Experts often tell us that retail investors should steer well clear of speculating in the soft commodities market. It’s too risky, they warn, with too many variables for the average private investor to make a fully informed choice. Chuck in a splash of unpredictable weather and a dash of political interference, and it’s all too easy to make a wrong call.
Others believe food speculation is just plain wrong. It is blamed for causing sharp rises in prices and genuine hardship in emerging markets, where food accounts for a much higher proportion of household budgets. Tunisia and Egypt show the destabilising effect that soaring food prices can have.
Of course, anyone who listened to the naysayers’ advice over the past year – or couldn’t shake off the moral implications of food speculation – would have missed spectacular gains which have made some astute hedge fund managers and traders very rich indeed.
After falling back from its 2008 peak in the wake of the financial crisis, the UN food price index is now approaching these lofty heights once again. Some blame speculation, but higher demand boosted by excess liquidity pumped into the world economy by central banks is a more likely culprit. Certainly, the strength of the global economic recovery and growth in global demand for food as a result of increasing wealth and populations in emerging markets means the price spike many not be as temporary as observers suggested last year.
Price rises in cocoa, sugar, wheat and cotton are only part of the story, though – while there is much to suggest that the bull market in food still has a long way to run, what’s really appetising to short-term traders is rising volatility, with prices prone to big intraday swings as supply worries are exacerbated by poor harvests or La Nina-related weather incidents.
That’s why former energy traders are said to be switching their attention towards soft commodities – somewhat ironic, as the rising oil price is a major determinant of rising food costs, increasing the price of fertilisers and transportation.
political blame game
Politicians – and in particular France’s Nicolas Sarkozy, who has made commodity prices the leading issue of his presidency of the G20 – blame speculators for this current volatility, and want to curb their activity. But other leading figures like John Murray, deputy governor of the Bank of Canada, are not so sure the link is that strong. “The extent of destabilising speculation and its impact on commodity prices remain open questions,” he said in a recent speech. “Available evidence suggests that most of the major swings, as well as a large proportion of the short-run volatility that we observe, can be explained by market fundamentals.”
He believes that volatility is the commodity market’s natural state – indeed, the supply and demand imbalances that are currently causing prices to soar may shift just as quickly in the opposite direction. In many cases, soft commodity markets are ultimately self-balancing, with high prices leading to increased supply. Cotton farmers, for example, are now increasing plantings to capitalise on the high profit opportunity that a 150-year price-high presents, which should reverse the current structural deficit in important markets like China, bringing prices down.
Of course, rebalancing supply does not happen instantaneously, and in the meantime the predictably unpredictable conditions traders crave are likely to continue. Bunge, one of the world’s biggest agricultural trading groups, said alongside better than expected fourth quarter results that it expected the favourable environment in agricultural trading to continue in 2011. “Demand for our products is growing, and the world needs big harvests to meet this rise in consumption”, it said.
And for all the short-term volatility, the longer-term trend looks like it’s only going in one direction: up. According to the United Nations, food production needs to rise by 70 per cent over the next 40 years to cope with population growth, and – contrary to the views of politicians like Sarkozy – only high prices will encourage the huge levels of investment needed to hit that target.
As Murray also points out, we may have been getting food on the cheap for decades – while nominal food prices are now three times higher than they were in 1970, in real, inflation-adjusted terms food costs half what it did 40 years ago.
If that’s the case, then the riskiest approach any investor can take to soft commodities is to sit on the sidelines. It could be the only way to hedge against some hefty inflation still to come.