Is Goldman Sachs to blame for everything?

4th September 2012

Consumers want to know why. They demand to know whom to blame. And they long for a reversion to the era of cheap food. But for investors into food commodities – either directly via specialist vehicles, exchange traded funds, commodity futures or indirectly through hedge funds or stock in companies involved in the food chain – the question is more subtle. They need to know what's behind the price rises so they can calculate how to deal with them.

The basic dichotomy pits natural causes against speculators – higher demand across the globe versus the activities of Goldman Sachs and banking allies.

Media rule one is banker-bashing never fails. The Daily Mirror recently ran a story loosely based on a "report" which is never directly named although there is a reference to the World Development Movement as a source in the final paragraphs. This went for the financier-jugular, listing a number of supermarket food items which had risen in price. And media rule number two is that defending "vampire squid" Goldman Sachs and its ilk is a guaranteed route to a zero readership.

But simple – or audience-pleasing – solutions are not the best basis for investment decisions even if it means breaking those media rules.

It is impossible to deny investors have made money from rising commodity prices – and not just in foodstuffs. Investors have also made money in Apple shares but lost it on Facebook. The question is whether these gains are due to the speculative activity itself or whether they are down to supply and demand or if it is a mix of the two – with the demand super-charging investment returns.

How Goldman Sachs created the Food Crisis is the key text. Posted in April 2011, it contains the theoretical reasoning why the banks – and in particular the one regarded and the biggest and the baddest – are responsible for the problem.

Vampire squid ate my food budget

The thesis is that Goldmans invented the GSCI – the Goldman Sachs Commodities Index – in 1991 and then, presumably, lobbied for deregulation in 1998. The result is that banks have taken positions in agricultural products in a way which they could never have done before. But what is odd about this text is the assertion that the index could only be played in the long direction – that it was impossible to short it – so as money came into food materials, possibly from investors looking for a non-correlated alternative to stocks and bonds – it could only go up and continued to rise with each injection of new money.

It says: The structure of the GSCI paid no heed to the centuries-old buy-sell/sell-buy patterns. This newfangled derivative product was "long only," which meant the product was constructed to buy commodities, and only buy. At the bottom of this "long-only" strategy lay an intent to transform an investment in commodities (previously the purview of specialists) into something that looked a great deal like an investment in a stock — the kind of asset class wherein anyone could park their money and let it accrue for decades (along the lines of General Electric or Apple). Once the commodity market had been made to look more like the stock market, bankers could expect new influxes of ready cash. But the long-only strategy possessed a flaw, at least for those of us who eat. The GSCI did not include a mechanism to sell or "short" a commodity.

This imbalance undermined the innate structure of the commodities markets, requiring bankers to buy and keep buying — no matter what the price. Every time the due date of a long-only commodity index futures contract neared, bankers were required to "roll" their multi-billion dollar backlog of buy orders over into the next futures contract, two or three months down the line.

Exotic derivatives appear absent

The strange – and unexplained – point is that all this long only activity was supposed to have happened at a time when banks were coming up with more and more clever derivatives to cater for more and more exotic tastes. Even when shorting stocks and bonds was difficult two or three decades ago, shorting agricultural products and other commodities was always possible. The entire commodity markets were based on producers and users hedging positions – taking out insurances variably for gluts and shortages. This article does not explain where the counter-parties to the long positions were to be found or why those betting against price rises could not have used other methods.

Nor does it go into the "commodity bubble". Other assets – everything from tulip bulbs in Amsterdam hundreds of years ago to land in Tokyo in the late 1980s to dotcom stocks at the turn of the millennium – have been inflated beyond reason. In all cases, there is an eventual – often fast – return to more normal valuations at the bubble is pricked.  

It might, however, be that there is a fundamental supply-demand imbalance in foodstuffs, even if exaggerated by current speculator bull positions.

The role of extreme weather

There have been extreme weather events such as the US drought, a growing world population and, as part of the enrichment of developing countries, the move from a vegetarian lifestyle to the far more grain-intensive meat eating.

Nestle chairman Peter Brabeck-Letmathe blames growing crops for biofuels. "The time of cheap food prices is over," he told the the BBC.   

"The rise in the production of bio-diesel puts pressure on food supplies by using land and water that would otherwise be used to grow crops for human or animal consumption. If no food was used for fuel, the prices would come down again – that is very clear," he says.

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