What are future contracts?

The type of contract that speculators buy and sell is called a ‘future contract’. A ‘future contract’ gives the bearer the right to buy or sell a certain amount of a good for a fixed price at a specific point in the future; for example, the right to sell one tonne of wheat for €250 in three months time.

This way, the buyer and the seller both know what the price of the commodity will be in the future and they can plan accordingly. The buyer and the seller both benefit from the future contract. For example, a farmer can buy fertilisers and seeds because he/she knows they will receive €250 in three months for the wheat they are producing at the moment. And the buyer of the future contract, a large bakery in this example, can calculate the price its bread will cost to make in the future.

The system of future contracts therefore gives both buyer and seller – farmer and baker – more certainty about the future. It is an insurance against the risk of price fluctuations. In economic jargon, this process is called ‘hedging’ and the actors who engage in it are called ‘hedgers’.

What happens if a farmer wants to sell his/her goods on the futures market but there is no producer to buy it (or the other way around)?

This is when speculators enter the picture. Speculators buy future contracts even though they don’t want to trade any goods. The speculators sell on the contracts before they are due to be honoured. By buying and selling future contracts at times when nobody else wants to, their activity can be useful for producers and buyers. In these circumstances, the activities of speculators help markets run more efficiently. The only goal of speculators is to make a profit, but when there is a lack of demand or supply their activities can be useful to farmers and buyers because it gives them the opportunity to ‘hedge’. In economics terminology, this is called ‘providing liquidity to the market’.

 

How exactly does food speculation distort the market?

There are two problems with food speculation. First, when speculators dominate the market, the prices that are paid for actual, physical goods (bought and sold in what is known as ‘spot markets’) are not determined by demand and supply anymore. They are instead determined by the prices of the future contracts.

Sellers do not sell their goods if they know they can get a higher price in the future. So buyers have to pay a similar price now to what buyers are contracting to pay in the future. When a lot of money flows into buying future contracts prices are driven up unconnected from supply and demand. ‘Spot’ and ‘future’ prices are driven up regardless of how supply and demand are expected to change.

Secondly, speculators often react to each other’s behaviour, something that is called ‘herding’. This means they can not only drive prices up, but can also cause rapid falls in prices. Markets whose prices go rapidly up and down are described as ‘volatile’. Volatile markets are bad for everyone – producers and consumers – because it becomes more difficult to know how prices will develop. The only people who can profit from volatility are the speculators.

Who are the speculators?

Speculators used to be specialised financial traders with knowledge about agricultural production worldwide. But, in recent years, other speculators have entered the market. Many pension funds and other investors have put money into agricultural goods and other commodities because they were seen as safe havens in times of economic turmoil. The amount of money flowing into agricultural speculation increased sharply during the financial crisis.

The massive inflow of money caused prices to go up until the bubble burst, and then they sharply declined.

In this kind of market structure, the banks always win. They charge fees to clients who want to invest regardless of whether prices go up or down. Banks also trade themselves and make profits from directly speculating on agricultural goods.

Who loses from speculation?

Those who lose most from food speculation are the poorest people on the planet. People living in urban areas are hit especially hard. Poor people spend the highest proportion of their income on food: between 50% and 80%. The United Nation’s Food and Agriculture Organisation estimates that the food price crisis of 2008 pushed 100 million people into hunger and malnutrition.

Small producers also lose. They don’t have the means to insure themselves against price volatility. Small producers sell food and in that way profit from higher prices, but they are also buyers of agricultural goods and therefore still lose out when prices rise.

Countries in Africa import food worth 13 billion US dollars per year, so their economies and trade balances are negatively affected by high food prices as well.

What can be done about food speculation?

Friends of the Earth Europe and other groups campaigning to halt excessive food speculation are calling for a mechanism called ‘position limits’. Position limits restrict the number of contracts that can be held by each speculator or bank. This allows for speculators to provide liquidity to the market, but stops them from dominating the market and driving up prices.

Position limits regulated commodity markets between the 1930s and 1990s, a time in which food prices remained low and stable. During financial deregulation in the 1990s, they were abolished due to pressure from the big investment banks. Re-establishing position limits would help to secure low and stable prices in the future.

Is there anything I can do about it?

You can check if your bank is involved in food speculation and ask for them to stop. A report by Friends of the Earth Europe provides an overview of which European banks speculate with food.

The campaigns have already forced the second-largest German bank Commerzbank to stop speculating with food and other banks have pulled out as well. But we need to keep the pressure up!

Where can I get more information?

Here is a selection of interesting reports that explain how food speculation works and what can be done about it:

World Development Movement published an infographic that explains food speculation in an easily understandable way

Two great videos explain how food speculation works: One has been produced by WEED and the other one by Finance Watch

An extensive report by the World Development Movement explains how speculation affects food prices

If you want to know more about position limits, there is also a World Development Movement report explaining how they work and how they can be effective

The German NGO foodwatch has written a long report that explains everything you want to know about food speculation (also available in German and French)

Two reports that outline policy recommendations have been released by World Development Movement and Finance Watch

Friends of the Earth Europe has written a report showing which European banks are involved in food speculation and land-grabbing

If you want to get to the nitty-gritty of how commodity markets work and how speculation influences prices, there is also a lot of material available. Here is a small selection:

WEED provides a regularly updated overview of research on food speculation, available here

Another overview of the literature has been published by the Institute for Agriculture and Trade Policy

The United Nations Conference on Trade and Development (UNCTAD) takes a close look at commodity markets and how they are influenced by speculation

Two academic papers (here and here) look at the influence of commodity index funds on food prices

Another research paper investigates the relationship between future and spot market prices

MiFID: See for an explanation of what the Markets in Financial Instruments Directive (MIFID) is and what has happened in the last years this presentation: http://www.wdm.org.uk/mifid