Hi,
Vivek Kaul the author of Easynomics, my favorite newsletter on economics, shared a book recently that captured my attention - Price Wars: How Chaotic markets are creating a chaotic world by Rupert Russell. In his newsletter, Vivek quoted the origin story of derivatives which was an eye opener for me. The story incentivized me to read the book and it was full of gems that were great to learn!
The premise of the book is that many of the momentous events our world has faced- 2008 financial crisis, Arab Spring protests, ISIS terrorism - stem from increasing food prices. These prices are driven by commodities markets and not the supply and demand of actual agricultural goods!
In fact, the book postulates that when food prices shoot up and breaches a critical level of about 210 in the Food Price Index - order fractures and chaos erupts.
Fascinating right? Let’s dive in
All parts in italics are references from the book, emphasis are my own.
What is the problem today?
Food prices today are divorced from actual food production and have led to multiple crises.
Between 2005 and 2008, global food prices had risen by 83 per cent as the price of wheat more than doubled. As the prices surged, over 155 million people were pushed into poverty and 80 million into hunger in 2008 alone. Riots broke out in forty-eight countries from India to Egypt to Argentina.
This was called the Global Food Crises of 2008. Similar spikes in food prices had been observed prior to the Arab Spring Protests. But,
During the Arab Spring, and the Global Food Crisis before it, there was plenty of food. In fact, both years had seen the most food produced in history. So why did prices soar at a time of abundance?
How does Finance play a part in the problem?
The problem stems from the prices of all commodities moving upwards together.
There was no reason why the supply of American wheat, Indian cotton, Guatemalan coffee, Russian oil, Chilean nickel or Qatari natural gas should be connected.
To understand why prices were moving in lockstep with one another, we have to go back to the bursting of the tech bubble;
Up until then, large institutional investors such as pension funds and university endowments had traditionally invested in stocks and bonds. When the tech bubble burst in 2000, their portfolios imploded. ‘So having been burnt badly, they were looking for something that was not US stocks,’ Masters [a hedge fund manager] says. They wanted to ‘diversify’ their portfolios.
Where there is a need, suppliers will come rushing in to satisfy the demand.
Goldman Sachs, AIG and other financial institutions, developed a derivative product, called a commodity index fund. The money raised was deployed into a mixture of around two dozen commodities. The selling point of the commodity index fund was that the returns could provide a cushion in the face of another crash, as the returns were uncorrelated to the stock market.
Investments into commodity index funds had grown from $13 billion in 2003 to $260 billion in the middle of March 2006.
And it was because commodity index funds purchased commodities as a bundle that all commodity prices were moving upwards together. This onslaught of financial capital was pushing prices away from their ‘fundamental’ real-world values.
Some examples of a commodity
Examples of commodities are cocoa, coffee, zinc, copper, wheat, soyabeans, silver, gold, oil, and coal. Here is an amazing article by the Economist explaining - “What makes something a commodity?”
A derivative product helps gain more exposure to the underlying asset, in this case commodities as less initial capital is required v/s if you were outright going to invest in the commodity.
Cut to the present
Just to give you an idea about the market size, the gross market value of outstanding commodity derivatives is $920 billion as of June 2022.
On the ground however, this means that instead of the physical world influencing the prices of derivative products, the derivatives are influencing prices in the physical world.
During the commodity boom of the 2000s, they [banks] aggressively moved into the commodity-storage trade, buying up oil terminals, granaries and metals warehouses. These were not small plays. In many commodities, the banks dominated. Morgan Stanley, for instance, was the world’s ninth-largest oil shipper with over 100 tankers, had storage facilities capable of holding 58 million barrels of oil, and was the primary supplier of jet fuel to United Airlines.
Commodities had, in every sense, become ‘financialised’. Not only had they been placed in portfolios as financial assets like stocks and bonds, but the very business of producing, storing and transporting commodities had been taken over by financial institutions too. Neither the pension funds nor the banks had any real interest in the reality of the commodity trade. They were instead exploiting the financial alchemy of derivative contracts. In doing so, they had fundamentally transformed the nature of commodities – those things like food and fuel we all need to survive – into something else altogether.
It might be easy to think about this as just some abstract phenomenon. But this is having real world consequences, both on the macro as well as micro levels.
Below is the story of a Guatemalan coffee farmer and the reason why he wanted to go to USA. The author traced the farmers journey back to the coffee plantations in Guatemala.
In 2018, he [the coffee farmer] was no longer making a profit. The coffee prices were below his costs. This continued into 2019. Interest payments compounded and his debt grew unmanageable. If he failed to pay, he’d lose his land and his home. ‘So I travelled to the States because the coffee price was so low,’ he tells me. ‘We left from here and got on a truck, and from there we hopped on a train towards the border.’ He had heard that he’d be able to enter the US if he travelled with his seven-year-old son. But when they were caught, they were held in a detention centre for fifteen days. They slept outside. Torres [the coffee farmer] was given a single meal a day. ‘It was always a little rough, but he hung in there with me because he’s still young.’ They were returned to Guatemala. His debts remain. ‘If the coffee price remains low, I might try to cross again, to pay my debt.’
Who set these low coffee prices?
As per the Financial Times, the downward turn in coffee prices was being driven by speculators
The coffee market is struggling under a ‘big short’ created by hedge funds that have built up record bearish positions. Expectations of a record crop in Brazil, the world’s largest producer, and high inventories among importing countries have been weighing on arabica, the higher-quality bean. Prices last week hit the lowest level in two years of 115.30 cents a pound in New York, and, although they have bounced back, they are trading well below the cost of production for many coffee farmers. Hedge funds and other speculators have been increasingly bearish on arabica since the middle of last year, astonishing many in the market. The position size was ‘extraordinary’, said James Hearn, co-head of agricultural commodities at brokers Marex Spectron.
The stories of increasing supply of coffee from Brazil and Vietnam were rooted in reality, but the market machine amplified the change in price from a modest correction to a sharp and devastating shock.
The disastrous effect of climate change combined with falling prices meant there was no food on the table. Forcing farmers to abandon their land and migrate to the USA.
It seems like derivatives are the root of all evil. But then why were they created in the first place?
The origin story of derivatives
When Chicago became the grain capital of North America in the mid-nineteenth century, the market was chaotic. Farmers would arrive in Chicago at the same time with their freshly harvested wheat. Supply soared, prices plummeted, and farmers ended up dumping their worthless grain into Lake Michigan. A contract was invented that would let farmers store their grain at home and then have a guaranteed delivery date at some point in the year. They called them ‘futures contracts’. Farmers could pre-sell their crop in advance to real buyers, such as hotels or bakeries. Since there may not always be enough buyers throughout the year, private investors – later called ‘speculators’ – were invited into the market to make sure that somebody would always be available to buy the farmer’s contracts. The speculators guaranteed to pay an agreed-upon price for the wheat in the future, and the farmers could then use this guarantee to get a bank loan to fund the harvest. The speculators were given a small discount to compensate them for the risk they were taking, called the ‘risk premium’. Since the value of these contracts was ‘derived’ from something real – bushels of wheat – they were among the first so-called ‘derivatives’.
Derivatives were born out of a need, a need to protect the farmers and the crop. But soon greed changed the structure of the market.
Soon this magic economy became much bigger than the physical economy: there were far more wheat contracts than bushels of wheat. In 1875, the Chicago Tribune estimated that the physical market was $200 million, but the paper market was ten times greater at $2 billion. Rather than just taking the risk premium, speculators were making large bets on their future prices. Before these magic pieces of paper, speculating on the price of wheat or pork bellies was prohibitively cumbersome for most. Warehouses would have to be rented, the physical commodity delivered and stored. Now all somebody needed to do was purchase a futures contract. And the wall between these two worlds – physical and magical – didn’t last long. Speculators tried to rig the futures prices by trying to corner the physical market by monopolising the supply of wheat or oats or pork. Speculation in the derivative markets was changing the physical market. The tail wagged the dog. Prices swung wildly. Chaos had returned. President Franklin Roosevelt finally regulated the markets and curtailed speculation in 1934. Order had reigned ever since.
That is until the 2000’s when the Commodity Futures Modernization Act changed the landscape and led to the problems we face today.
My assessment of the situation
A lot of money has been printed in the past two decades, a massive chunk of this money has gone into the hands of the already wealthy, who bought real-estate and whatever else they could get their hands on, including commodities.
We are taught in college prices are a signal wrapped as an incentive, they dictate whether we should buy that sandwich, stock or home. But this book makes me question what if the prices don’t reflect the actual picture.
People set the prices and what happens if the mechanism is driven by speculation?
I think the formula is broken, it favors a set of people at the expense of the majority and the ramifications are huge - it affects whether or not there is food on the table for millions of people. And if there is no food there will be anger boiling over into wars, protests, and terrorism.
So, to correct a wrong, would the world be better off if we curtailed the commodity derivatives market? How would that alternate world look like?
If you liked reading this article, you will love the book- Price Wars: How Chaotic markets are creating a chaotic world by Rupert Russell
I hope you enjoyed this edition of Filtered Kapi. Do consider sharing it with your friends and family, as it helps me get a broader audience.
Do let me know if something struck a chord with you.
Filtered Kapi #43 Someone sent you this?
Nicely written and makes absolute sense. Speculators greed warping the markets is casting a shadow on capitalism as a system now. That said, I think there is a deeper problem with the concept of ‘price’. A bit off topic, but I always wonder how we can get stuff for relatively cheap even though production of the stuff is ruining the environment. Even without derivatives, we don’t price in the environment cost into the price do we. At least not fully. We do relative pricing, so if the production one year was less then last because of some environment factor, then the price will be proportionately higher. But the cost of the initial damage done to the environment when production started in the first place is not priced in. Take the example of tea...depending on the fog levels in Munnar, the prices of tea changes, but the cost of clearing all that land was cleared of all trees 200 odd years ago is not priced in. The earth doesn’t charge us for what it provides.
I know this is more of a rant, but can’t just blame the speculators here. Anyone who produces and consumes is to be blamed, we don’t really pay the true price. Speculators just exacerbate the problem.