Fundamentals drive wheat prices

by Morton I. Sosland
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When France held the presidency of the European Union several years ago, international grain markets were being roiled by unprecedented advances in wheat prices that began during 2008 and continued several years thereafter. It was at an E.U. meeting that France proposed the union press in international forums for implementation of new futures regulations that would not just impose tougher rules on futures speculators, but would prohibit trade that threatened to cause sharp advances in prices. Even in America, a similar viewpoint appeared with bakers seeking government support for new controls that would help food manufacturers facing higher ingredient costs.

Thanks to numerous such assertions that the dramatic gains in wheat prices were due to futures activity related mainly to index trading, the Economic Research Service of the U.S. Department of Agriculture undertook a comprehensive study aimed at identifying exactly what was at work. In effect, the ERS was responding to a broad range of serious concerns claiming that speculation was boosting food prices. The ERS study happily concludes that as trying as the price moves might have been, it was bullish demand and supply surprises affecting market fundamentals that drove the advances.

Coming to such a conclusion, which may disappoint many people hoping for expanded limits on speculative activity in wheat futures, required the ERS to enlist well regarded economists and similar professionals to conduct what is named “Deconstructing Wheat Price Spikes: A Model of Supply and Demand, Financial Speculation, and Commodity Price Comovement.” If that’s not scary enough to the non-professional, consider this explanation of how the study was done: “The study uses a structural vector autoregression (SVAR) econometric model to decompose observed wheat prices into a set of factors and to explain the relative contribution of each factor to observed price changes.”

When it comes to the set of factors, the study focuses on four that are familiar to everyone concerned with position taking in wheat futures. One is general economic activity and how it affects demand for all commodities, especially wheat. Two combines the “passive activity” of commodity index funds as well as speculation by commodity index traders building “baskets” of commodities as investments. Three is precautionary speculation related to expected prices as well as building inventories. Four is supply-demand shocks affecting the wheat market. The study undertook specific measurement of price moves associated with shocks in any one of these factors. In an important salute to reality the impact of each shock was mitigated by prior information about price factors. In an important provision for the study, shocks caused by index traders and speculators were given precedence over others. This means that this trading effect “was given the best chance to reveal itself,” the study says.

Looking at wheat market moves between 1991 and 2011, the study finds that demand-supply shocks specific to wheat were the dominant causes of price spikes on all three U.S. exchanges. Centering on the wild upturns in February 2008, the study concludes that wheat prices, depending on the market, would have been 40% to 62% lower in the absence of demand-supply shocks. Prices would have been 11% to 36% lower without precautionary demand. Fluctuations associated with global economic activity were credited with a 9% to 12% price impact.

In contrast to these findings, the study says that index traders accounted for almost none of the price spike. “The peak price would have been only 1% lower in the absence of shocks attributable to financial speculators,” the study declares. Additionally looking at the period between 2006 and 2011, when index funds and associated speculators had their greatest impact, speculation added 5% to 8% to wheat prices.

While disproving assertions that speculation, not fundamental surprises, was driving wheat prices, the study underscores futures efficiency. Restrictions like those proposed would never work. Their advocates should now agree that new limits would not prevent price surprises.

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