Analysis of investing on food and commodity prices as of September 2008

1. Food Prices: A View from the Finance Sector
World Trade Institute, 26-27 September 2008
Judson Berkey

2. Summary
1. What is the Issue?
2. What is the Evidence?
3. Potential Conclusions
4. Parting Thoughts
Disclaimer: the following are personal views and do not represent an official
position of UBS AG or any of its affiliates.
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3. 1. What is the Issue?

4. Key global food price, supply and demand developments
♦ Prices Up and Stocks Down: since 2001, food commodity prices have gone up significantly
(reversing an almost 75% decline since the mid 1970s) and inventories for most major
commodities have fallen. The most dramatic changes occurred 2005-mid 2008.
♦ It Could Get Worse: according to OECD-FAO, over the period 2007-2016, non-OECD
countries will continue to increase consumption of agricultural products and as a result
food prices are expected to rise another 20–50% by 2016. The International Food Policy
Research Institute (IFPRI) has estimated that world agricultural GDP is likely to fall by 16%
by 2020 due to global warming, with a larger, disproportionate impact on developing
economies compared to industrial countries.
♦ The Question: is this basically supply and demand at work or is there something else going
on in the markets causing additional price increases?
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5. Prices Rose As Commodity Investments Increased
♦ Commodity funds have become a new asset class in the investment allocations of investors,
particularly institutional investors (i.e. pension funds, sovereign wealth funds, endowments).
♦ From a low base, the amount of assets under management has increased significantly (e.g. <
10 B USD at end 2002 to approx. 200 B USD as of Jun 2008) as spot prices, represented by
index prices, increased more than 3 times during the same period.
♦ There even may be scope for further increase – e.g. 3.5% allocation by estimated USD 29
trillion of institutional investment money would result in USD 1 trillion in commodities.
♦ This includes investment in agriculture/livestock.
Source: 8 July 2008 Financial Times article 4

6. Types of Investors
♦ There are two main types of investors in commodity markets – commercials (i.e. traditionally
hedgers of physical product) and non-commercials (i.e. speculators - traditional and now
index investors).
♦ In some cases, the index speculators have reached a significant market size the value of
which has increased as prices of commodities increased.
5
Source: 20 May 2008 testimony of Michael W. Masters to US Senate Committee on Homeland Security and Governmental Affairs.

7. Commodity Index Investment via Futures
♦ The investments in commodity funds involve the use of futures. These futures represent
potential future claims on real products (but only if delivery is actually taken). Unlike
traditional speculators who are spread traders (i.e. long one month and short another to bet
on price direction) index investors are always net long (but someone else is short).
♦ Index investors do not take possession but roll futures forward each month. Some argue this
is equivalent to additional stocks (i.e. form of inventory “hoarding”) that raises prices
beyond what would otherwise be the market clearing level.
Source: 20
Source: 11 Sep
May 2008
2008 CFTC
testimony of
Staff Report
Michael W.
on Commodity
Masters to US
Swap Dealers
Senate
& Index
Committee on
Traders with
Homeland
Commission
Security and
Recommenda-
Governmental
tions
Affairs.
6

8. 2. What is the Evidence

9. Increases in Futures Contracts versus Prices
♦ World Bank study concluded that 130% increase in the IMF’s index of internationally traded
food prices from January 2002 to June 2008 was due to confluence of factors
– 25-30% due to higher energy prices , related increase in fertiliser and energy costs, and dollar weakness
– 70-75% due to biofuels and related consequences of low grain stocks, land use shifts, export bans, and
speculative activity
♦ The study did not identify the amount due to speculative activity but placed it last in its list
of potential causes.
♦ In addition, it noted that increases in future contracts did not coincide with increases in
commodity prices for those commodities where index speculators are supposed to have a
large market share.
Thus, the study concluded
that it is difficult to state
that speculation played a
material role in price
increase.
8
Source: World Bank July 2008 Policy Research Paper 4682 “A Note on Rising Food Prices” by Donald Mitchell

10. Price Increases without Futures Contracts
♦ A further piece of evidence is that prices have increased significantly for commodities that
are not even traded. This favors explanations focused on supply and demand fundamentals.
♦ Others have noted that past attempts to shut down commodity futures markets in the face
of price increases proved futile at alleviating price increases.
♦ These are further pieces of evidence that raise doubts about the role of commodity
speculation in driving prices far out of alignment with fundamentals.
Source: 8 July 2008 Finance Times article 9

11. Looking for Causation
♦ The most detailed studies to date on recent investment activity in commodity markets
have been done by the US Commodities Futures Trading Commission. The first, released in
July 2008, relied primarily on oil futures data from January 2003 to June 2008 and tried to
determine the potential for causal links between investment activity and price increases.
♦ “…the correlations between position changes and price changes tend to be quite variable.
While it is true that the positions of non-commercial traders in general, and hedge funds
in particular, often move in the same direction as prices, these correlations, standing
alone, do not provide definitive information about causation. Thus, further assessment of
the dynamic relationship between position changes and price changes is warranted”
Primarily negative
correlation – i.e.
commercials go net
shorter when prices
go up as they sell
more forward
Primarily positive –
i.e. hedge funds
going net longer as
prices go up
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Source: Interim Report on Crude Oil, Interagency Task Force on Commodity Markets, July 2008

12. Looking for Causation
♦ “Over the full time period, there is little evidence that daily position changes by any of the
trader sub-categories systematically precede price changes. This result holds for all
potential categories of speculators – for non-commercial traders in total, for hedge funds
and swap dealers individually...”
Thus, positions likely are
being adjusted to reflect
new price information
and represent economic
interests of the different
classes of trader.
Caveats:
• tests are of trader
groups not individual
traders
• test use end of day
positions and not
intraday trades
• tests are on nearby
contracts alone and not
on the full term structure
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Source: Interim Report on Crude Oil, Interagency Task Force on Commodity Markets, July 2008

13. Are there Hidden Factors?
♦ Some have argued that speculators “hide” in the CFTC commercial trader category through
their OTC swaps with swap dealers (i.e. swap dealers will combine all OTC and index
positions they handle and then enter into futures to hedge the residual exposure which right
now count as commercial hedges in CFTC data sets).
♦ CFTC analysis showed that while gross positions increased significantly, the swap dealer NET
positions decreased between 2006 and June 2008 and they were NET SHORT during first five
months of 2008 (i.e. betting on falling prices during a period of rapid increase).
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Source: Interim Report on Crude Oil, Interagency Task Force on Commodity Markets, July 2008

14. Additional Analysis of Swap Dealers and Index Traders
♦ CFTC released another study in September 2008 specifically examining detailed position
data collected on swap dealer and index trader activity in index commodities from 31 Dec
2007 – 30 Jun 2008. Focus on NYMEX crude, CBOT wheat & corn, and ICE cotton.
– Nature of market activity has changed since reporting requirements and position limit structure last modified
– Index trading volume still reasonable relative to total open futures interests in most commodity categories as of end
Jun 08 (13% for NYMEX crude, 47% for CBOT wheat, 18% for CBOT corn, 23% for ICE cotton)
– Index trading volume (measured by number of futures equivalent contracts) either steady or decreasing over time
period examined (Jan-Jun 08) so increase in value invested more due to price increase than new money (-11% for
NYMEX crude, +5% for CBOT wheat, +7% for CBOT corn, +1% for ICE cotton)
– Some client positions with swap dealers have exceeded exchange traded position limits (18 traders out of 550
examined with 35 individual positions). Amount of excess usually small but in a few cases non-commercial client
combined ETF position and OTC position combined significantly exceeded limits.
– Regular data collection to occur with specific data collected on swap dealers and a new quot;long formquot; report for large
traders. CFTC to consider eliminating bona fide hedge exemption on position limits for swap dealers and replace
with narrower risk management exemption. Also, CFTC to review separation between trading and research.
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Source: Staff Report on Commodity Swap Dealers & Index Traders with Commission Recommendations, September 2008

15. 3. Potential Conclusions

16. Expert Analysis on the role of speculators
♦ Expert opinion generally sees speculators as contributing to “price discovery” and thus
helping stabilise the markets with their futures investments. This does not deny the role
that speculation can have on prices but places it into a more holistic context in terms of
signalling the need for adjustments to the supply and demand fundamentals in future.
– IEA (International Energy Agency) (June 2008, re oil): quot;Blaming speculation is an easy solution
which avoids taking the necessary steps to improve supply-side access and investment or to
implement measures to improve energy efficiency.“
– Sanders, Irwin, and Merrin (The Adequacy of Speculation in Agricultural Futures Markets: Too
Much of a Good Thing, June 2008): “First, if there is a market impact from index fund activity, it
seems likely that it would have occurred during the period of most rapid growth: 2004-2005.
Second, the stabilization of the index funds’ percent of total open interest may suggest that
other traders have adjusted their strategies to better cope with this relatively new market
participant. Third, Working’s speculative index [a measure of speculative activity relative to
hedging activity] suggests that long-only index funds may in fact be beneficial in markets
dominated by short hedging pressure. That is, they improve the adequacy of speculation by
helping the market to ‘carry’ unbalanced short hedging.”
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17. Financial industry analysis on the role of speculators
♦ Financial industry analysis focuses on major structural and cyclical reasons for the price
increases and agrees with regulators and other experts on the role of speculation:
– UBS (Sep 2007): quot;In the near-term, food prices are unlikely to rise in simple linear fashion – short-
run supply responses are sufficiently elastic to mitigate many price increases. Over longer time
horizons, however, the secular forces of supply and demand are likely to place strong pressure on
the prices of many agricultural products, as well as on the inputs of modern food production,
including land, fertilizers, pesticides, water use, and related infrastructure.“
– Barclays Capital (June 2008): “Our view is that the rise has been well supported by fundamentals
and that purely speculative demands have not played a role.”
– Deutsche Bank (July 2008): quot;When regulators turn the lights on these 'dark markets', they will
find no monsters in the room – rather underlying fundamentals driving prices higher.“
– Goldman Sachs (June 2008): “The role of speculators is to bring new information to the market
on forward supply and demand fundamentals….The role of index investors is to supply a pool of
stable, passive, unleveraged capital to bear commodity price risk….by allowing commodity
producers to transfer their inherent commodity price risk exposure to long-term investors who
are better-suited to bear it, the participation of the index investors in the commodity futures
markets lowers the cost of capital to commodity producers, and by lowering costs helps to lower
commodity prices over the long run.”
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Source: Speculators, Index Investors, and Commodity Prices (Goldman Sachs, June 29, 2008)

18. So it comes back to shocks in supply and demand
Taken from Bernd Schanzenbächer, Global Head Environmental Business Group, Credit Suisse at Trading on 17
Scarcity: Ecological Progress and Financial Market Innovations conference, 10-11 Sep 2008, Zurich.

19. 4. Parting Thoughts

20. Are We Asking the Right Questions?
♦ We are asking whether weak market structures allow speculators to manipulate prices
beyond fundamentals – i.e. are investors contributing to the food price crisis
– On balance, markets (in their role as a means to identify prices and allocate resources) work.
– This assumes that markets have the necessary and sufficient information to make decisions and
the reporting and other rules are sufficient to prevent market manipulation.
♦ Should we instead ask whether markets get all necessary and sufficient information to
perform their role efficiently – i.e. how do we best address the food quality crisis
– Need to include negative externalities from agricultural processes (climate change, environmental
damage, human health)
– Need to consider the distorting effects of subsidies, tariffs, and taxes (including water pricing)
– Need to determine whether to include non-monetary values (ecosystem services, local production
& food security, food waste and consumption choices (e.g. meat, agrofuels), economic
development, traditions associated with certain agricultural practices and food products).
♦ The question is whether our cheap food was really as cheap as we thought – i.e. was it only
cheap because of our lack of knowledge or deliberate avoidance of certain considerations.
– As with climate change, we need a public debate, informed by science and economics, about the
kind of agriculture that we want.
– This may fit into a broader discussion about tradeoffs in the use of natural resources (see, e.g., the
UN Millennium Ecosystem Assessment & EU Economics of Ecosystems and Biodiversity reports)
– Once the goals are set, technology and markets will provide tools to achieve the identified ends
with governments there to make sure the rules of the game are followed
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