Institutional commodity index speculators distort wheat futures markets, Senate panel reports

Large institutional specualtors that only buy indexes tied to wheat futures contracts on the Chicago Board of Trade and other exchanges distort the futures markets so that they ruin the price-hedging effectiveness of the futures contracts for farmers and food manufactures who use the markets to hedge their price risks, according to a report issued by the U.S. Senate’s Permanent Subcommitte on Investigations. The CBOT is owned by the Chicago Mercantile Exchange (CME).

Simply put, pension funds and hedge funds that only buy and never short the futures markets have increased the cost of foodstuffs for the whole world, and similar speculation has increased the cost of energy and probably the costs of metals and other commodities.

Call this the Jim Rogers effect, because his mutual funds and book, Hot Commodities (Random House, 2004, 252 pp.), convinced the institutional investors that they could hedge against inflation buy buying commodities.

From the 174-pp. report’s executive summary:

In the current investigation, the Subcommittee has examined how the activities of
many traders, in the aggregate, have constituted excessive speculation in the wheat
market. To prevent this type of excessive speculation, this Report recommends that the
CFTC phase out waivers and exemptions from position limits that were granted to
commodity index traders purchasing wheat contracts to help offset their sales of
speculative financial instruments tied to commodity indexes.

A commodity index, like an index for the stock market, such as the Dow Jones
Industrial Average or the S&P 500, is calculated according to the prices of selected
commodity futures contracts which make up the index. Commodity index traders sell
financial instruments whose values rise and fall in tune with the value of the commodity
index upon which they are based. Index traders sell these index instruments to hedge
funds, pension funds, other large institutions, and wealthy individuals who want to invest
or speculate in the commodity market without actually buying any commodities. To
offset their financial exposure to changes in commodity prices that make up the index and
the value of the index-related instruments they sell, index traders typically buy the futures
contracts on which the index-related instruments are based. It is through the purchase of
these futures contracts that commodity index traders directly affect the futures markets.

The Subcommittee investigation examined in detail how commodity index traders
affected the price of wheat contracts traded on the Chicago Mercantile Exchange. CFTC
data shows that, over the past three years, between one-third and one-half of all of the
outstanding wheat futures contracts purchased (“long open interest”) on the Chicago
exchange are the result of purchases by index traders offsetting part of their exposure to
commodity index instruments sold to third parties. The Subcommittee investigation
evaluated the impact that the many purchases made by index traders had on prices in the
Chicago wheat futures market. This Report finds that there is significant and persuasive
evidence to conclude that these commodity index traders, in the aggregate, were one of
the major causes of “unwarranted changes”—here, increases—in the price of wheat
futures contracts relative to the price of wheat in the cash market. The resulting unusual,
persistent, and large disparities between wheat futures and cash prices impaired the
ability of participants in the grain market to use the futures market to price their crops and
hedge their price risks over time, and therefore constituted an undue burden on interstate
commerce. Accordingly, the Report finds that the activities of commodity index traders,
in the aggregate, constituted “excessive speculation” in the wheat market under the
Commodity Exchange Act.

The futures market for a commodity provides potential buyers and sellers of the
commodity with prices for the delivery of that commodity at specified times in the future.
In contrast, the cash market provides potential buyers and sellers with the price for that
commodity if it is delivered immediately. Normally, the prices in the futures market
follow a predictable pattern with respect to the cash price for a commodity. Typically, as
a contract for future delivery of a commodity gets closer to the time when the commodity
is to be delivered under the contract (the expiration of the contract), the price of the
futures contract gets closer to the price of the commodity in the cash market. The prices
are said to “converge.” In recent years in the wheat market, however, the futures prices
for wheat have remained abnormally high compared to the cash prices for wheat, and the
relationship between the futures and cash prices for wheat has become unpredictable.
Oftentimes the price of wheat in the Chicago futures market has failed to converge with
the cash price as the futures contract neared expiration.

The result has been turmoil in the wheat markets. At a time when wheat farmers
were already being hit by soaring energy and fertilizer costs, the relatively high price of
wheat futures contracts compared to the cash price, together with the breakdown in the
relationship between the two prices and their failure to converge at contract expiration,
have severely impaired the ability of farmers and others in the grain business to use the
futures markets as a reliable guide to wheat prices and to manage price risks over time.
Participants in the grain industry have complained loudly about the soaring prices
and breakdowns in the market. “Anyone who tells you they’ve seen something like this
is a liar,” said an official of the Farmers Trading Company of South Dakota. An official
at cereal-maker Kellogg observed, “The costs for commodities including grains and
energy used to manufacture and distribute our products continues to increase
dramatically.” “I can’t honestly sit here and tell who is determining the price of grain,”
said one Illinois farmer, “I’ve lost confidence in the Chicago Board of Trade.” “I don’t
know how anyone goes about hedging in markets as volatile as this,” said the president of
MGP Ingredients which provides flour, wheat protein, and other grain products to food
producers. “These markets are behaving in ways we have never seen,” said a senior
official from Sara Lee. A grain elevator manager warned, “Eventually, those costs are
going to come out of the pockets of the American consumer.”

The inability of farmers, grain elevators, grain merchants, grain processors, grain
consumers, and others to use the futures market as a reliable guide to wheat prices and
manage their price risks over time has significantly aggravated their economic difficulties
and placed an undue burden on the grain industry as a whole.

This Report concludes there is significant and persuasive evidence that one of the
major reasons for the recent market problems is the unusually high level of speculation in
the Chicago wheat futures market due to purchases of futures contracts by index traders
offsetting sales of commodity index instruments. To diminish and prevent this type of
excessive speculation in the Chicago wheat futures market, the Report recommends that
the CFTC phase out existing exemptions and waivers that allow some index traders to
operate outside of the trading limits designed to prevent excessive speculation.

Click on the “futures markets” category below this post to see my previous blogs on institutional speculation in commodity futures.

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