New Paradigms in Marketing: Are Speculators or the Fundamentals Driving Prices? Scott H. Irwin

New Paradigms in Marketing: Are Speculators or the Fundamentals Driving Prices? Scott H. Irwin

Outline of Presentation Role of speculation in the recent commodity price boom Changing fundamentals Convergence problems at the CBOT

A New Type of Commodity Speculator Commodity Index Investors Desire portfolio exposure to returns from a basket of commodities Long-only Popular Indexes GSCI Dow Jones-AIG Reuters/Jeffries-CRB Investment Types OTC index funds Exchange-traded funds Exchange-traded notes Investors $ Swap Dealer $ π π Long Futures Positions Index

Notional Value of Commodity Index Trading on U.S. Futures Exchanges (CFTC) 1,000 946 Investment (bil.$) 750 500 250 0 118 133 161 Dec-07 Mar-08 Jun-08 All Futures Jun-08

Proportion of Open Interest Held by Index Traders in Grain and Livestock Futures Markets, Jan 2006-Jun 2008 30% 30% Lean Hogs 25% 25% Wheat 20% 15% Soybeans 20% Live Cattle 15% 10% 10% Feeder Cattle Corn 5% Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 CIT/Total OI CIT/Total OI 5% Source: Sanders, Irwin, and Merrin (2008a) Perma-longs

Index Trading in NYMEX Crude Oil Futures 12/31/2007 3/31/2008 6/30/2008 Notional Value (bil. $) 39.1 41 51 Net Long Position (# contracts) 408,000 398,000 363,000 Total Futures Equivalent Open Interest (# contracts) 2,508,971 2,885,101 2,837,447 Index Position/Total Open Interest 16% 14% 13% Source: CFTC Staff Report on Commodity Swap Dealers and Index Traders (2008)

It Has to be a Bubble! A titanic wave of money invested in commodity futures markets Overwhelmed normal supply and demand fundamentals Greatly magnified upward trend in commodity prices Final result: A bubble So it s becoming increasingly clear that there are very few people left in academia and economics-land that think that commodities were anything but a bubble. In fact it appears the only economists left attacking the bubble theory are the ones being paid by Wall Street to defend their actions. ---Accidental Hunt Brothers Blog, October 15, 2008

The World According to Mr. Masters

Conceptual Error #1: Money Flows are Not the Same as Demand Futures markets are zero-sum games If long positions of index funds are new demand then the short positions for the same contracts are new supply? Simply observing that large investment has flowed into the long side of commodity futures markets at the same time that prices have risen substantially does not necessarily prove anything for every long there is a short, for everyone who thinks the price is going up there is someone who thinks it is going down, and for everyone who trades with the flow of the market, there is someone trading against it. Tom Hieronymus

Conceptual Error #2: Index Futures Positions Distort both Cash and Futures Prices Futures contracts are financial transactions that only rarely involve the actual delivery of physical commodities (i.e. side bets ) To impact the equilibrium price of commodities in the cash market, index investors must take delivery and/or buy quantities in the cash market and hold these inventories off the market Absolutely no evidence that index fund investors are taking delivery and owning stocks of commodities

Conceptual Error #2: Index Futures Positions Distort both Cash and Futures Prices Futures contracts are financial transactions that only rarely involve the actual delivery of physical commodities (i.e. side bets ) To impact the equilibrium price of commodities in the cash market, index investors must take delivery and/or buy quantities in the cash market and hold these inventories off the market Absolutely no evidence that index fund investors are taking delivery and owning stocks of commodities

Conceptual Error #3: Hedgers are Benign Risk- Avoiders and Speculators are Harmful Risk-Seekers Hedging and speculation are best described as a continuum Index funds entered a dynamic and ever-changing game between commercial firms and speculators with various motivations and strategies Commercial firms tend to have an informational advantage Index funds add liquidity and may improve competition in commodity futures markets

Inconsistent Fact #1: Speculation is not Excessive Compared to Hedging (2006:I-2008:I Averages) Long Short Long Short Hedging Hedging Speculation Speculation Corn ---# of contracts--- 2006 328,362 654,461 558,600 208,043 2008 598,790 1,179,932 792,368 182,291 Change 270,428 525,471 233,768-25,752 Soybeans 2006 126,832 192,218 183,105 107,221 2008 175,973 440,793 351,379 74,844 Change 49,141 248,575 168,274-32,377 Wheat 2006 57,942 213,278 251,926 92,148 2008 70,084 240,864 300,880 121,578 Change 12,141 27,585 48,954 29,430 Source: Sanders, Irwin, and Merrin (2008a)

Inconsistent Fact #2: Price Increases Did Not Occur in All Commodity Futures Markets Included in Popular Indexes (January 3, 2006 April 15, 2008) 200% Corn Soybeans Soybean Oil CBOT Wheat KCBT Wheat Cotton Live Cattle Feeder Cattle Lean Hogs 150% 100% 50% 0% -50% Jan 2006 - Apr 2008 Change (%)

Inconsistent Fact #3: Price Increases Occurred in Commodity Futures Markets not Included in Popular Indexes or Markets Without Futures January 2006 April 2008 Change Nearby Rough Rice Futures $8.27/lb. $22.17/lb. +168% Nearby Fluid Milk Futures $12.65/cwt. $17.29/cwt. +37% Apples Fresh Use (cash) $0.26/lb. $0.41/lb. +58% Edible Beans (cash) $19.30/cwt. $34.40/cwt. +78%

Inconsistent Fact #4: Inventories did not Increase for Storable Commodities P B P E Inventory Increase S Ending Stocks/Use (%) 40 35 30 25 20 15 10 5 Ending Stocks as a Percent of Use, 2001/02-2007/08 0 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 Corn Soybeans Wheat D Q So my challenge to people who say there s an oil bubble is this: let s get physical. Tell me where you think the excess supply of crude is going.

Inconsistent Fact #5: Commodity Index Fund Trading is Predictable Index funds do not attempt to hide their current positions or their next move Publish mechanical procedures for rolling to new contract months Indicate desired market weightings when the index is re-balanced Theory shows that trading must be unpredictable for any trader group to consistently push prices away from fundamental value Highly unlikely that other large traders would allow index funds to push futures prices away from fundamental values for long when trades are so easily anticipated

This Time is Different! Facts build a persuasive case against bubble hypothesis But, evidence is circumstantial Bubble proponents can argue this time is different Direct evidence on the relationship between speculator positions and price changes is needed Solution: Granger causality tests

We Have Been Here Before: Lessons from History Abraham Lincoln: For my part, I wish every one of them [speculators] had his devilish head shot off. Vladimir Lenin: For as long as we fail to treat speculators the way they deserve with a bullet to the head we will not get anywhere. Harry Truman: the cost of living in this country must not be a football to be kicked around by grain gamblers. U.S. Congress: Speculative activity in the futures markets causes such severe and unwarranted fluctuations in the price of cash onions as to require complete prohibition of onion futures trading in order to assure the orderly flow of onions in interstate commerce.

Changing Fundamentals? The most basis question in fundamental analysis is the price a prospective buyer (user) is willing to pay for a unit of the commodity For at least the last 50 years the primary determinant of the fundamental value of corn has been the value placed on corn by livestock feeders The price of feed is determined by livestock feed demand, feed production, exports, and food and industrial uses. The lines of causation are from consumer demand through the livestock sector to feed prices. Master Model of Midwestern Agriculture, Hieronymus, Good, and Hinton (1980)

US Corn, Ethanol for Fuel Use, 1975/76-2008/09* 4,000 Ethanol (million bushels) 3,500 3,000 2,500 2,000 1,500 1,000 500 0 1975/76 1982/83 1989/90 1996/97 2003/04 US Corn, Ethanol for Fuel Share of Total Use, 1975/76-2008/09* Source: USDA Marketing Year *2008/09 Projected 35 30 FSI/Total Use (%) 25 20 15 10 5 0 1975/76 1982/83 1989/90 1996/97 2003/04 Source: USDA Marketing Year *2008/09 Projected

Weekly Ethanol and Corn Prices at Iowa Plants, January 27, 2007 March 20, 2009 8.00 3.00 7.00 2.75 6.00 Ethanol (right-scale) 5.00 4.00 Corn Price ($/bu.) Ethanol Price ($/gal.) 2.50 2.25 2.00 1.75 3.00 2.00 Corn (left-scale) 1.50 1.25 1/26/07 3/23/07 5/18/07 7/13/07 9/7/07 11/2/07 12/28/07 2/22/08 4/18/08 6/13/08 8/8/08 10/3/08 11/28/08 1/23/09 3/20/09

Relationship between Weekly Corn and Ethanol Prices at Iowa Plants, September 7, 2007 March 20, 2009 8.00 7.00 Corn Price $/bu.) 6.00 5.00 4.00 y = 2.4212x - 0.3103 R 2 = 0.8999 3.00 2.00 1.25 1.50 1.75 2.00 2.25 2.50 2.75 3.00 Ethanol Price ($/bu.)

RFS Mandate for Corn-Based Ethanol, 2008/09 2015/16 5.5 5.0 4.5 4.0 3.5 5.3 5.4 5.1 4.9 4.6 4.4 4.1 3.6 Corn (bil. bu.) 3.0 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 Marketing Year

Monthly U.S. Ethanol Production + Imports vs. RFS Mandate, October 2007 - January 2009* 1.00 0.90 0.80 0.70 0.60 0.50 0.40 Production + Imports Mandate Ethanol (bil. gal./mo.) 0.30 Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Source: EIA/EPA *Dec 08 and Jan 09 Production + Imports Projected

Convergence The pattern of cash and futures prices tending to come together, that is, basis approaching zero at the delivery market as the futures contract expires Price Futures Basis Cash Expiration

Arbitrage and Convergence In theory, arbitrage in the cash and futures markets should force prices to converge (law of one price) Futures > cash price: buy cash commodity, sell futures, and deliver Futures < cash price: Buy futures, stand for delivery, and then sell cash The existence of delivery options and costs of arbitrage means that convergence should be thought of as a range of basis, not necessarily a zero basis Direct costs estimated to be 6 to 8 cents per bushel

Delivery Location Basis on the First Day of Delivery for CBOT Corn Futures, Illinois River North of Peoria, March 2000-March 2009 40 0-40 -80-120 -160-200 Mar-00 Sep-00 May-01 Dec-01 Jul-02 Mar-03 Sep-03 May-04 Dec-04 Jul-05 Mar-06 Sep-06 May-07 Dec-07 Jul-08 Mar-09 Basis (cents/bu.) Contract Expiration Month

Delivery Location Basis on the First Day of Delivery for CBOT Soybean Futures, Illinois River North of Peoria, January 2000 March 2009 40 0-40 -80-120 -160-200 Jan-00 Aug-00 Mar-01 Sep-01 May-02 Nov-02 Jul-03 Jan-04 Aug-04 Mar-05 Sep-05 May-06 Nov-06 Jul-07 Jan-07 Aug-08 Mar-09 Basis (cents/bu.) Contract Expiration Month

Delivery Location Basis on the First Day of Delivery for CBOT Wheat Futures, Toledo, March 2000-March 2009 40 0-40 -80-120 -160-200 Mar-00 Sep-00 May-01 Dec-01 Jul-02 Mar-03 Sep-03 May-04 Dec-04 Jul-05 Mar-06 Sep-06 May-07 Dec-07 Jul-08 Mar-09 Basis (cents/bu.) Contract Expiration Month

Problems Created by Non-Convergence Wedge between futures and cash indicates out-of-balance contracts Hieronymus (1977, p. 340) warns, When a contract is out of balance the disadvantaged side ceases trading and the contract disappears. Increased basis uncertainty and loss in hedging effectiveness Long-run viability of markets is threatened

Major Factors Contributing to Non-Convergence Spreads reflecting a relatively high percent of full carry Corn, soybeans, and wheat Structural issues related to the delivery process Wheat

Full Carry and the Decoupling of Cash and Futures Markets Spreads Go to 100% of Full Carry Delivery Takers Hold Certificates and Sell Deferred Futures No Load Out to Cancel Certificates Bottom line: Arbitrage link between cash and futures broken

% Full Cost of Carry Calculation % = [(F2 F1)/(Storage + Interest Costs)]*100 F2 = Price of next nearest to expiration futures contract F1 = Price of nearest to expiration futures contract Storage = CBOT contract rate x # days Interest = (3 mo. LIBOR rate)/365 x # days

Spread on the First Day of Delivery between Prices of the Expiring and Next-to-Expire Contracts for CBOT Corn Futures, March 2000-March 2009 120% 100% 80% 60% 40% 20% 0% Mar-00 Sep-00 May-01 Dec-01 Jul-02 Mar-03 Sep-03 May-04 Dec-04 Jul-05 Mar-06 Sep-06 May-07 Dec-07 Jul-08 Mar-09 % of Full Carry Contract Expiration Month

Spread on the First Day of Delivery between Prices of the Expiring and Next-to-Expire Contracts for CBOT Soybean Futures, January 2000 March 2009 120% 100% 80% 60% 40% 20% 0% Jan-00 Aug-00 Mar-01 Sep-01 May-02 Nov-02 Jul-03 Jan-04 Aug-04 Mar-05 Sep-05 May-06 Nov-06 Jul-07 Jan-07 Aug-08 Mar-09 % of Full Carry Contract Expiration Month

Spread on the First Day of Delivery between Prices of the Expiring and Next-to-Expire Contracts for CBOT Wheat Futures, March 2000-March 2009 120% 100% 80% 60% 40% 20% 0% Mar-00 Sep-00 May-01 Dec-01 Jul-02 Mar-03 Sep-03 May-04 Dec-04 Jul-05 Mar-06 Sep-06 May-07 Dec-07 Jul-08 Mar-09 % of Full Carry Contract Expiration Month

Total Deliveries of CBOT Corn Futures, March 2000-March 2009 160 140 120 100 80 60 40 20 0 Mar-00 Sep-00 May-01 Dec-01 Jul-02 Mar-03 Sep-03 May-04 Dec-04 Jul-05 Mar-06 Sep-06 May-07 Dec-07 Jul-08 Mar-09 Deliveries (mil. bu.) Contract Expiration Month

Total Deliveries of CBOT Soybean Futures, January 2000 March 2009 160 140 120 100 80 60 40 20 0 Jan-00 Aug-00 Mar-01 Sep-01 May-02 Nov-02 Jul-03 Jan-04 Aug-04 Mar-05 Sep-05 May-06 Nov-06 Jul-07 Jan-07 Aug-08 Mar-09 Deliveries (mil. bu.) Contract Expiration Month

Total Deliveries of CBOT Wheat Futures, March 2000-March 2009 160 140 120 100 80 60 40 20 0 Mar-00 Sep-00 May-01 Dec-01 Jul-02 Mar-03 Sep-03 May-04 Dec-04 Jul-05 Mar-06 Sep-06 May-07 Dec-07 Jul-08 Mar-09 Deliveries (mil. bu.) Contract Expiration Month

Daily Total of Registered Shipping Certificates for CBOT Corn Futures, July 2003-March 2009 40 35 30 25 20 15 10 5 0 Jul-03 Nov-03 Mar-04 Jul-04 Nov-04 Mar-05 Jul-05 Nov-05 Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07 Mar-08 Jul-08 Nov-08 Mar-09 Certificates/Receipts (mil. bu.) Date

Daily Total of Registered Shipping Certificates for CBOT Soybean Futures, July 2003- March 2009 40 35 30 25 20 15 10 5 0 Jul-03 Nov-03 Mar-04 Jul-04 Nov-04 Mar-05 Jul-05 Nov-05 Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07 Mar-08 Jul-08 Nov-08 Mar-09 Certificates/Receipts (mil. bu.) Date

Daily Total of Registered Shipping Certificates or Warehouse Receipts for CBOT Wheat Futures, July 2003- March 2009 40 35 30 25 20 15 10 5 0 Jul-03 Nov-03 Mar-04 Jul-04 Nov-04 Mar-05 Jul-05 Nov-05 Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07 Mar-08 Jul-08 Nov-08 Mar-09 Certificates/Receipts (mil. bu.) Date

Basis and Percent of Full Carry on First Day of Delivery for CBOT Corn Futures, Illinois River North of Peoria, March 2000- December 2008 40 % Carry (right scale) 100% 0 80% -40 Basis (left scale) -80-120 20% -60% -160-200 Mar-00 Sep-00 May-01 Dec-01 Jul-02 Mar-03 Sep-03 May-04 Dec-04 Jul-05 Mar-06 Sep-06 May-07 Dec-07 Jul-08 Mar-09 Basis (cents/bu.) % of Full Carry -140% -220% Contract Expiration Month

Basis and Percent of Full Carry on First Day of Delivery for CBOT Soybean Futures, Illinois River North of Peoria, March 2000-December 2008 40 % Carry (right scale) 0 100% 80% -40-80 -120 20% -60% -160-200 Jan-00 Aug-00 Mar-01 Sep-01 May-02 Nov-02 Jul-03 Jan-04 Aug-04 Mar-05 Sep-05 May-06 Nov-06 Jul-07 Jan-07 Aug-08 Mar-09 Basis (cents/bu.) % of Full Carry Basis (left scale) -140% -220% Contract Expiration Month

Basis and Percent of Full Carry on First Day of Delivery for CBOT Wheat Futures, Toledo, March 2000-December 2008 40 % Carry (right scale) 0 100% 80% -40-80 Basis (left scale) -120 20% -60% -160-200 Mar-00 Sep-00 May-01 Dec-01 Jul-02 Mar-03 Sep-03 May-04 Dec-04 Jul-05 Mar-06 Sep-06 May-07 Dec-07 Jul-08 Mar-09 Basis (cents/bu.) % of Full Carry -140% -220% Contract Expiration Month

Explaining the Large Carry 1. CBOT maximum storage rates below actual commercial storage costs 2. Presence of large longonly index funds 3. Risk premium due to increased uncertainty

Mid-2008 Comparison of Commercial Storage Costs and CBOT Contract Rates Corn Soybeans Wheat CBOT Survey 4.3 cents 4.6 cents 7.1 cents Contract Rates 4.5 cents 4.5 cents 4.5 cents

Goldman Roll Effect on the Nearby Futures Spread F 2 -F 1 0 Beginning of Roll Window Expiration of Contract 1

Average Nearby Spreads for CBOT Corn Futures during the Roll Window of Long-Only Index Funds, March 1995 - March 2009 Contracts Days 1-4 Days 5-9 Days 10-13 100 90 93 90 % of Full Carry 80 60 40 20 20 22 18 37 42 37 61 70 68 0 Mar 1995 - Dec 2001 Mar 2002 - Dec 2003 Mar 2004 - Dec 2005 Mar 2006 - Mar 2009

Average Nearby Spreads for CBOT Soybean Futures during the Roll Window of Long-Only Index Funds, January 1995 - March 2009 Contracts Days 1-4 Days 5-9 Days 10-13 100 80 85 87 82 60 % of Full Carry 40 20 0 21 21 16 30 36 28-20 -40-34 -26-32 Mar 1995 - Nov 2001 Jan 2002 - Nov 2003 Jan 2004 - Nov 2005 Jan 2006 - Mar 2009

Average Nearby Spreads for CBOT Wheat Futures during the Roll Window of Long-Only Index Funds, March 1995 - March 2009 Contracts Days 1-4 Days 5-9 Days 10-13 % of Full Carry 120 100 80 60 40 40 51 55 48 46 43 79 84 78 105 106 100 20 0 Mar 1995 - Dec 2001 Mar 2002 - Dec 2003 Mar 2004 - Dec 2005 Mar 2006 - Mar 2009

Spread on the First Day of Delivery between Prices of the Expiring and Next-to-Expire Contracts for CBOT Corn, Soybean, Wheat Futures, March 2000-March 2009 1.20 Corn Soybeans Wheat 1.00 0.80 0.60 0.40 0.20 0.00 Mar-00 Sep-00 May-01 Dec-01 Jul-02 Mar-03 Sep-03 May-04 Dec-04 Jul-05 Mar-06 Sep-06 May-07 Dec-07 Jul-08 Mar-09 % of Full Carry Correlations C/S: +0.17 C/W:+0.38 S/W: +0.04

Risk Premium in the Carry Craig Pirrong Positive shock to volatility of fundamental uncertainty increases the precautionary demand for grain inventories Like increased demand for cash in uncertain times Leads to an increase in the expected price of storage, as reflected in the spreads between near and deferred futures Adds a risk premium component to spreads Spread = Storage + Interest - Convenience + Risk Premium