses and the only "risk management tool" currently used by the mills is to sell in the spot market.
This creates a problem for retailers: they cannot now buy their clothes or garments 1 or 2 years forward
because mills also no longer sell forward, being unable to secure their cotton supply without exposure to
too much risk.
Credit lines
The banking sector that surrounds the commodity industry is extremely important as the most cost
effective method of transporting commodities, though economies of scale, is in large quantities. Trade
financing banks provide credit lines that increase the working capital and that enable the purchase and
transportation of the physical cargo by the trading company.
Volatility
Although volatility in the markets has been extremely high in
recent years, this is not due to any single sector or players.
If we consider price evolution of various commodities (namely
wheat, rice and corn) between 1960 and 2010, volatility appears
lower today than in the past. “Price fluctuation observed 20
years ago cannot be attributed to deregulated financial markets
as those were nothing comparable as of today.”14
“Commodities markets have
always been volatile […] Indeed,
the OECD found a “consistent
tendency” for greater volume of
index-fund trading to sit
alongside declining volatility.”
“Dr Evil, or drivel?,” (2010), The
Moreover examples exist where extreme volatility occurs in
Economist
markets with no futures contracts at all, such as onions (see the
figure below). The trading of futures for onions was banned in 1958 when growers were convinced that
14Economiesuisse,
«Commerce des matières premières agricoles : malédiction ou bénédiction ?, » (2013)
12
futures traders were depressing the price of onions. In fact it seems that onions are one of the most
volatile markets with a recorded price swing in 2006-2007 of 400% when bad weather diminished the crop.
The high price gave farmers the signal to plant more onions and the price crashed the following March 96%,
but again rose 300% this year. We can see from the graph comparing volatility of onions and oil that onions
are far more erratic than oil, the most widely exchange traded commodity.
In 2007 the rice market, with very little traded futures contracts, saw prices triple as governments hoarded
as much rice as possible, often paying above market price. They also placed export restrictions onto the
world market, in an attempt to secure food supply for consumers domestically. Although this may have
maintained low domestic prices, the world prices soared higher and faster than in the 1973-75 food crisis.
Even though there is no liquid futures market the price for rice has steadily increased since 2000, similar to
other commodities. The volume of rice traded by funds on the futures exchange in Chicago accounts for 1%
of all rice traded globally. There are spikes still evident, which cannot be attributed to financial investors
rallying/squeezing the market upwards. It is also true that the volume of rice traded internationally (30
million metric tons) is tiny in comparison to the total volumes consumed (700 million metric tons).
Furthermore, when the volume of rice produced and consumed globally is considered, it is easy to
determine that the limited futures market has no bearing on the price of rice at all; instead, it is
influenced by physical supply and demand. The only futures market for rice is a US rice contract and most
rice traded is exported from Thailand, Vietnam, India, and Pakistan with increasingly more from South
America. The rice market, with its low liquidity, sees prices seasonally fluctuate, dropping during harvest
and increasing as stocks deplete. The biggest spikes in the rice market occur when there are crop failures
or governments subsidise farmers, buying rice above export market price. Thailand is normally the largest
exporter of rice. However, due to government subsidies Thai rice was trading at a $100 premium to Indian
rice, so India became the largest exporter of the product. This supports the theory that traders will choose
the cheapest origin to bring the most competitive price to the consumer.
Above: Bloomberg chart on rice prices between 1992 and 2011
When commodity trading houses and financial investors are targeted for inducing higher food prices, it is
interesting to see the breakdown of one dollar of food to the end consumer. The raw material typically
accounts for only 18 cents of every 1 dollar spent on the final product. 40% of the final cost is on labor, 10% is
packaging and 5% is transportation. Then throughout the whole supply chain of that 1 dollar only 4.5 cents
is made into profits for all participants. It is therefore far from clear that the cost or price of the
“commodity” has significant bearing on the cost to the consumer of the finished or packaged food.
13
Synthesis and Conclusion
Switzerland plays host to a large number of commodity trading houses that move raw materials around
the world, thanks to globally recognised expertise in logistics, financing of trade and risk management.
As a country, very few of the traded goods pass through Switzerland, the business being by nature very
global. This would be the same if the products were traded from anywhere in the world. Moreover these
companies are not solely based in Switzerland and tend to be settled all over the world. Other trading
hubs, such as London, Chicago, Dubai and Singapore play host to an enormous number of commodity
trading houses, some not being present in Switzerland. A global approach is therefore required in order to
understand and address issues related to commodity trading.
The world population is growing fast and the demand for meat and protein-based diets has increased
dramatically over the last 30 years. In short, food production will need to double from current levels over
the next 40 years to meet the demand. The world will need to produce as much food during the next 4
decades as has been produced during the last 8,000 years
It is very clear that in the last 20 years there have been more frequent weather events that have impacted
global supply of agricultural commodities. The consequences of global warming include melting glaciers,
more precipitation, more and more extreme weather events, and shifting seasons. The accelerating pace
of climate change, combined with global population and income growth, threatens food security
everywhere.
The physical trading house’s primary concern is to move commodities from surplus to deficit, operating in
extremely competitive markets. Banks offer financing to multinational trading houses, allowing them to
move large quantities of raw material across the globe in a cost effective way.
Financial markets allow for the discovery of a price, by bringing together an unknown buyer and an
unknown seller. Price discovery is the continuous process by which the futures market is constantly
reassessed as new information becomes available. Effective price discovery needs high liquidity.
The futures markets allow merchants to hedge themselves against flat price exposure. Without the ability
to hedge, it would be almost impossible to exist as a physical trading company as commodity traders and
merchants would potentially be exposing themselves to huge losses. Limiting financial markets might
affect liquidity and result in an increase of price level and volatility rather than a decrease.
“Commodity futures have become an integral part of food markets, and they perform an
important role for many market participants. Adequate regulation should improve, not ban,
speculative trading in order to foster market performance.”
FAO, “Price surges in food markets: how should organized futures markets be organized?” (2010)
Government intervention and policy makers distort markets through mandates, export bans/quotas and
stock building. Coupled with increasing demand, declining acreage has created some of the lowest stocks
to use ratios we have experienced. It is of great importance to support the WTO in fighting export bans
and technical barriers to trade and enforcing export duties in order to avoid market disruption.
In conclusion, it is evident that prices are determined by the supply and demand of commodities and that
it is essential for a merchant to be able to secure its operations using the financial market. The price
increase is mainly driven by the constant increase of demand, climate change, the huge waste of food (1.3
14
billion tons per annum) and the limited new arable land. The financialisation of commodity markets cannot
be held responsible for increase in food prices as no empirical evidences supports such claims.
Investing into underdeveloped land and helping farmers produce more efficiently would increase global
output enormously. It is essential for farmers to have a decent reward of their work to prevent them from
quitting agriculture for the cities. Since mostly male members of farming household move to urban areas,
women play an increasingly important role in agriculture. Empowering women through education, modern
technologies and credit is therefore crucial for the future of agriculture. Higher prices provide incentives
for farmers to increase acreage, investment, yields and overall production. Once farmers plant more and
supply increases, prices can come down through market efficiency. As stated by Olivier de Schutter, “the
solution lies in supporting small-scale farmers’ knowledge and experimentation, and in raising incomes of
smallholders so as to contribute to rural development” 15.
“But increasing food production to meet future needs, while necessary, is not sufficient. It will
not allow significant progress in combating hunger and malnutrition if it is not combined with
higher incomes and improved livelihoods for the poorest –particularly small-scale farmers in
developing countries.”
Olivier de Schutter, former United Nations Special Rapporteur on the right to food (2008-2014)
15Olivier
de Schutter, “Eco-Farming can double food production in 10 Years, says new UN report,” (2011)
15
Glossary of Industry Terminology
Commercial participant: A classification used by the Commodity Futures Trading Commission (CFTC) to
describe traders that use the futures market primarily to hedge their business activities 16
Derivative: A contract/security, whose price is dependent on or derived from the value of the
commodity/underlying asset.
IFC: International Finance Corporation, belongs to the World Bank Group
Inflation: The rate at which the general level of prices for goods and services is rising, and, subsequently,
purchasing power is falling. As inflation rises, $1 will buy less of any product.
Merchant: A buyer and a seller of commodities with the intention to make profit.
Liquid Market: A market in which buying and selling can be accomplished with minimal effect on price.
Long: Purchase of a commodity and store it, with the expectation of a rise in prices, before making afinal
sale.
Non-commercial participant: People who have no interest in ever holding the physical commodity, only the
futures contracts, and profit from their price change.
Stocks to use ratios: They are calculated by dividing the total annual consumption by the end stocks for a
given year. The stocks to use ratio indicates the level of carryover stock for any given commodity as a
percentage of the total demand or use.
Short: Implies a sale has been made without purchasing the commodity yet. This occurs when prices are
expected to fall in the future at time of delivery.
16Investopedia,
“Commercial Trader”
16
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