Gambling with the futures

A GLOBAL food crisis is taking place because of the skyrocketing cost of foodstuffs--sparking protests and rioting around the world.

There are many causes of this crisis. One obvious one is the rising price of oil, which is increasing transportation and other costs for agricultural products. Another is profiteering on the part of the heavily subsidized agribusiness sector. Other causes include the increased use of corn in ethanol production, rather than for food, as well as the damaging effects of free trade on small farmers and changing consumption patterns.

There is another force is at play, as well: speculators are driving up the prices of all commodities, including wheat, corn, soy, etc., because of intense trading on what are known as futures markets.

Such markets were originally designed to help producers and users of commodities manage the risk of price fluctuations. But another aspect of futures trading has taken on greater prominence in recent years. Futures are also traded by individual investors and financial institutions, based on a gamble as to whether the price of the goods will rise or fall.

Today, traders of exchange-traded funds, hedge funds and other speculators far outstrip the actual buyers and sellers of commodities. As a result, these speculators have generated a big demand for futures contracts, therefore helping send the prices of underlying commodities upward.

Furthermore, futures markets, once heavily monitored by governments, have been--like most of the rest of the financial markets--systematically deregulated to the point that trading is going virtually unchecked.

How do we understand what's going on with the futures market today? Here are some answers to questions about how futures function--specifically, futures in basic commodities--and what role they are playing in the current food crisis.

WHAT ARE futures?

FUTURES ARE contracts in which one party agrees to buy or sell a certain commodity, such as a bushel of wheat or a barrel of oil, at a certain price at an agreed upon date in the future.

Everything is spelled out in the contracts, including the quantity and quality of the commodity, the price per unit, and the date and method of delivery. The futures market is different from the "spot market," where buyers and sellers trade the same commodities, but in the present time.

It helps to think of this as traders buying a service up front. In practice, people complete these sorts of transactions every day. For example, when you purchase an airline ticket, you are paying the company today for the right to travel on an agreed upon time in the future. Futures contracts are the same thing, except they typically involve companies buying and selling commodities in the future--oil, wheat, corn, soybeans, pork, cattle, butter, milk, gold, silver, etc.

The practical benefit of futures contracts is that they help firms to lock in the prices of what they are buying or selling in advance. For example, airlines use futures contracts when buying jet fuel, rather than buying it on the so-called spot market. It helps both buyers and sellers to more accurately predict their operating costs and incomes.

HOW ARE the prices determined?

THIS IS where futures exchanges come into the picture. The largest futures exchange is the Chicago Board of Trade, which has been in operation since 1848. All futures contracts are registered at such exchanges, which then create the benchmarks for further contracts.

For example, if a company agrees to buy 1,000 barrels of oil from another firm for delivery in June at $125 a barrel, the two parties report the contract to a futures exchange. This becomes a new standard price for oil futures.

Another supplier could decide if they thought that price was too high (or too low) and make an offer to deliver 1,000 barrels at $125.50. If a buyer steps forward and accepts, this sets a new benchmark. Then another supplier could enter the picture and make the same calculation, or a different one. These trades happen over and over throughout the course of the day. Demands for futures contracts sends prices up. When demand falters, prices drop.

What happens next is that at the end of every day, the two parties must settle up based on where the futures price of that commodity ended the day.

Let's say Buyer A (known as the "long" position) and Seller B (known as the "short" position) agree to a futures contract in which Buyer A would buy 1,000 barrels of oil from Seller B on July 1 for $125 a barrel. On the next day, say the futures price increases to $130 a barrel. The Seller B has lost $5 per barrel because he is now obligated to sell at a price below the market. Buyer A has made $5 per barrel because the price he is obligated to pay is below the market. The Seller must pay the Buyer $5,000 ($5 times 1,000 barrels) to settle the account.

These adjustments are made daily, depending on how the price of futures changes, until the contract expires, the goods are delivered and the final settlements are made.

Therein lies another benefit for the actual traders in commodities. The futures markets enable buyers and sellers to hedge against--or cushion the impact of--pricing changes. Buyers and sellers could set up trades to minimize potential losses from rising and falling prices on spot markets through these hedges in the futures market.

If prices fall after a contract is signed, a seller would be protected from lower prices on the spot market because he would be collecting income on existing futures contract. If prices rise, the seller would lose money on the futures contract, but could try to sell more in the spot market to make up the difference. In theory, futures contracts are meant to be a zero-sum hedge to protect against changes in prices.

WHAT'S WRONG with this picture?

HISTORICALLY, FUTURES contracts were traded primarily between producers of commodities and consumers of commodities at large, regulated commodities exchanges. Most futures contracts eventually resulted in the actual delivery of a commodity on a set date.

That's all changed in recent years. Now, the bulk of firms trading on futures exchanges are speculators with no intention of ever receiving delivery of the commodities they are trading.

For example, for some crops, it might take only 10,000 contracts to satisfy the needs of buyers and sellers to hedge prices. However, the volume of wheat contracts from the beginning of the year through March 2008 was 5.7 million contracts.

As well, contracts are usually wound down or rolled over without commodities ever being exchanged. Instead, traders make their profits simply through creating and exchanging contracts, and timing those moves to make the most of day-to-day price fluctuations on the futures markets.

Plus, new, unregulated exchanges have emerged, so traders don't even have to report all of their activity. Thus, traders could make a trade on a public market and then make another on an unregulated market to balance or heighten the first trade.

It used to be that all futures trading was monitored by the U.S. Commodities and Futures Trading Commission (CFTC). Created in 1974, the CFTC was built upon legislation passed in the 1920s and 1930s in response to speculation on grain futures prior to the Great Depression. However, the CFTC lost some of its oversight ability in 2000, thanks to legislation passed that makes it easier to trade in futures outside monitored exchanges (such as the Chicago Board of Trade and the New York Mercantile Exchange).

HOW IS this affecting food prices?

THE PRICE of futures contracts is affected to some degree by prices in the present. For example, when the cyclone hit Myanmar, it wiped out some of the country's anticipated rice production and thus sent the price of rice and rice futures up. Similarly, when Nigerian rebels disrupt oil pipelines, this sends the price of oil futures up as it raises concerns about future deliveries.

At the same time, if futures prices are going up and a gap develops with current spot market prices, this could lead buyers of commodities to hoard in the present--to take advantage of the lower current prices and avoid paying higher prices in the future. If, say, the price of oil futures is $125, but the price of oil on the spot market is only $115, more firms will buy oil today, thus putting upward pressure on the current price of oil. On the flip side, rising oil prices in the present can help push futures prices upwards.

Thus, rising prices in either the spot market or the futures market could end up reinforcing each other and further exacerbate inflation.

And there's more. There is mounting evidence that prices on futures markets are out of whack with what's happening in the real-world supply of the commodities being traded.

All other things being equal, the prices of expiring futures contracts should converge with the pricing on spot markets on the date of expiration--that is, the price of oil in June should be pretty close to the price of oil futures contracts trading today that expire in June. But there are huge divergences developing.

Why? Because there are too many investors chasing too few futures contracts, and this is creating demand for the underlying commodity that drives up the price of the commodity to be delivered in the future.

Thus, according to AgResource Co., total index fund investment in corn, soybeans, wheat, cattle and hogs amounts to $47 billion, up from $10 billion just two years ago.

Some of this is increase is to rising demand based on the boom in the world economy in the middle of this decade, as rising incomes in China, India and other developing countries spur greater consumption of foodstuffs.

But the rising prices have encouraged speculators to move in as well. The situation has grown all the worse as other financial markets falter. With interest rates low, inflation on the increase and stock markets in turbulence, growing numbers of investors are turning to commodities futures market in search of returns.

"There is a shortage of futures for sale amid an index fund business model for carrying long positions for extended periods," Richard J. Feltes, senior vice president and director of MF Global Research, wrote in a recent note. "Wall Street money flows in the long side of market exceed influence of short hedgers by many multiples...

"The answer to the 'mystery' is that grain futures contracts for some have become investment securities--not hedging instruments that offset either cash inventories or future usage."

WHAT'S THE outcome of all of this?

IN INDIA, the imbalances became so bad that the country last week moved to suspend futures trading in soybean oil, rubber, chickpeas and potatoes. This is an attempt by the government to reign in inflation. Chickpea futures jumped 89 percent in the past 12 months, while rubber rose 41 percent and soybean oil 21 percent. The Indian government already suspended trading on rice and wheat futures last year.

It's possible that other nations could follow suit with similar measures. It's also possible that in the U.S., regulators could try to limit the amount of over-the-counter trading occurring on unregulated markets or expand the powers of the CFTC. There have been hearings before the CFTC in recent weeks exploring the link between futures markets and the skyrocketing costs of fuel and food.

However, none of that is likely to happen very quickly, since there is little agreement as to how big a role futures markets are playing in the overall crisis. Meanwhile, this factor in the global food crisis will continue to have an effect.