Hot Commodities, Stuffed Markets, and Empty Bellies -- Finance Industry Fuels the Food Crisis

By Ben Collins, Dollars and Sense. Posted August 12, 2008.

Since 2003, prices of basic agricultural commodities such as corn, wheat, soybeans, and rice have skyrocketed worldwide, threatening to further impoverish hundreds of millions of the world's poor.

Shifts in fundamental supply and demand factors for food grains have undoubtedly contributed to higher food prices. Prominent among these shifts are the increasing diversion of food crops for biofuel production in the United States and Europe; sustained drought and water scarcity in Australia's wheat-growing regions; flooding in the U.S. grain belt; rising prices for oil and fertilizer worldwide; and the adoption of European and American meat-rich diets by the growing middle classes throughout Asia.

On top of these recent developments, long-term threats to worldwide agricultural output have eroded the world food system's resilience in the face of changing supply and demand. Although decades in the making, a loss of agricultural capacity worldwide caused by soil depletion, climate change, water scarcity, and urbanization has begun to take its toll on food production. Moreover, half a century of import restrictions and cheap agricultural exports by wealthy countries has devastated domestic food production capacity in poorer countries, forcing many countries that were once self-sufficient to rely on imported food from the world market.

At the same time, however, the growing presence of buy-and-hold investors in commodity markets has prompted heated debate among commodity traders, economists, and politicians over other possible causes of higher commodity prices apart from supply and demand shifts. Since 2001, the declining value of the U.S. dollar, low U.S. interest rates, weak stock market returns, and accelerating inflation have drawn investment dollars away from stocks and into non-traditional investments such as commodities. This flight to perceived safety in commodity markets turned into a stampede in 2007 and early 2008, as a credit-induced financial crisis in the United States compounded these existing stresses on global financial markets.

Rising commodity prices and financial speculation on food are not new phenomena. The 1970s saw a similar rise in commodity prices in the United States, and in the 1920s, U.S. investors formed commodity pools to bet on commodity price movements. But the quantity and liquidity of money flowing through today's global markets is unprecedented in human history. The current commodities boom could be a sign of looming agricultural scarcity, or it may prove to be a short-lived speculative bubble that will deflate over the next few months or years. But regardless of where agricultural commodity prices are headed, the boom has already begun to transform how food is financed, grown, and sold, and may dramatically change how people around the world eat (or don't).

Commodity Investment Goes Retail

Commodity exchanges exist as a mechanism for the producers and consumers of grains, energy, and livestock to transfer risk to financial institutions and other traders. For example, wheat farmers might seek to reduce the risk of price fluctuations by selling a contract for the future delivery of their wheat crop on a commodity exchange. This futures contract will guarantee a price for the farmer selling the contract, enabling them to pay for their planting costs, and avoid the risk that the price of wheat may decrease between the date they sell the contract and the date they agree to deliver the wheat. Food giants such as Kraft and Nabisco, as well as smaller bakers and grain consumers, typically purchase commodity futures contracts to avoid the opposite risk -- that the price of their raw materials may increase in the future. (Commodity markets also trade "spot" contracts, which entitle the purchaser to the immediate delivery of a commodity.)

Because producers and consumers seek to reduce risk, they function as so-called hedgers in commodity markets. In contrast, commercial trading firms and other speculators bet on the price of a commodity rising or falling, buying and selling futures contracts frequently in order to profit from short-term changes in their prices.

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Ben Collins is a member of the Dollars & Sense collective and a research analyst at KLD Research & Analytics, a sustainable investment research company. Mr. Collins's views do not necessarily reflect those of KLD or its clients.