Tuesday, July 08, 2008

Excess speculation? Onions tell the tale

Are commodity speculators to blame for higher commodities prices and increased volatility in price movements? A study of the now defunct onion futures market may shed more light on this ongoing political debate.

This morning, both the Wall Street Journal and the Financial Times ran articles on the current political witch hunt against commodity speculators. Each paper used the story of the onion futures ban to illustrate how futures markets actually work, while addressing the recurring blame game centered on "evil" commodity speculators.

An excerpt from the WSJ editorial, "The Onion Ringer":

"In 1958, Congress officially banned all futures trading in the fresh onion market. Growers blamed "moneyed interests" at the Chicago Mercantile Exchange for major price movements, which could sink so low that the sack would be worth more than the onions inside, then drive back up during other seasons or even month to month. Championed by a rookie Republican Congressman named Gerald Ford, the Onion Futures Act was the first (and only) time that futures trading in a specific commodity was prohibited, and the law is still on the books.

But even after the nefarious middlemen had been curbed, cash onion prices remained highly volatile. In a classic 1963 paper, Stanford economics professor Roger Gray examined the historical behavior of onion prices before and after the ban and showed how the futures market had actually served to stabilize prices.

The fresh onion market is highly seasonal. This leads to natural and sometimes large adjustments in prices as the harvest draws near and existing inventories are updated. Speculators became the fall guys for these market forces. But in reality, the Chicago futures exchange made it possible to mitigate the effects of the harvest surplus and other shifts in supply and demand."

The editorial goes on to note that, "to this day, fresh onion prices still cycle through extreme peaks and troughs." So the overall stabilizing effect that the onion futures market might have had is now gone.

In fact, some are looking for a return to onion futures trading, as the benefits of such a market are now being seen by the sons of those who originally advocated the ban in onion futures trading.

Now, to be fair, we should mention that there was an attempt at manipulation in this market that prompted some outcry and support for the onion trading ban that came later (see the 1956 Time article cited in Marginal Revolution's post).

But were these manipulation attempts indicative of a problem with the onion futures market itself, or was this a sign of problems with the rules governing traders? Shouldn't the exchanges examine the possibilities for price manipulation and censure traders found guilty of such actions, rather than allowing for a ban on entire market?

It seems that anytime prices for a commodity are driven higher or lower than some people would care to see, the old attacks on speculators are renewed. In this light, it's not all that surprising to hear calls for a ban on futures trading in a given commodity, as public alarm over rising prices leads politicians and regulators to jump on the anti-speculation bandwagon.

The FT sums up the situation in, "The usual suspects...":

"The International Energy Agency, the western countries’ oil watchdog, recently accused politicians of looking for “an easy solution” that avoids taking the necessary steps to improve supply and curtail demand. Michael Lewis, head of commodities research at Deutsche Bank, says: “When regulators turn the lights on these ‘dark markets’, they will find no monsters in the room – rather underlying fundamentals driving prices higher.”

The Onion Futures Act is a perfect case study. When economists studied the market, they discovered that volatility and prices were higher in the period after the ban than they were before. Frédéric Lasserre, head of commodities research at Société Générale in Paris – who has studied the onion example – says today’s context is very similar. “The politicians are leading the debate pressured by the people,” Mr Lasserre says.

The onions market is not the only example. India last year banned financial trading in most agricultural commodities but prices continued to rise. “[Banning financial trading] is irrelevant,” says a senior Indian official. “When a commodity is scarce, its price rises, whether it is traded on an exchange or not.”"

Seems there's no getting around supply and demand in the end.