Monday, July 27, 2009

Got Milk? - Chicago Mercantile Exchange Edition

Did the investment choices of a pension fund manager in California affect the welfare of dairy farmers in Stratham, NH? recently published an article by Michael Mccord about how the recent drop in milk prices is hurting a local dairy farmer in Stratham, NH.  Something Mr. Mccord wrote toward the end of the article really caught my attention:

Taylor said one aspect of the price setting formula needs to change immediately because it's connected to commodity prices set by the Chicago Mercantile Exchange — which has become a proven ground for ever more-complicated derivative investment schemes designed to turn quick profits, not unlike the same ones that produced mortgage-backed securities and credit default swaps.

"It's fairly obvious there's speculation, we know there's speculation," Taylor said. And there's little the local dairy farmer can do to stop it.

Financial speculators running wild in the milk market? What's up with that?  

It turns out that under the US government's Byzantine agricultural price support program, the price paid to dairy farmers for their milk is indirectly connected to prices set on the Chicago Mercantile Exchange for butter and cheddar cheese.  So when the spot price of butter or cheese increases on the Chicago Mercantile Exchange, The Stuart Farm in Stratham is likely to get a better price for their milk.  Likewise, if commodity prices collapse, it can really hurt local dairy farmers.

You may recall that last year some politicians were blaming high gas prices on commodities speculators.   The concern was that people with no interest in an underlying commodity were making big bets on future prices and by doing so, were impacting the prices of the underlying commodity.  Most of the fuss was about oil speculators, but the same forces were at work in other commodities.   

Now back to milk prices.   The graph below shows the wholesale price of milk since 1995.   The price is quoted in something called dollars per hundredweight ($/cwt).  You can see that the price is quite volatile.  In just the last year the price has ranged from under $10 to well over $20.  It'd sure be tough to run any kind of business when the market price for your output is bouncing around like that.

Milk price data from USDA through

Next, to see how the fortunes of dairy farmers appear tied to those of commodities traders, take a look at the graph below of the price of milk vs the CRB foodstuffs index.  This well known commodity index does have butter in it, but it also has 9 other commodities including corn, sugar, hogs, soybean oil and wheat.  Aside from a general uptrend from inflation, there's no clear reason why the price of milk would be correlated to this broad agricultural index.

Commodity index data from the Commodities Research Bureau (CRB)

But as you can see from the graph above, the two lines may not trace identical paths, but they definitely rhyme.  It sure seems like the prices of unrelated commodities may be impacting the price paid to NH dairy farmers for their milk.  At the least, something is causing milk and a diverse basket of agricultural commodities to be very highly correlated.

Maybe you're skeptical, since the CRB foodstuffs index is comprised of only agricultural products?  The graph below shows the price of milk vs the CRB commodity spot index.  This index includes everything in the foodstuffs index plus metals, textiles,  industrial materials, and livestock.  Since it contains a broad mix of unrelated commodities, it isn't nearly as volatile as the price of milk.  Still, there does seem to be a connection.

The plot of most commodity indices looks roughly similar to the green line in the graph above.  That line clearly shows that between 2005 and 2008, the world was in the grips of a nasty commodities bubble that impacted the prices of nearly all commodities, including milk.   For us here in NH, the most immediate impact of this bubble was a sharp spike in the price of gasoline, home heating oil, groceries, and other essentials, followed by an abrupt crash late last year.

Ok, so how does all this explain a how a pension fund in California could impact the price of milk in Stratham, you might ask?  Well,  the "speculators" that got the blame for high gas prices, and even the high milk prices, were often portfolio managers for pension funds, college endowments and other investment firms.   The charge was that all this new money entering the commodities market inflated prices, and when the market fell last year, these same speculators rushed for the exits and caused commodity prices to plummet.

Although there were certainly speculators, the big money flowing into commodities between 2005-2008 wasn't speculating as much as hedging.  Large institutional portfolio managers, such as CalPERS, the retirement system in California, were just doing what their investment textbooks said they should do.  They were following recent asset allocation research that suggested holding a broad basket of commodities futures could help immunize them from the ravages of high inflation and reduce the overall riskiness of their investment portfolio.

Economists disagree on the impact of  these new commodities investors.  Since they don't consume the commodities they invest in, many economists think their impact is limited.   Economics blogger and Professor James Hamilton did a pretty extensive analysis on the topic.  His conclusion was that speculators along with these new commodities investors may increase price volatility, but their impact is mostly temporary and wasn't the primary driver of the commodities bubble.  Many economists believe that the commodities bubble was a natural result of strong worldwide economic growth through early 2008.  They believe increased demand from several emerging economies, such as China and India, strained the supply of all commodities and that's why the prices of seemingly unrelated commodities increased together.

Regardless of whether the impact on prices of commodities by pension fund investors was transient or more sustained, most agree that the inflow of institutional money from sources such as CalPERS has been a big factor in the volatility of commodity markets over the last few years.  There's little doubt that this added volatility has at least played a role in the pain felt by dairy farmers in places like Stratham, NH. 

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