17 May 2011

Can we blame Goldman Sachs?

JWT sent me this op/ed that claims that Goldman Sachs and Wall Streeters have "caused" high food prices by speculating on futures markets.

I don't believe it. Even if GS et al. have increased prices by demanding more delivery contracts in the short run, they cannot use that food in the long run. The real market is between farmers and eaters. If GS et al. take delivery at a high price per ton, they can only turn around and sell it at a loss. (Unless they are dumping the food in the ocean, making a bigger loss.)

What am I missing here?


Eric Morey said...

The demand curve for scapegoats...

JWT said...

What you are missing is that there is NO one for GS to sell to because all the actual customers have bought what they need. Try thinking about this as a giant Ponzi scheme because that is what it really is.

David Zetland said...

@JWT -- no-one to sell to means losses. Try again.

Concerned Citizen said...

No, you continue to miss the point. GS never intends to sell anything. They only want to buy to force the price up higher and higher.

GS took a simple method of spreading risk in home mortgages and distorted it to make incredible profits for themselves. You should be able to see the same method at work in commodities.

Finally, let's reviews how Ponzi schemes work. To succeed, ever increasing investors are needed. That is EXACTLY what is happening with GS, et al, in commodities. You never sell in a Ponzi scheme and ditto a GS scheme.

Go back and review the mechanics and you cannot miss the correspondence.

David Zetland said...

@CC -- A Ponzi scheme requires ever more credulous buyers getting above market returns and the price eventually crashes. Who are the buyers, where are their returns and where's the crash?

I know that the article says buyers of index products or futures contracts, but where are their returns? And where's the crash from a lack of additional buyers?

JWT said...

O.K.. let me explain how the real world works, not the theoretical one.

(This process begins in the fall, but we'll start with today.) I manage Wesson Oil and I have XXX gallons of processed soybean oil in bottles and cans in warehouses across the U. S. It was all made with soybean oil from the 2010 crop. When it is all sold, it is all gone and there is now more. Then we are out of business, period. Of course, I can't let that happen so in my FY2010 plan, I bought enough soybean oil to cover all I expected to sell and a little more for a cushion.

There is somebody at P&G doing the same thing for Crisco Oil, and at Kraft for Kraft Oil, and maybe six or seven other managers at smaller companies. Altogether, we make the market for soybean oil, and there are a couple of thousand farmers in the Midwest growing soybeans who the suppliers to the market.

Are you with me so far? Now I know I am going to run out of product sometime soon and I have to make arrangements to re-stock our warehouses. Ditto P&G, et al.

So I have to buy new soybean oil to use in my 2011 inventory. But at what price do I plan to pay for this upcoming crop? That is a huge, huge problem because I have to plan what price to charge at retail, because I need to cover product costs, inventory costs, advertising, sales promotion, etc. etc. and still make a profit.

On the other side, there are all those farmers trying to decide what to plant in the spring of 2011 for harvest in the fall. Should they plant soybeans, corn, something else? And that depends on the costs of each crop, the likelihood of crop failure, weather, etc. and MOST importantly, what price will they get for their crop in the fall when harvest comes along?

So here is the problem; the marketing managers need a price they can use for planning and the farmers need a price they can use for planning.

Hence, forward contracts. My buying guy goes to the Chicago market and says we will pay $XX per thousand pounds of soybeans that meet certain quality standards, etc. in say, September, 2011. Some farmers say OK. I'll sign that contract at that price. But that is not enough contracted soybeans so we offer new contracts at a higher price. You realize all the other managers are doing the same thing at the same time. But we still need more product so we offer more contracts at a higher price.

Eventually, the entire market is cleared and farmers have committed to grow enough soybeans at a satisfactory price to satisfy the forecasted needs of all the customers.

And this has worked for over 100 years quite well, not perfectly, just imagine how pissed off that farmer who signed the first contract is when he finds out what the final price was?

Now here comes GS and starts bidding on those contracts. To get contracts, they have to out bid me and the P&G guy, et al. But we have to have contracted product to manufacture in the fall of 2011, or we go out of business and I (and him/her) look for new jobs. Good luck with that given the huge fuck up we just committed!

We have no choice, bid higher and higher until we have guaranteed supply contracts. And we have to raise our prices to cover our newer higher costs. Period, end of story.

GS never intends to take possession of the soybeans like I plan to do. They want to sell their contracts to some other sucker who can be convinced that those contracts will be worth more in the future. Simple, and dishonest, as that.

David Zetland said...

@JWT -- (1) Why doesn't Wesson just make direct contracts with farmers. (2) Why are people "just willing" to buy more expensive food due to foolish market moves? If so, Wesson et al. should have raised prices in the past. (3) How is in the GS is ALWAYS, 100% of the time able to drive up the price and STILL find a buyer? After all, if they take delivery, they then have 200 tons of useless soybeans.

RM said...

I'm glad you don't buy it. Certain people who don't understand anything about risk in businesses can't figure out how anyone who deals in futures and options can be doing anything but getting untoward gains at the expense of little guys. In practice, if GS bought up futures and prices went up, farmers could lock in higher profits by committing to sell their crops at the higher price. 90% of futures are offset and settled without delivery, so if GS bought more they would have to settle them later and if the underlying value of the crops, based on projected yields, etc, was less than the prices GS paid, then GS would take losses when it settled contracts.

Futures and options markets are fascinating and important parts of the economy. Crop futures allow farmers to lock in prices, and allow end users to lock in prices. For example, think of wheat. Selling a September future in wheat allows a farmer expecting to harvest his wheat crop in September to lock in a price if he thinks it is good. This eliminates his downside price risk. For a baker, buying the wheat future eliminates the risk of having to pay higher prices for wheat in September. In order to have a liquid market that allows farmers and bakers to easily sell wheat futures, you have speculators both buying and selling. The actions of speculators in the long run reflect, not influence, underlying market conditions. In the short run, speculation reflects various predictions about the future conditions of markets.

Anonymous said...


Your model covers the initial and final ends but not the speculative middle. As long as I have margin, I have the right to buy and sell soybean futures just like everyone else.

So first GS buys up some contracts, then all the information channels tell about the rise in soybean prices. Here's the key, others come in as well and also buy soybean contracts at a higher price. It's the classic herd mentality that creates bubbles (unless you don't believe in bubbles.)

Who does GS sell the contracts to? Mostly to other investors. So when the actual price comes in, GS is largely out of the game with a handsome profit and the late comers are at risk. If you saw how all sorts of people joined in on oil speculation (like retirement funds???) You can see how the early people are in and out while the later people took a beating.

As long as you can sell enough of your position to other investors to cover your downside risk you can do this with little risk. You wait for some negative supply news and you buy in to push the market. Others believe this is a rational reaction to the news rather than a calculated skimming operation.

Even if the information time differential is hours, that is enough to make this kind of situation beneficial. Of course, there is always the risk that can lose the whole company...

The reason farmers and producers don't make direct contracts is that they producers want to be insulated from local crop issues. If the locusts swarm in southeast, direct contract prices are meaningless because there are not enough soybeans to be had. The global futures trading market damps local variations and assures supply, which is what the producers want.

David Zetland said...

@Anon -- I agree that GS et al. can make $ off of fools, but how does that translate into higher food prices?

Anonymous said...

It took me a few days to get back to this.

Food prices and farm prices are not directly coupled. When supply prices go up, be they crop, fuel or other, the producer will buffer for a while and then raise their prices. When supply prices go down, the producers will pocket the profit and chalk it up to good management. :)

As long as the overall market pricing structure holds (wesson runs about 3% more than crisco and the generics are 15% below that) there is little need to drop prices unless market share shifts dramatically. This actually happens infrequently in the food industry, it's been a long time since generics shook up the model.

As long as MBAs set wholesale prices and investors demand maximum short term profit, this form of market stability is predictable. This is a big part of farmer's complaints about food pricing. They never get the kind of good margins that the producers can have in good times but they have as much or more risk on the down times. As a hint of this, look at the rate at which farm land is going out of active planting/harvesting.

So each time GS generates a supply price bubble to increase their profits and the bubble size/duration surpasses the producer's ability to buffer, the net result will be a near monotonic increase in end price.


Concerned Citizen said...

jerry thinks food prices are not directly related to farm prices. He could not be more wrong!! He has apparently never had the responsibility for producing a profit on a food product. It seems to me he is relying on the same sort of theories David uses to bolster his arguments.

Concerned Citizen said...

David makes two comments that demonstrate how little he understands of how the real world works as opposed to the theoretical world.
1)Why doesn't the Conagra manager make direct contact with 100,000 plus farmers? That question is almost funny.
2)Why are people willing to buy more expensive food? People actually get hungary? Theories never get hungry. Right now, food cost inflation is growing rapidly. But people keep right on eating.

And finally, David and I have long agreed that there is no one so blind as someone who will not see. This interchange is a perfect example of that truth.

Concerned Citizen said...

And finally to answer David's question about how GS profits, I offer The Greater Fool explanation. It has worked for centuries.

Anonymous said...


Are you in the food business? I talk to farmers and producers. I did my best to paraphrase what they say when I ask them about their price pressures, risks and the results it has. I know how hard producers claw to make margins.

To say they are coupled to the crop supply is to deny the other costs that the suppliers have as well as their margin targets. Some, life fuel, naturally compound and others like labor cost, storage and lending do not.

Are you saying that when the crop prices go down, that producers automatically drop the costs that amount?


Concerned Citizen said...

Yes, Jerry, at one time in my life I was Marketing Manager for Wesson Oil. The salad and cooking oil business is huge and we had a 45% share so we were a major player. I think you need to go back and re-read my description of how forward contracts actually work. And there is a direct relationship between supply and demand, and it works just like economic theory says. Although it never happened on my watch, I would have lowered my prices if soybean futures fell (although that never happened on my watch)for the simple reason that P&G would have lowered their prices to gain a competitive advantage, and I would never have held a price umbrella over them.

David Zetland said...

@CC says "I would have lowered my prices..." because he would have bought forward contracts for delivery of cheaper inputs. This fits economic theory.

CC's ideas about speculators make profits from selling "overpriced" contracts to other speculators who will then, somehow, be able to get a higher price (when their supply exceeds real food demand) is silly (and contradicts theory). CC needs to talk to some purchasing managers at stores (and consumers!) to understand how you can't push a string.

Concerned Citizen said...

David, I have talked to hundreds of purchasing agents and thousands of consumers (customers). I do not understand "you can't push a string" in this context. I think you should also re-read my explanation of how future contracts work. Then understand that the futures market worked very well for over a hundred years until GS started buying contracts and competing with users of the commodity. What GS is doing is playing a side game just like they did with mortgages. They are only selling future contracts for products they never intend to take to Greater Fools. Why is this simple fact so difficult to understand?

Mister Kurtz said...

I have traded in the commodities markets (as a producer, not speculator) for over 30 years. Speculators are an essential component, both to provide liquidity and to curb abuses such as "squeezes" and "corners".
What has changed in the past couple of years is that the huge volumes of dollars that the Goldman-types are used to playing with have overwhelmed the comparatively tiny grain, cotton, and oilseeds markets. It used to be unusual to have more than two or three "limit" moves in the entire 18 month life of a typical contract. Now we might see several limit moves in one week. This has caused some margin problems, and sleepless nights for buyers and sellers. But it has not made prices go either up or down. If anyone had the power to do *that*, they could buy and sell Goldman and the rest of us before breakfast every morning.

David Zetland said...

@CC -- are you implying that ADM and Cargill are greater fools for GS? Because it's only purchases by REAL users that will pass along higher cost -- not intermediaries who can't take delivery (they will buy future high, take delivery and be forced to dump on spot).

Concerned Citizen said...

I will defer to Mr. Kurtz. His viewpoint is minute to minute. Mine was month to month. He is the guy that helped me make a profit. Having said that, there is a huge problem with what he has to say about reality and what David has to say about theory.

Here it is. For over 100 years, commodities market served as a reasonably efficient way to spread risk and reward among the suppliers (the farmers) and the customers (the manufacturers). Now CS is allowed to enter this reasonably closed system. They are only allowed to buy, not sell. But somehow, they can take a profit for themselves out of this reasonably closed system. It can only come from increased prices for the commodities, or from lower profits for the suppliers and/or customers.

This is not economic theory. This is the laws of physics. Even though there may some certain facilities in Amsterdam where such laws are thought to be temporarily suspended.

And GS can eat all of us before breakfast since they own the U.S. Treasury. We explained that two years ago in The Great Recession Conspiracy.

Concerned Citizen said...

Well, David and Mr. Kurtz seem to have been unable to suspend the laws of physics, so it is time to drop the big bomb. My understanding is that their position is that speculators do not cause prices to rise or fall. That is absurd beyond believe. Take just one example, West Texas Intermediate crude. In July, 2008 the price of one gallon was $145. In December, 2008, it was $30.28 a gallon. In that six months there were no substantial changes in supply or demand. The wild swing was solely the work of speculators.
Yes, gentlemen, speculators do affect the prices of commodities.

David Zetland said...

@CC -- your funny comments aside, you still miss my point -- that speculative prices on commodities among spectators who cannot use the goods affect real market prices, e.g., oil price changes only show up in gasoline prices when supply and demand say so.

Concerned Citizen said...

David, you have no point. When a lot of buyers pursue a limited number of suppliers, prices will be bid up. That is thousands of years of history. That is a fact today. It even fits economic theory.

Apparently, gasoline prices in Holland are set by the state. That is the only way I can think of that would create a disconnect between the market and prices. If you actually had a point, gas prices in the U.S. would be dropping since demand is down significantly.

By the way, the price of the Kalashnikov AK-47 has skyrocketed since the Arab Spring began.

David Zetland said...

@cc -- I'll try ONE MORE time. It's the price that food processors pay to take delivery -- NOT spectators trading forward contracts -- that affects food prices. You will note that MANY people pay high prices for houses a few years ago. Are those prices high today? No, and those people (=the spectators) are taking losses on current spot prices (=food processors).

Concerned Citizen said...

David, you really don't understand how markets work. The price that processors pay for commodities is set by competition. The processors compete with the speculators to set those prices. Why is this so mysterious?

I'll try one more time. If speculator prices are separate from processor prices, how do speculators make profits?

And to answer your question, EVERYBODY is taking a loss on the high prices we paid five years ago, and that includes me. There is no separate market for people who live in their houses and for speculators. We are all in it together, believe me!!!

David Zetland said...

@CC -- please revise your comment to reflect the difference between spot and futures markets.

Mister Kurtz said...

CS, only the index funds are pure buyers. All other speculators are free to go long or short, or (more commonly) combine both positions in a straddle or spread. Any speculator going 100% long or short would have a very short career. The people running the index funds make their money from the fees they charge, period. They could give a hoot whether or not the customers make money.
Speculation in commodities markets in nothing new. Only the large volume, and the use of electronic (instead of auction-pit) trading is new.
As to the moves in crude you mention, markets do all sorts of irrational things on a short term basis. That is why all those books on how to make quick trading profits are useless.
And I still don't understand how the evil speculators can make prices go up, but can't make them go down. Since there is just as much money to be made my moving the market in any direction, why do they just want to trade the long side?

TW said...

You're right and people arguing with you don't understand commodity markets. The only thing I would add is that speculation can push spot prices higher if people decide to store more today because of higher futures prices and make less available for the market but that's self correcting overtime. So more volatility is definitely possible but higher prices in the long run is not.

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