Fundamentals drive wheat prices

by Morton Sosland
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Thanks to numerous assertions that the dramatic advances in wheat prices that occurred beginning about six years ago were due to futures activity mainly related to index trading, the Economic Research Service of the U.S. Department of Agriculture undertook a comprehensive study aimed at identifying exactly what was at work. In effect, the E.R.S. was responding to serious concerns that came from such varied sources as American bakers facing unprecedented upturns in production costs and the consumer-minded leaders of the European Union who contended that banning speculation in commodity markets should be undertaken on an international scale to maintain stability in wheat and bread prices. The E.R.S. study happily concludes that as trying as the price moves might have been, it was bullish demand and supply surprises affecting market fundamentals that drove the advances.

Coming to such a conclusion, which may disappoint many people hoping for expanded limits on speculative activity in wheat futures, required the E.R.S. to enlist well regarded economists and similar professionals to conduct what is named “Deconstructing Wheat Price Spikes: A Model of Supply and Demand, Financial Speculation, and Commodity Price Comovement.” If that’s not scary enough to the non-professional, consider this explanation of how the study was done: “The study uses a structural vector autoregression (SVAR) econometric model to decompose observed wheat prices into a set of factors and to explain the relative contribution of each factor to observed price changes.”

When it comes to the set of factors, the study focuses on four that are familiar to everyone concerned with position taking in wheat futures. One is general economic activity and how it affects demand for all commodities, especially wheat. Two combines the “passive activity” of commodity index funds as well as speculation by commodity index traders building “baskets” of commodities as investments. Three is precautionary speculation related to expected prices as well as building inventories. Four is supply-demand shocks affecting the wheat market. The study undertook specific measurement of price moves associated with shocks in any one of these factors. In an important salute to reality the impact of each shock was mitigated by prior information about price factors. In an important provision for the study, shocks caused by index traders and speculators were given precedence over others. This means that this trading effect “was given the best chance to reveal itself,” the study says.

Looking at wheat market moves between 1991 and 2011, the study finds that demand-supply shocks specific to wheat were the dominant causes of price spikes on all three U.S. exchanges. Centering on the wild upturns in February 2008, including the unforgettable Minneapolis climb from $8 to $24, the study concludes that wheat prices, depending on the market, would have been 40 to 62 per cent lower in the absence of demand-supply shocks. Prices would have been 11 to 36 per cent lower without the precautionary demand that saw supplies being accumulated. Broad-based demand fluctuations associated with global economic activity were credited with a 9 to 12 per cent price impact.

In contrast to these findings, the study says that index traders accounted for almost none of the price spike. “The peak price would have been only 1 per cent lower in the absence of shocks attributable to financial speculators,” the study declares. Additionally, looking at the period between 2006 and 2011, when index funds and associated speculators had their greatest impact, speculation added 5 to 8 per cent to wheat prices.

It’s a remarkable coincidence that this study has been made public shortly ahead of the convening of the annual Purchasing Seminar sponsored by this publication and its publisher. The seminar has historically emphasized the role of and prospects for the fundamental forces driving prices. In line with the study’s conclusion, the seminar reflects a belief in futures market efficiency. Restrictions like those proposed by some would not work and their advocates ought now agree that new limits would not prevent price surprises.

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