There is no smoking gun linking actions by funds in futures markets to crop prices, but plenty of allegations. In both 2007-08 and 2010-11, the relationship between rising crop prices, rising total open interest, and a rising share of long positions held by noncommercial investors shows some general correlations, but does not necessarily indicate any causal effects, according to a new USDA study.
"When viewed in longer-term annual time periods, changes in prices appear to reflect changes in the market fundamentals of supply and demand," says the USDA/ERS report, "Why Have Commodity Prices Risen Again?"
If noncommercial investors affect prices, their influence is likely temporary and takes place over shorter periods. The study’s authors say that one hypothesis is that the momentum or trend-following trading practices of large noncommercial entities can result in larger short-run price movements on both the upside and downside than market fundamentals would suggest, however.
For example, when price increases are sustained (e.g., 2005-08 and again in the last half of 2010), trend-following noncommercial longs disproportionately buy from commercial shorts (sellers) hedging physical commodities. The number of contracts (open interest rises) rises and the share of long positions held by noncommercials increases. When prices subsequently turn down (e.g., June 2008), noncommercial longs sell their contracts, while short commercial interests who had hedged physical commodities are slow to liquidate their favorable positions.
"As a result, prices fall sharply and may continue to decline as noncommercial longs have difficulty finding new buyers. Prices decline until they have dropped sufficiently to entice buyers, generally commercial long hedgers using futures contracts as a temporary substitute for an eventual cash market purchase (e.g., December 2008)."
During this period the share of long positions held by noncommercial investors drops. Under this scenario, noncommercial interests have a series of short-term price-influencing effects—first toward the end of a sustained upward price movement, "then in the quick reversal of prices, and finally toward the end of the downswing in prices—which may accentuate short-term price volatility."
The price effects associated with the rapid increase or decrease in noncommercial open interest may be interpreted as a lack of short-term liquidity on the commercial or hedging side of the market, resulting in a short-term over-reaction of prices, the study says.
"However," the authors say, "others may argue that the actions of such noncommercial traders have the effect of increasing the rapidity of price adjustment to changing fundamental market conditions."
The study notes that from 2005 through mid-2008, hedge funds, index funds and sovereign wealth funds became increasingly involved with agricultural futures markets. Over this period, the share of open interest (the total number of contracts) held by funds in the futures market for agricultural commodities doubled. Investors in these funds were not so much interested in agricultural commodities specifically as they were in using commodities as an asset class to diversify their financial portfolios. These investors had primarily a financial interest in the markets and were not hedging physical commodities as would be typical of commercial agricultural-sector hedgers.
During the 2010-11 surge in commodity prices, involvement by noncommercial interests increased again. Total open interest increase in U.S. futures markets for wheat, corn, soybeans, and rice and the share of long positions held by noncommercial investors also increased.