Role of Speculators in Agricultural Commodity Price Spikes during 2006-2011

INTRODUCTION Agricultural futures markets primarily function as a mechanism for discovering prices, facilitating financing, and managing market risks associated with variability and stock holding. Unfortunately, recent volatility and high commodity prices in the commodity futures markets provide uncertainty for agricultural producers, food processors and manufacturers in their discovery processes. FAO and World Bank data show that food and commodity prices started to rise in 2006 and peaked in 2008 and 2011 (FAO, 2009; FAO, 2011). Other reports indicate that these high agricultural commodity prices have caused inflationary pressures and posed great concern for the global economy and the outlook is that world agricultural prices will continue to remain high and volatile (Abbott, 2009; FAO, 2011)). Many researchers and institutions have linked the recent rise in commodity prices to fundamental economic factors of demand and supply, while others have blamed the speculation in the commodity futures contracts by hedge funds and investors in commodity indexes (CHSGA, 2008; AFPC, 2008; FAO, 2009; Sanders et al, 2010; US Senate, 2009) as the cause of the high prices. Despite these allegations, many investors and financial institutions continue to invest in agricultural commodities through index linked instruments and over-the-counter (OTC) swaps because investments in agricultural commodities are considered low risk against inflation or provide higher return than other asset classes (Kaufman, 2010). These have resulted in significant flow of funds into the agriculture commodity futures markets in recent years. Furthermore, these investments were never viewed as high risks until early 2008 when commodity prices skyrocketed (Sanders et al, 2010). Many argue that the rise of these new class of investments (especially long-only commodity index funds) into the agricultural futures markets may be speculative investments that possibly create price distortions and may potentially disrupt traditional cash-futures convergence pattern (AFPC, 2008; Henriques, 2008; US Senate, 2009). Consequently, there have been visible world-wide policy changes to control the role of swap dealers and index traders in commodity futures markets. Indeed, many G-20 governments and several international agencies such as IOSCO, OECD, IFPRI and UNCTAD, have expressed interest in implementing policies and programs (e.g. increased financial regulation, strict supervision and transparency in commodity derivatives markets) that will curb the high agricultural commodity prices by the end of 2012 (G-20 Agricultural Ministers, 2011). Particularly, the US Congress passed HR 4173 (Dodd-Frank Wall Street Reform and Consumer Protection Act) in 2011 that is intended to regulate the role of swap dealers and index traders in commodity futures markets (US Congress, 2011). The number and type of investors in the agricultural futures markets, their classifications, and the type of positions they hold potentially impact the levels in these markets. There have been controversies over the classification of swap dealers and hedge funds in the agriculture commodity futures markets. There is the belief that CFTCs traditional categories of Commitment of Traders (COT) are ambiguous especially when swap dealers are classified as commercials (Peck, 1982; Ederington and Lee, 2002; Sanders, Boris, and Manfredo, 2004). For example, although institutional investments in commodity futures markets are considered speculative, yet the Commodity Exchange Act (CEA) governing futures trading does not prohibit investors from using the futures markets to gain exposure to commodity indexes. Moreover, there may be incentive for speculators to self-classify their activities in commodity futures markets as commercial hedging to circumvent speculative position limits. Indeed, the CFTC has classified the trading activities of swap dealers in the commodity futures market as commercial rather than noncommercial because swap dealers use futures markets for hedging their risks (US Government Accountability Office, 2009). …