How do speculators in agricultural commodity markets impact production decisions and commodity prices? A theoretical analysis

• Date: 01 June 2019
• Author: Tilo Treuter,Christian Koziol
• DOI: http://doi.org/10.1111/eufm.12201
• Published date: 01 June 2019

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718 © 2018 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2019;25:718–743.

DOI: 10.1111/eufm.12201

ORIGINAL ARTICLE

How do speculators in agricultural commodity

markets impact production decisions and

commodity prices? A theoretical analysis

Christian Koziol Tilo Treuter

1Department of Finance, University of

Tübingen, Nauklerstraße 47, 72074

Tübingen, Germany. Email:

christian.koziol@uni-tuebingen.de;

tilo.treuter@uni-tuebingen.de

Abstract

We analyze the impact of speculative trading in agricultural

commodity markets on major economic quantities. We con-

sider a theoretical model with production shocks, in which

a farmer interacts with a retailer in both the spot and the

forward market. The contribution of the paper is twofold.

First, we show that the current forward price drives agri-

cultural production decisions. Since the forward trading of

speculators influences the forward price, they indirectly af-

fect production decisions. Second, we identify crucial vari-

ables determining whether speculative trading is beneficial

or dangerous, such as the correlation between the specula-

tors’ portfolio and the commodity prices, the risk premium

of the forward, and the producer’s gains.

KEYWORDS

commodity spot prices, production decisions,speculative trading

JEL CLASSIFICATIONS

Q02, D53

1INTRODUCTION

According to a large share of public opinion, speculative financial investors focus only on the returns on

their investments, rather than the consequences for the real economy. For this reason, it is conceivable

that the activity of those investors can worsen the characteristics of specific markets and create losses

for the real economy. This debate is particularly important where the core existential needs of every

human being are concerned, such as with global feeding. The coincidence of rising commodity futures

We are grateful to John Doukas (the editor) for his valuable suggestions as well as to four anonymous referees for in-depth

comments which significantly improved the paper. We also thank participants of the GEABA Hohenheim conference for their

helpful remarks.

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prices and speculative trading has led to the assertion that speculative investors in the agricultural

commodity market might cause higher futures prices and are therefore a potential reason for hunger

crises in the world. Those assertions are mainly based on observed correlations. For example, the

futures prices for soft red winter wheat and corn (both traded on the Chicago Board of Trade) from

1982 to 2015 and speculators’ net positions in those markets (measured by its open interest) exhibit

high positive correlations equal to 48.2% and 50.5%, respectively.

Given that these conclusions were valid, a prohibition on speculative trading in the agricultural

commodity market would be our human duty in order to improve global feeding. If, however, this

conclusion is false, there is the danger that a prohibition on speculative trading in agricultural products

could affect economic conditions and might even create welfare losses in total. In fact, there are some

arguments that the futures commodity market is not disadvantageous for global feeding. First, specu-

lative investors are mostly engaged in products with cash settlement rather than trades in the physical

good itself. Hence, they do not directly affect the available amount of any agricultural product for

consumption purposes at all. Even more importantly, an efficient futures market allows the actors in

the production chain to hedge their risks, which might improve their production conditions and may

therefore favor additional supply.

Still, the major problem in this debate is the impossibility of simultaneously observing both an

agricultural market with speculative investors and an otherwise identical market without speculation.

Hence, it is the aim of this paper to introduce a reasonable theoretical model comprising all of the

relevant aspects of a commodity that reveals the economic consequences when speculative investors

are involved or prohibited from participation in the futures market. In particular, we illustrate the main

drivers of our model using empirical observations.

Our model focuses on the interaction of producers and retailers of a commodity. The pro-

ducer/farmer must plan her production volume with regard to the expected selling price of the com-

modity and the current futures price. This important mechanism goes beyond the papers of Branger,

Grüning, and Schlag (2016), Ekeland, Lautier, and Villeneuve (2017), Hirshleifer (1988, 1990), or Liu,

Qiu, and Tang (2011), who treat the production volume as an exogenous random variable. Given an

exogenous production decision of the farmer, speculative trading would affect only the futures price

of the commodity, but the supply would remain unchanged. Hence, analyzing the indirect impact of

speculative trading on the farmer’s production decision helps to elucidate how consumers (i.e. the real

economy) are affected when speculators trade in agricultural futures.

If there is a prohibition on speculative investors, only the actors in the production chain (i.e. produc-

ers and retailers) have access to the futures market in our model. For an unrestricted market, financial

speculators can also have positions in commodity futures and therefore have an impact on the hedging

possibilities. To analyze the economic effects, we focus on the following three outcomes:

rProduction amount. Apparently, the more units of the commodity produced, the more there is avail-

able for global feeding.

rConsumption price at risk. In particular, poor people are not only interested in a low level of the

price for basic foods but also care about the risk of adverse price movements (i.e. of sharp price

increases). We capture this fact with a risk measure that we denote as the ‘‘consumption price at

risk.’’ The consumption price at risk covers a critical level of the retail price that is not exceeded

with 95% probability.

rGain of producers. The higher the gain of the producers, the higher the incentive for new producers

to enter the market and/or for existing producers to expand their businesses because potential fixed

investment costs associated with entry or expansion can be covered more easily.