High Food Prices? Blame Wall Street

It's not your imagination -- food prices are going through the roof.

According to the United Nations, the average price of food has increased a staggering 77% since the beginning of 2006. What used to be a $50 trip to the grocery store six years ago will now set you back $89.

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Source: Food and Agriculture Organization of the United Nations.

We've been told that this increase is a result of three factors: heightened demand from developing countries like China, the use of corn and other products to produce ethanol, and the increased price of fossil fuels. High food prices, in other words, are simply a consequence of supply and demand -- the benign and unbiased forces of capitalism.

The problem with this explanation is that it's incomplete and misleading. While those factors do influence the price of food, they have also been seized upon by interested parties to mask a more powerful and pernicious force behind the skyrocketing trend: Wall Street.

When the market set food's price
The commodity futures market has operated in relative obscurity for much of its existence, familiar only to a small group of producers, consumers, and traders centered in Chicago.

Farmers and other producers use it to sell futures contracts at the beginning of planting season to hedge against a decline in crop prices prior to harvest. Consumers like restaurant chains and supermarkets -- think McDonald's (NYS: MCD) and Whole Foods (NAS: WFM) , among others -- buy contracts at the same time to hedge against the risk that prices will increase. And traders act as intermediaries by buying contracts from producers and then reselling them to consumers for a profit.

The size of the futures exchange has accordingly always paled in comparison to the size of the world's equity and bond markets. In 2004 and 2005, for instance, the latter accounted for $43.6 trillion and $54.3 trillion in market capitalization, respectively. Meanwhile, the futures exchange was only $183 billion in size, less than 0.2% of the other two combined.

Given the nature of the market participants, prices of commodities have traditionally tracked the supply and demand of the underlying products. Excluding the last few years, for instance, the price of corn only accelerated when there was a supply shock: The abrupt spike in 1988 corresponds to one of the worst droughts in U.S. history, and the massive spike in the mid-1990s corresponds to disastrous crop failures in China.

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Source: U.S. Department of Agriculture; Feed Grains Database.

In addition, commodity prices were rarely positively correlated with each other. If the price of corn was high one year, farmers would plant more of it and less of, say, soybeans the following year. The resulting increase in the supply of corn would drive its price down, whereas the decrease in the supply of soybeans would drive its price up. This give-and-take pattern ensured that there would never be a sustained deficit of one crop or another, providing a near-textbook example of the virtues of a free market.

And then Wall Street intervened...
The financial wizards of Wall Street paid scant attention to the commodity futures market prior to the turn of the 20th century. Its measly size made it appear unworthy of their consideration. And even if it had been sufficiently large, many of the financial industry's most lucrative clients -- institutional investors -- preferred to avoid investing in it anyway.

All of this changed with the confluence of three developments in the early 2000s. First, institutional investors developed an appetite to diversify away from equities after suffering through the tech bubble, the 9/11 attacks, an ensuing recession, and the Enron and Worldcom debacles. Second, and at about the same time, a series of academic papers discovered that commodity returns inversely correlated to equity returns. And finally, spurred on by these developments, financial institutions like Goldman Sachs (NYS: GS) , American International Group (NYS: AIG) , and UBS (NYS: UBS) constructed indexes that made it easier to track and invest in commodity futures.

The two most popular indexes are the Standard & Poor's Goldman Sachs Commodity Index and the Dow-Jones UBS Commodity Index. The first tracks 24 commodities weighted according to worldwide production value and is thus heavily influenced by energy products. The second tracks 19 commodities, 18 of which it shares with the S&P-GSCI, weighted according to worldwide production and liquidity factors.

Component

S&P-GSCI Weighting

DJ-UBS Weighting

Energy 70.5% 32.6%
Industrial metals 6.6% 18.6%
Precious metals 3.3% 12.6%
Agriculture 14.7% 30.4%
Livestock 4.7% 5.8%

Sources: S&P GSCI Fact Sheet and DJ-UBS CI Handbook.

To provide actual exposure to these indexes -- since you can't invest in an index itself -- investment banks used swaps, the now-infamous derivatives that crippled the financial system in 2008.

In a typical commodity swap agreement, an institutional investor agrees to pay the three-month Treasury-bill rate plus a management fee to a Wall Street bank, and the bank agrees to pay the total return on either the S&P-GSCI or the DJ-UBS. To hedge their positions, investors can invest the notional amount of the swap in three-month Treasury bills, while the banks can invest in futures contracts that replicate the targeted index.

The capital that flowed into the commodities futures market as a result of these agreements resembled a veritable tsunami. The total open interest of the 25 commodities included in the S&P-GSCI and DJ-UBS indexes went from $183 billion in 2004 to $356 billion by 2008. For comparison, this would be equivalent to flooding $12 trillion into the S&P 500. Not surprisingly, in turn, the increased demand for futures contracts corresponded with the dramatic increase in their price. And as you can see below, to stick with corn as a representative example, institutional ownership is now a leading indicator of its price.

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Sources: Commodity Futures Trading Commission and U.S. Department of Agriculture.

Wall Street and the price of food
At the end of the day, there's no question that factors like ethanol production influence the price of commodities and, thereby, food. At the same time, however, a bigger and less benign force is at work. Indeed, it evidently wasn't enough that investment bankers and their ilk on Wall Street crashed our credit system and contributed to the artificial creation and subsequent destruction of trillions of dollars of home equity. They've now taken it upon themselves to manipulate and control the world's supply of food.

At the time this article was published Fool contributor John Maxfield does not have a financial stake in any of the companies mentioned above. Motley Fool newsletter services have recommended buying shares of  Goldman Sachs, McDonald's, and Whole Foods Market. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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