It’s no news that energy and commodity prices have been rising at breakneck speeds; just look at the Dow Jones AIG Commodity Spot Index - which tracks commodity price levels and is up nearly 40% over the last nine months. Instead, the $126/barrel question that’s stirring up controversy and making news is: why?

There seems to be broad agreement among economists as to who the culprits are: rising demand from countries like India and China for food and energy (exacerbated by a weak dollar), weather-related crop shortfalls reducing supply, speculation in the commodity markets and - perhaps most controversially - the use of corn crops for biofuels.

There is broad disagreement, though on which one of these structural/speculative factors is most to blame, and the tug-of war is just beginning. On Friday, the Wall Street Journal reported that 51% of economists in its latest forecasting survey said that demand from China and India was the prime factor in soaring energy pries, and 41% said that demand was the chief contributor to food costs. Perhaps most strikingly, only 11% saw a bubble developing due to speculation.

Now, no one can deny that growing demand for a refrigerator in every Chinese kitchen and a car in every Indian garage isn’t a powerful driving force behind commodity demand for everything from grains to metals to petroleum. However, looking at the timing of this latest explosion in commodity prices, one is tempted to give the speculation thesis a bit more weight in this debate.

Last week, the U.S. Joint Economic Committee on the Economy held a hearing on precisely this issue, with Tom Buis, President of the National Farmers’ Union and U.S. Department of Agriculture Chief Economist Joseph Glauber leading the testimony (watch the C-SPAN video here). About the first hour was good old-fashioned political grand-standing and speechmaking, but the last hour contained a few excerpts worth sharing:

[1:37:23] Rep. Carolyn Maloney (D-NY): According to the New York Times, commodity-exchange traded funds, which was developed barely 4 years ago, have grown nearly seven-fold since 2005, and to what extend are higher food prices being driven by speculation in commodity markets?

[1:37:42] Tom Buis: I appreciate that question because this has been a big concern. [. . . ] It’s something we’ve been hearing in farm country for quite some time is we can’t capture this price as I mentioned before this futures market has which markets have counted on forever has been eliminated and part of the reason is because the speculation into the market price has caused the market to explode. In the case of wheat, they reached contract limits day after day and, well, when you do that, that country elevator or that farmer has to pay a margin call and one country elevator I talked about that had pre-bought wheat for fall delivery had a million bushels and the price of wheat was going up 60 cents a day. Nothing was changing in the fundamentals at that point. There was lot of speculation, export markets coming in, that was costing him 600 thousand dollars per day to meet the margin calls and as a result he hit his credit limits. Hitting those credit limits forced him to cut off buying that grain from the farmer. So we raised these concerns and we were told nothing extraordinary was wrong except they could not explain: cotton. Cotton - we have a huge surplus of cotton, we had a great crop, it’s all over the country, you can’t hardly give it away and cotton prices spiked upon speculation. Now, when they went up, every farmer’s hoping that they would be able to get that price but weren’t able to. There’s explanations that need to be made. I think its similar to some of the other bubbles we’ve seen recently, and it could be the biggest train wreck we ever see.

[A quick primer on margin calls: let's say I own a grain elevator. The way I make money is basically via a broking business: buy grains low, sell high. To enhance my returns, I may buy grains on margin, meaning that I borrow funds to make the purchase. If my margin limit is 50%, then that means that I must keep my equity at least at 50% until I sell the grains and close my position. So if I buy $100 worth of grains and the price goes up, say, 20%, then I get a margin call from my lender asking me to deposit an additional $10 of equity to meet my 50% margin limit (which went from $50 to $60 as a result of the purchase.]

Long story short: if you are grain elevator posting margin and are locked-in for future delivery via a futures contract, then your short-term liquidity dissipates and you don’t have money to purchase additional grains - even if your grain elevator is just sitting there half empty. If this is indeed what’s happening in farm country right now, then this may indeed be a train wreck waiting to happen since it means that speculation in grain commodities is essentially causing a bottleneck in the supply chain: grain elevators are being maxed out, but not by fundamentals like overproduction but by speculation.

So what impact does this have on the commodities markets? To check it out, I took Buis’s example - cotton - and plotted a USDA-published index for U.S. cotton production alongside a middling index for average U.S. cotton prices on a relative scale starting in July 2007 (see below):

By any standard, this does not look like a healthy price vs. production index graph, where you expect the two variables to move in opposite directions. From August through September, and from November through December, cotton prices actually increase at a faster rate than production (to compare this with price vs. production curves I ran for other commodities on Bloomberg, click here).

Sure, it could be because of higher demand, but the timing here makes me think otherwise: money seems to be pouring into the market about the same time that the credit crunch hits - August - and comes back with a vengeance - November. That it could be dislocated money from the credit crunch looking to find a new home - especially in the midst of a Fed easing cycle - is not entirely implausible.

Granted, so far this amounts to nothing stronger than a hop-skip from correlation to conviction. But when you combine it grain elevators being effectively maxed out due to margin calls, a sharper image starts to take shape. As Buis notes in his written testimony (see below), “with stocks and bonds in turmoil as a result of the mortgage crisis, investment firms seized opportunities in the commodity futures markets. Billions of dollars from pension and other investment houses poured into the hot commodity markets. As a result, many commercial entities of farm commodities have faced skyrocketing margin calls on hedge contracts which have for a long-time been a financial risk tool for farmers and grain elevators.”

Granted, Buis lists higher energy costs (to which food prices are very highly leveraged due to transportation), weather-related supply shocks and the weak dollar and export demand as his top three reasons for hot commodities (ethanol - as expected from a farm man - is not the culprit).

But if this disturbing scenario is indeed playing out in farm country right now, then the bubble which economists seem to be hitherto dismissing - while not the main culprit behind hot commodities - could be far uglier, far larger, and far more damaging than we currently acknowledge.

* * * UPDATE: After I wrote this post, a friend alerted me to an article on the the impact of margin calls on grain elevators from the April 2 edition of the Wall Street Journal. Check it out to get a better understanding of how this all works, and what the potential consequences may be.

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