A primer on how they work and what they do When farmers think about commodity funds, they often take a skeptical view.
"They think the funds drive prices down when lower prices are really not warranted," says Darrell Good, University of Illinois ag economist. "And farmers think commodity funds make it harder for them to figure out when to sell."
Commodity funds are much like mutual funds, except investors' money is used exclusively to trade in commodity futures and options.
But some economists, including marketing consultants who help farmers sell their crops, take the opposite view. They argue that the funds help to lift prices and, at the same time, provide a valuable indicator of which way prices are heading.
"Most people don't pick up on all the players in the market," says Heath Key, chief analyst at OSA Crop Marketing Group, Union City, TN. The estimated 150 funds specializing in agriculture are one group of players to watch, he says. "The market will generally trend whichever way the commodity funds are leaning."
And Richard Brock, head of Brock Associates, says fund activity can help determine when the market is about to change directions, sending prices up or down.
Most funds operate on a simple principle. They buy and sell futures and options contracts in corn, soybeans and other commodities. These contracts call for delivery of the commodity at a specified price on a specified date. But the funds have no interest in actually taking control of the commodity. They sell contracts before maturity. They make their money by correctly gauging whether prices are going up or down, and then buying or selling contracts at the right time.
The funds spend a small fortune on computer programs and skilled analysts so that they can gauge the market correctly as often as possible. As such, they provide another clue to where prices are heading.
But using the commodity fund activity to decide when to sell can be difficult. Experts say the funds should only be used along with data from other sources, such as worldwide crop and weather forecasts.
Funds shouldn't be used at all unless you fully understand what you're doing, because reading the signals correctly can be a tricky business. "This is a tool to be used by an experienced analyst and not by a novice trader," says Brock.
For instance, to determine when soybean prices might reverse course, Brock charts futures purchases and futures sales by both commodity funds and commercial companies, such as grain millers and soybean processors.
Then he compares their buying and selling patterns. For example, he explains, "when processors are buying futures contracts and commodity funds are selling futures contracts following an extended downturn in prices - this could indicate prices are about to go up."
Commodity fund trading data is easy to access. Every other week, the Commodity Futures Trading Commission releases data showing the positions of large speculators, which include commodity funds. The data moves through DTN and other electronic services. Commodity fund data is also on the Chicago Board of Trade Web site (www.cbot.com).
While the figures don't focus on any particular fund, they do give an aggregate view of what the funds are doing. "If the funds are selling futures contracts, prices usually are going down. If they're buying, prices are usually going up," says OSA's Key.
Of course, farmers shouldn't use the funds exclusively.
"Funds can be extremely accurate and extremely inaccurate," says Key. So farmers should also monitor other market indicators, such as worldwide crop projections, weather patterns, government trade policies and odd factors that can impact prices, such as the movement in Europe against biotech foods.
Bear in mind that funds are good mid-range indicators, but not good barometers for the long term. "They're not great long-term indicators because they're not two- or three-year traders," Key points out. "But over six to eight months or less they're good indicators of the market trend."
Some farmers think, however, that funds themselves sometimes move the market instead of worldwide forces such as supply and demand.
"Whenever prices move a lot, futures funds are one of the usual suspects," says Craig Pirrong, assistant professor of finance at the Olin School of Business at Washington University, St. Louis. "Over a short period, they can move the market. Whether they can cause prices to move above or below where they otherwise would have been for a long period, I seriously doubt."
It's more likely that the funds are simply reading market trends faster than other observers. "The funds can have a short-term blip effect on prices," says Pirrong, who has been an advisor to the Chicago Board of Trade. "But they may be anticipating some fundamental change and moving the market slightly faster in a direction it was going to go anyway."
Some farmers might argue that funds have an economic incentive to manipulate the market. This is unlikely for two reasons, economists say.
- The funds don't care whether prices are going up or down. They can make money either way. "It doesn't make any difference whether the market is going up or down, as long as they forecast the trend correctly," says Key.
- Manipulating the market is financially dangerous, and it poses the risk of federal criminal prosecution. In a classic example of what can go wrong, several members of the billionaire Hunt family of Texas cornered the silver market in 1979 and 1980, driving prices from $5/oz to $50/oz. The higher prices activated the law of supply and demand as people all over the world sold their silver to cash in. That, in turn, caused silver prices to crash, taking much of the Hunts' fortune with it.
"Their fate has been an object lesson to those who might want to muscle the market one way or another," says Pirrong.
On the other hand, the funds help to increase market liquidity by pumping billions of dollars needed to keep futures markets running smoothly, economists say. Without a strong futures market, prices would gyrate much more than they do today, and commercial grain users, such as grain millers and soybean processors, would be unable to hedge efficiently. As a result, these commercial users would seek to increase their margins by paying farmers less.