No one has ever before seen markets like those we are witnessing today. The combination of Chinese demand, ethanol plants, rising energy prices and index funds has resulted in the “perfect storm” for commodity bulls.
What is concerning, however, is the massive amount of misinformation that's being spewed by the media, blaming the biofuels industry for the majority of the problem.
For example, the media harps on the $3.4 billion dollars in blender tax credits that were given last year. They fail to mention that the blender tax credits went to oil companies and not directly to farmers.
They fail to point out that the ethanol industry paid in an additional approximately $4.3 billion dollars in taxes (these industries didn't exist five years ago).
They also fail to point out that the taxpayers saved almost $6 billion in subsidies through the LDP program to farmers. The net tax benefit to the consumer was at least $7 billion on the positive side — not $3.4 billion on the negative side.
The media is also quick to point out that approximately 30 percent of the corn raised in the United States now goes to feed ethanol plants. But they fail to point out that a byproduct of ethanol plants is dried digestible grain (DDGs) that is replacing corn in cattle rations everywhere. Approximately 60 percent of the corn going into ethanol plants is still being used for animal feed.
By far the biggest cause of a sharp increase in food prices is the price of oil itself. Transportation costs amount to a larger share of today's food dollar than the input costs themselves. That's another story in itself.
Let me turn my attention now, however, to the biggest inflationary concern we have in commodity prices — index funds. At the risk of using a number that might not be exactly correct and thus creating legal problems for me, I'm not going to mention the name of the two biggest index funds. Let me just say that the largest one currently has approximately $132 billion in it and the second largest one has $102 billion. Let's call them funds number one and number two.
The amount of money flowing in and out of these funds is remarkable. Fund number one, on April 17, 2007, had approximately $63 billion invested. By March 18 of this year, it was up to $145 billion but has now dropped back to $132 billion.
Fund number two on April 17, 2007, had $47 billion invested and has now gradually risen to $101 billion.
So what does this mean? These funds currently own 33 percent of the open interest in heating oil, 21 percent in crude oil, and over 17 percent of gasoline. While the percent of open interest is not available in the grain markets, the index funds as a whole are long over 2 billion bushels of corn, over 1 billion bushels of soybeans and approximately 2.5 times the soft red winter wheat crop in Chicago.
Throw in the advent of electronic trading rather than open outcry and the fact that the markets now trade nearly around the clock and we have a world of commodities entirely different than what existed three years ago. The players have changed and the volatility has increased substantially.
Where is this going to take us? The function of the futures market has always been concentrated in two specific areas — a place where buyers and sellers can offset their risk and facilitate trade and, to a much larger extent, a vehicle for price discovery.
The latter has all but been destroyed in the last few months as the primary player has become index funds who are in this for only speculative gains — not price discovery. It has increased the volatility to an extreme level which has resulted in sharp increases for financing hedge positions and has thus resulted in producers being unable to use the very tool they should be taking advantage of at this time.
Speculation is good in that it provides liquidity to markets. Speculation to the extreme that now exists is not good for anyone.