Are hedge funds to blame for rising food prices?

How would you like to earn a million dollars today, just to have it disappear tomorrow? Worse, how would you like it if this happened every day?

That’s exactly what grain elevators are experiencing as record commodity prices and dramatic price swings force them to adjust the amount of margin money they ante up every day for grain forward contracts used to hedge, or lock in, today's price.

“That’s concerning and it’s wearing—we receive margin returns of hundreds of thousands or millions of dollars one day and we send it back the next,” says Michael Sulzberger, manager of Prairie Central Coop, which runs 10 elevators in Illinois. “That doesn’t disable us, it just kind of wears out the managers.”

And many of those managers in the grain elevator and farm industries say that long-only, passively managed index fund speculation is to blame.

Randy Gordon is the spokesman for the National Feed and Grain Association, a Washington, D.C.-based group with about 900 members which represent nearly 70 percent of the grain and oilseeds produced in the U.S.

Gordon explains that the volatility in commodity markets is forcing grain elevators to tap into higher and higher lines of credit to meet margin requirements and buy forward contracts.

With historically high prices of corn, soybeans and wheat, the elevators are running low on options to finance the contracts and some are asking the farmers to shoulder some of the burden.

“It wouldn’t be uncommon in previous years for elevators to even offer forward contracts into the next crop year, the 2009 crop. And to my knowledge, that has virtually ended, given this kind of volatility and capital requirements and demands,” Gordon says.

The NGFA blames the entry of long-only index funds—such as hedge funds and pension funds—for exacerbating price volatility. Gordon says while there are a number of factors that have made the markets tight, including increased demand from emerging markets and ethanol production, the NGFA has formally requested a moratorium on long-only investment activity until the Commodities Futures Trading Commission can further examine the issue.

But the CFTC has already looked into the issue and concluded that there was no evidence that long-only funds are manipulating the markets.

The commission hosted a forum in April to address concerns of those in the agricultural industry that speculation was adding to commodity price volatility. The CFTC stated in unequivocal terms that hedge funds, index funds and sovereign wealth funds were not the cause of the instability, and Jeffrey Harris, chief economist of the CFTC, relayed that message to a Congressional committee on May 15.

“All the data modeling and analysis we have done to date indicates there is little economic evidence to demonstrate that prices are being systematically driven by speculators in these markets,” said Harris, reading from a prepared statement before the General Farm Commodities and Risk Management committee.

“Simply put, the economic data shows that overall commodity price levels, including agriculture commodity and energy futures prices, are being driven by powerful fundamental economic forces and the laws of supply and demand,” Harris concluded.

Sulzberger of Prairie Central says while the CFTC needs to monitor the problem, he understands why these investment vehicles are interested in commodities and is not willing to endorse the NFGA’s moratorium on index fund trading.

“I think it’s a wonderful opportunity for farmers, and I think the bulls in exchange-traded funds are looking at the devaluation of the dollar and emerging economies in Southeast Asia, and I don’t necessarily think they’re wrong when they look at energy prices and say grains are going to have to go up,” Sulzberger says.

“But I do think it’s incumbent upon the regulators and the futures association to make sure the game stays fair and related to the cash markets, so that we don’t turn it into gambling,” he concludes.

This divergence of views within the grain industry demonstrates the difficulty in discerning what role these long-only funds are playing.

Part of this difficulty is that there are already a great many factors influencing food prices, including increased demand from emerging markets, shortfalls in grain production due to bad weather and a weakening dollar.

Added to that list are protective policies adopted by both importing and exporting nations, the role of biofuels in diverting grain away from food production, a global reduction in grain stocks and the effect of large reserves of foreign money now held by nations like China.

Because of this “perfect storm” of factors, singling out speculators as the scapegoats could be a misguided approach, says Ronald Trostle, an economist at the Economic Research Service, part of the U.S. Department of Agriculture.

“To sort out the relative contribution of each one is to come up with something that is intellectually defensible with integrity is something we haven’t been able to do,” Trostle said.

Even Gordon, who says he believes speculation is a “major” factor, cannot quantify the funds’ influence.

“We haven’t done that and I’m not sure I could accurately,” Gordon says. “Those who are much more attuned to futures markets I don’t think can quantify that percentage either.”

The question is further complicated by the fact that there’s no precedent for index funds investing in commodities in the long term, according to Adolfo Laurenti, senior economist at Mesirow Financial. That’s because commodity markets are two way markets, so when prices rise there is usually a production response by farmers that eventually yields greater supplies and lowers prices.

“So this may work for a very short-term strategy,” says Laurenti, who adds that he does not believe hedge funds play a large role in the rising prices. “It makes no sense in the longer term. It makes much more sense to actually buy the land or buy the companies but not to buy the actual commodities.”

Chris Manns, head trader at The Traders Group in Chicago, also minimizes the role of hedge funds in contributing to high commodity prices. He draws a metaphor to a beer, wherein in the index fund activity would represent only the head of the beer whereas supply-demand fundamentals would be the beer itself.

“And there’s a little, of course, froth on the top that causes the market to go from $123 crude oil to $125,” Manns says.

For now, it seems that the cooler heads are prevailing, but if commodity prices continue to rise that could change.