Sunday, August 01, 2010

Food, markets, hunger and profit

The July 2010 issue of Harper's Magazine contains a most disturbing story by Frederick Kaufman, "The food bubble: How Wall Street starved millions and got away with it."  If you are looking for a story of how greed and unregulated business practices on Wall Street and beyond affect life, literally in "life and death" scenarios, this is one you need to read and understand.  The essay is long.  I've cut and pasted pieces for your consideration. You may want to pick up a copy and read the entire essay. 

The history of food took an ominous turn in 1991, at a time when no one was paying much attention. That was the year Goldman Sachs decided our daily bread might make an excellent investment.

Agriculture, rooted as it is in the rhythms of reaping and sowing, had not traditionally engaged the attention of Wall Street bankers, whose riches did not come from the sale of real things like wheat or bread but from the manipulation of ethereal concepts like risk and collateralized debt. But in 1991 nearly everything else that could be recast as a financial abstraction had already been considered. Food was pretty much all that was left. And so with accustomed care and precision, Goldman’s analysts went about transforming food into a concept. They selected eighteen commodifiable ingredients and contrived a financial elixir that included cattle, coffee, cocoa, corn, hogs, and a variety or two of wheat. They weighted the investment value of each element, blended and commingled the parts into sums, then reduced what had been a complicated collection of real things into a mathematical formula that could be expressed as a single manifestation, to be known thenceforward as the Goldman Sachs Commodity Index. Then they began to offer shares.

As was usually the case, Goldman’s product flourished. The prices of cattle, coffee, cocoa, corn, and wheat began to rise, slowly at first, and then rapidly. And as more people sank money into Goldman’s food index, other bankers took note and created their own food indexes for their own clients. Investors were delighted to see the value of their venture increase, but the rising price of breakfast, lunch, and dinner did not align with the interests of those of us who eat. And so the commodity index funds began to cause problems.

Wheat was a case in point. North America, the Saudi Arabia of cereal, sends nearly half its wheat production overseas, and an obscure syndicate known as the Minneapolis Grain Exchange remains the supreme price-setter for the continent’s most widely exported wheat, a high-protein variety called hard red spring. Other varieties of wheat make cake and cookies, but only hard red spring makes bread. Its price informs the cost of virtually every loaf on earth.

As far as most people who eat bread were concerned, the Minneapolis Grain Exchange had done a pretty good job: for more than a century the real price of wheat had steadily declined. Then, in 2005, that price began to rise, along with the prices of rice and corn and soy and oats and cooking oil. Hard red spring had long traded between $3 and $6 per sixty-pound bushel, but for three years Minneapolis wheat broke record after record as its price doubled and then doubled again. No one was surprised when in the first quarter of 2008 transnational wheat giant Cargill attributed its 86 percent jump in annual profits to commodity trading. And no one was surprised when packaged-food maker ConAgra sold its trading arm to a hedge fund for $2.8 billion. Nor when The Economist announced that the real price of food had reached its highest level since 1845, the year the magazine first calculated the number.

Nothing had changed about the wheat, but something had changed about the wheat market. Since Goldman’s innovation, hundreds of billions of new dollars had overwhelmed the actual supply of and actual demand for wheat, and rumors began to emerge that someone, somewhere, had cornered the market. Robber barons, gold bugs, and financiers of every stripe had long dreamed of controlling all of something everybody needed or desired, then holding back the supply as demand drove up prices. But there was plenty of real wheat, and American farmers were delivering it as fast as they always had, if not even a bit faster. It was as if the price itself had begun to generate its own demand—the more hard red spring cost, the more investors wanted to pay for it.

“It’s absolutely mind-boggling,” one grain trader told the Wall Street Journal. “You don’t ever want to trade wheat again,” another told the Chicago Tribune.

“We have never seen anything like this before,” Jeff Voge, chairman of the Kansas City Board of Trade, told the Washington Post. “This isn’t just any commodity,” continued Voge. “It is food, and people need to eat.”

The global speculative frenzy sparked riots in more than thirty countries and drove the number of the world’s “food insecure” to more than a billion. In 2008, for the first time since such statistics have been kept, the proportion of the world’s population without enough to eat ratcheted upward. The ranks of the hungry had increased by 250 million in a single year, the most abysmal increase in all of human history.

Then, like all speculative bubbles, the food bubble popped. By late 2008, the price of Minneapolis hard red spring had toppled back to normal levels, and trading volume quickly followed. Of course, the prices world consumers pay for food have not come down so fast, as manufacturers and retailers continue to make up for their own heavy losses.
Imaginary wheat bought anywhere affects real wheat bought everywhere. But as it turned out, index traders had purchased the majority of their long wheat futures on the oldest and largest grain clearinghouse in America, the Chicago Mercantile Exchange. And so I found myself pushing through the frigid blasts of the LaSalle Street canyon. If I could figure out precisely how and when wheat futures traded in Chicago had driven up the price of actual wheat in Minneapolis, I would know why a billion people on the planet could not afford bread.

The man who had agreed to escort me to the floor of the exchange traded grain for a transnational corporation, and he told me several times that he could not talk to the press, and that if I were to mention his name in print he would lose his job. So I will call him Mr. Silver.

In the basement cafeteria of the exchange I bought Mr. Silver a breakfast of bacon and eggs and asked whether he could explain how index funds that held long-only Chicago soft red winter wheat futures could have come to dictate the spot price of Minneapolis hard red spring. Had the world starved because of a corner in Chicago? Mr. Silver looked into his scrambled eggs and said nothing.

So I began to tell him everything I knew, hoping he would eventually be inspired to fill in the blanks. I told him about Joseph in Egypt, Osaka in 1730, the Panic of 1857, and futures contracts for cat pelts, molasses, and onions. I told him about Goldman’s replication strategy, Gorton and Rouwenhorst’s 2005 paper, and the rise and rise of index funds. I told him that at least one analyst had estimated that investments in commodity index funds could easily increase to as much as $1 trillion, which would result in yet another global food catastrophe, much worse than the one before.

And I told Mr. Silver something else I had discovered: About two thirds of the Goldman index remains devoted to crude oil, gasoline, heating oil, natural gas, and other energy-based commodities. Wheat was nothing but an indexical afterthought, accounting for less than 6.5 percent of Goldman’s fund.

Mr. Silver sipped his coffee.

Even 6.5 percent of the Goldman Sachs Commodity Index made for a historically unprecedented pile of long wheat futures, I went on. Especially when those index funds kept rolling over the contracts they already had—all of them long, only a smattering bought in Kansas City, none in Minneapolis.

And then it occurred to me: It was neither an individual nor a corporation that had cornered the wheat market. The index funds may never have held a single bushel of wheat, but they were hoarding staggering quantities of wheat futures, billions of promises to buy, not one of them ever to be fulfilled. The dreaded market corner had emerged not from a shortage in the wheat supply but from a much rarer economic occurrence, a shock inspired by the ceaseless call of index funds for wheat that did not exist and would never need to exist: a demand shock. Instead of a hidden mastermind committing a dastardly deed, it was old Mike Mullin’s “brainless entity,” the investment instrument itself, that had taken over and created the effects of a traditional corner.

Mr. Silver had stopped eating his eggs.

I said that I understood how the index funds’ unprecedented accumulation of Chicago futures could create the appearance of a market corner in Chicago. But there was still something I didn’t get. Why had the wheat market in Minneapolis begun to act as though it too had been cornered when none of the index funds held hard red spring? Why had the world’s most widely exported wheat experienced a sudden surge in price, a surge that caused a billion people—

At which point Mr. Silver interrupted my monologue.

Index-fund buying had pushed up the price of the Chicago contract, he said, until the price of a wheat future had come to equal the spot price of wheat on the Chicago Mercantile Exchange—and still, the futures price surged. The result was contango.

I gave Mr. Silver a blank look. Contango, he explained, describes a market in which future prices rise above current prices. Rather than being stable and steady, contango markets tend to be overheated and hysterical, with spot prices rising to match the most outrageously escalated futures prices. Indeed, between 2006 and 2008, the spot price of Chicago soft red winter shot up from $3 per bushel to $11 per bushel.

The ever-escalating price of wheat and the newfound strength of grain markets were excellent news for the new investors who had flooded commodity index funds. No matter that the mechanism created to stabilize grain prices had been reassembled into a mechanism to inflate grain prices, or that the stubbornly growing discrepancy between futures and spot prices meant that farmers and merchants no longer could use these markets to price crops and manage risks. No matter that contango in Chicago had disrupted the operations of the nation’s grain markets to the extent that the Senate Committee on Homeland Security and Governmental Affairs had begun an investigation into whether speculation in the wheat markets might pose a threat to interstate commerce. And then there was the question of the millers and the warehousers—those who needed actual wheat to sell, actual bread that might feed actual people.

Mr. Silver lowered his voice as he informed me that as the price of Chicago wheat had bubbled up, commercial buyers had turned elsewhere—to places like Minneapolis. Although hard red spring historically had been more expensive than soft red winter, it had begun to look like a bargain. So brokers bought hard red spring and left it to the chemists at General Mills or Sara Lee or Domino’s to rejigger their dough recipes for a higher-protein variety.

The grain merchants purchased Minneapolis hard red spring much earlier in the annual cycle than usual, and they purchased more of it than ever before, as real demand began to chase the ever-growing, everlasting long. By the time the normal buying season began, drought had hit Australia, floods had inundated northern Europe, and a vogue for biofuels had enticed U.S. farmers to grow less wheat and more corn. And so, when nations across the globe called for their annual hit of hard red spring, they discovered that the so-called visible supply was far lower than usual. At which point the markets veered into insanity.

Bankers had taken control of the world’s food, money chased money, and a billion people went hungry.

Mr. Silver finished his bacon and eggs and I followed him upstairs, beyond two sets of metal detectors, dozens of security staff, and a gaudy stained-glass image of Hermes, god of commerce, luck, and thievery. Through the colored glass that outlined the deity I caught my first glimpse of the immense trading floor of the Chicago Mercantile Exchange. The electronic board had already begun to populate with green, yellow, and red numbers.

The wheat harvest of 2008 turned out to be the most bountiful the world had ever seen, so plentiful that even as hundreds of millions slowly starved, 200 million bushels were sold for animal feed. Livestock owners could afford the wheat; poor people could not. Rather belatedly, real wheat had shown up again—and lots of it. U.S. Department of Agriculture statistics eventually revealed that 657 million bushels of 2008 wheat remained in U.S. silos after the buying season, a record-breaking “carryover.” Soon after that bounteous oversupply had been discovered, grain prices plummeted and the wheat markets returned to business as usual.

The worldwide price of food had risen by 80 percent between 2005 and 2008, and unlike other food catastrophes of the past half century or so, the United States was not insulated from this one, as 49 million Americans found themselves unable to put a full meal on the table. Across the country demand for food stamps reached an all-time high, and one in five kids came to depend on food kitchens. In Los Angeles nearly a million people went hungry. In Detroit armed guards stood watch over grocery stores. Rising prices, mused the New York Times, “might have played a role.”

On the plane to Minneapolis I had read a startling prediction: “It may be hard to imagine commodity prices advancing another 460 percent above their mid-2008 price peaks,” hedge-fund manager John Hummel wrote in a letter to clients of AIS Capital Management. “But the fundamentals argue strongly,” he continued, that “these sectors have significant upside potential.” I made a quick calculation: 460 percent above 2008 peaks meant hamburger meat priced at $20 a pound.

On the ground in Minneapolis I put the question to Michael Ricks, chairman of the Minneapolis Grain Exchange. Could 2008 happen again? Could prices rise even higher?

“Absolutely,” said Ricks. “We’re in a volatile world.”

I put the same question to Layne Carlson, corporate secretary and treasurer of the Minneapolis Grain Exchange. “Yes,” said Carlson, who then told me the two principles that govern the movement of grain markets: “fear and greed.”

But wasn’t it part of a grain exchange’s responsibility to ensure a stable valuation of our daily bread?

“I view what we’re working with as widgets,” said Todd Posthuma, the exchange’s associate director of market operations and information technology, the man responsible for clearing $100 million worth of trades every day. “I think being an employee at an exchange is different from adding value to the food system.”

Above Mark Bagan’s oversize desk hangs a jagged chart of futures prices for the hard red spring wheat contract, mapping every peak and valley from 1973 to 2006. The highs on Bagan’s chart reached $7.50. Of course, had 2008 been included, the spikes would have, literally, gone through the roof.

Would the price of wheat rise again?

“The flow of money into commodities has changed significantly in the last decade,” explained Bagan. “Wheat, corn, soft commodities—I don’t see these dollars going away. It already has happened,” he said. “It’s inevitable.”


Chris said...

I might point out that you can google "Goldman Sachs--Response to the Food Bubble." to get the rebutal.

Mr Frederick appeared on "Democracy Now" recently which makes him highly suspect as an extreme left-winger.

Anonymous said...

As I expected, the truth does not reveal itself in the article presented in this blog. See Goldman Sachs rebuttal at this link.
In part the Goldman Sachs rebuttal notes the following:
"Mr. Kaufman glosses over the facts underlying the 2008 Minneapolis Wheat price spike, which was a classic commodity price spike driven by an extraordinary shortage of inventory. This shortage resulted from rising global demand for grain, which led consumption to exceed production in 7 of the 8 years preceding the price spike according to the USDA, and the worst drought in Australia in over 100 years, which cut the country’s wheat production in half. According to the USDA, US wheat inventories before the 2008 harvest had fallen to their lowest levels for 50 years, and world wheat inventories had fallen to their lowest levels since 1982 – not, coincidentally, the last time wheat was as expensive (in real terms) as in 2008.

Long-term trends, including increased meat consumption by the growing middle class in the emerging markets and the increased use of biofuels in the developed markets, have created a backdrop for global food shortages and, as a result, millions are left desperately exposed to the vagaries of the weather for their survival.

It is a shame that the plight of these millions appears to merit a cover story in your magazine only when it is exploited as a pretext to launch unsubstantiated attacks against the financial industry. Alleviating food shortages will require hard policy choices to be made based on a serious public discussion of the problem. Your unfounded conspiracy theories only serve to delay this vital debate."
In short, the Harper's propaganda is just another unsupported lefty attack on capitalism.

Larry James said...

In fact, as the report makes clear, the period in question was a time of amazing production--possibly the greatest harvest ever. Your "rebuttal" does not address the well documented practice of buying only long with no short purchases. Just a fact.

BTW--So, Harper's, a well respected journal for over a century, is not to be considered against the company report, read here "company line"? Are you kidding me? Talk about bias. At least refute the argument with a credible source. You fancy yourself objective here; but you are not.

rcorum said...

I first read the Kaufman article and then I read the Goldman Sachs response and to be honest it sure seemed to me that the folks at Sachs basically took apart just about everything Kaufman, and I find it interesting that Sachs is biased and yet Kaufman is not. I find you logic on this point a bit hard to follow. If someone disagrees with you they are biased. If someone agrees with you regardless of their bias they are on the up and up. What would you expect Goldman Sachs to do. I want to make it clear that I am giving my reaction as a total layman. I really think that the average person who read both articles would read the Kaufman article and be totally impressed until they read the Sachs article and like it or not they provide plausible answers the points Kaufman makes. Let's face it. We all are biased to some degree, but as usual it was an interesting and challenging post. There is so much that I would like to know about economics because it seems to me that very intelligent people from the right and left come to completely different conclusion on the inner workings of our economic system. At the end of the day I want our country to be as free as possible and as far away from socialism as we can get.

Anonymous said...

I have read the article, and the response.

To the point of this discussion: Let's ask the big question. Once people/entities start "investing" in food without actually owning, buying, and selling the actual food, it is bound to mess around with the price. And if recent financial history proves anything, when Wall Street starts dividing and slicing and dicing investments in any arena, it has great profit possibilities, and also possibilities of great disaster. Let me recommend that you read The Big Short by Michael Lewis to see what Wall Street did with mortgage investments (which had truly disastrous consequences), or, for a really interesting case study, read The Big Rich by Bryan Burrough to refresh your mind about what the Hunt brothers did to silver prices.

I am just a little bothered by the idea that people/entities can invest in food futures without having any actual interest in owning, and selling, the actual food. How can this be right/good for the people who need food?

Please consider the overall point of the article, revealed in this sentence from the opening paragraph: "That was the year Goldman Sachs decided our daily bread might make an excellent investment." Is this really a good idea -- for food to become another investment target? How did it work out when the mortgages of individual home owners became such a target?

Larry was certainly correct that the Goldman Sachs response was self-serving.

Harper's has a history of publishing substantive articles that raise major issues. Just yesterday, Frank Rich linked to the 1969 article by David Halberstam that raised all of the right questions about the Viet Nam war. Yes, people back then attacked him (and Harper's). History, to put it mildly, has proven Halberstam, and Harper's, right.

I appreciate Larry for posting this Harper's article.

Anonymous said...

Harper's is a lefty magazine, Generally, LJ usually only references lefty pubs. About the only time he cites a right of center pub is so he can attack it.

Lorlee said...

I guess that I have a hard time believing much of what Goldman says given their actions over the last few years.

Just confirms my belief that it is one big ponzi scheme where a few make a lot of money and the rest go hungry. (literally)

Larry James said...

My point about bias on the part of Goldman Sachs simply has to do with their obvious self-interest. Kaufman simply raises disturbing questions that they do not answer, RC.