Monday, March 31, 2008

Commodities market anomalies

The NYT reports that economists are baffled by the ever-widening disparity between the actual cash market prices of foodgrains like corn, soyabeans and wheat, and their prices in the derivatives market. The anomalies are occurring between the price of a bushel of grain in the cash market and the price of that same bushel of grain, as determined by the expiration price of a futures contract traded in Chicago. This gives the illusion of two prices for the same good at the same place and time.

The problem is something like this. Futures contracts are important hedging tools for farmers, grain elevators, commodity processors and anyone with a stake in future grain prices. A futures contract that calls for delivery of wheat in July may trade for more or less for each bushel than today’s cash market price. But as each day goes by, its price should move a bit closer to that day’s cash price. And on expiration day, when the bushels of wheat covered by that futures contract are due for delivery, their price should very nearly match the price in the cash market, allowing for a little market friction or major delivery disruptions like Hurricane Katrina. But on dozens of occasions since early 2006, the futures contracts for corn, wheat and soybeans have expired at a price that was much higher than that day’s cash price for those grains.

The most credible explanation for these anomalies relate to the role of hedge funds, pension funds and index funds, who are distorting futures prices by pouring in so much money without regard to market fundamentals.

Commodity prices world wide have been surging to unprecedented levels. Speculative investors see commodities as a safer and high return investment opportunity and accordingly a bubble has been building up in commodities based derivatives. An irrational exuberance in commodities have also bidded up the prices of these derivative contracts, way beyond even the actual market prices. Many of these speculative investors are holding huge quantities of long positions on these contracts, in anticipation of further rise prices.

As has been well documented by behavioural literature, these holders of long positions are often reluctant to wind down their holdings, even in the face of lower actual market prices. This maintains a disparity in the derivatives market and cash market prices of the same commodity. This disparity may thus be a reflection of the under-developed nature of the arbitrage or carry trade market, which takes advantage of this mis-pricing. My guess is that once this market becomes more liquid and more players get in, the mis-pricings will get arbitraged away and disappear.

Another interesting phenomenon, brought out by the NYT in this article relates to the rising price of rice. This is in direct contrast to the aforementioned two price phenomenon, and is a testimony to the power of globalization in ushering in a global market place.

About the reasons for the steep rice in global rice prices, it writes, "Rising affluence in India and China has increased demand. At the same time, drought and other bad weather have reduced output in Australia and elsewhere. Many rice farmers are turning to more lucrative cash crops, reducing the amount of land devoted to the grain. And urbanization and industrialization have cut into the land devoted to rice cultivation... Until the last few years, the potential for rapid price swings was damped by the tendency of many governments to hold very large rice stockpiles to ensure food security. But those stockpiles were costly to maintain. So governments have been drawing them down as world rice consumption has outstripped production for most of the last decade."

Unlike many other food grains, rice consuming countries are mostly self sufficient, and only 7% of the global rice production is traded across international borders each year. The sharp increase in prices, despite the relatively small quantities traded clearly indicates two things - a tight market, and more importantly, a fairly integrated global market in rice trade.

From the price rises across the world, it is obvious that the domestic rice market has become closely integrated with each other and with the market in global trade. Further, the relatively small quantities traded across borders, combined with small stockpiles, now mean that prices can move quickly in response to supply disruptions. The commodity contract speculators may have exacerbated the problems by artificially boosting the demand.

Interestingly, in both cases, one where the arbitrage market was not fully developed, and another where the market had become closely integrated, the impact has been extreme - lower prices for farmers in the former and higher price for consumers in the later.

Update 1
NYT has an article explaining the drought triggered shift away from water intensive rice to more profitable wine grapes. The six long years of drought has reduced Australian rice production by 98%. Even in normal times, little of the world’s rice is actually exported — more than 90 percent is consumed in the countries where it is grown. In the last quarter-century, rice consumption has outpaced production, with global reserves plunging by half just since 2000. A plant disease is hurting harvests in Vietnam, reducing supply. And economic uncertainty has led producers to hoard rice and speculators and investors to see it as a lucrative or at least safe bet.


gaddeswarup said...

I am not sure but my vague recollection is that future markets in grains have been abondoned in India. Do you any information on this? Thanks.

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