How commodity exchanges influence food prices, and why farmers don’t always benefit from price hikes

While commodities are bought and sold around the world, only a few are sold on the commodity market.

A commodity market is where commodities, including many food raw materials, are traded, much like stocks and shares.

This often affects the market price. Thus, the price of a commodity on the commodity exchange will be influenced by forces beyond the manufacturers themselves.

How are prices on the commodity exchange decided?

A commodity exchange, according to Andrew Moriarty, US director of commodity insights at commodity price data company Mintec Global, allows a buyer to ‘lock in’ a supply of their desired commodity in advance through futures contracts, thus guaranteeing that they are insulated against fluctuations in the market.

“The main benefit of an exchange is that it allows buyers and sellers of physical commodities to hedge their prices long before they ever transact physically. This is crucial as it allows both sides of the physical trade to participate in price discovery and lock in that forward view long beforehand,” he told us. Price discovery is the process by which a price is realised.

How much does the commodity price affect the price on the ground?

While the prices being paid on the commodity exchange often influence how much is paid by sellers in the physical world, it usually doesn’t determine this amount exactly.

The exchange specifications are very strictly defined, Moriarty told us, in terms of standard quality and quantity, location, and the delivery period of the commodity being traded. “This is done to attract as much liquidity as possible – the higher the number of people able to transact in that industry, the better the price discovery process is.”

Meanwhile, the seller on the ground will have his or her own priorities. “In the ‘real’ physical world, every buyer and seller will want something slightly different than the exchange specification – a different quality, a different location (anywhere between the seller’s and buyer’s locations) and a host of other things,” Moriarty told us.

The influence of the commodity price is, however, always present. “It is very common in most industries for physical contracts that relate to an exchange price to refer to the agreed price as ‘exchange +/- X amount’. For example, a Colombian arabica such as Excelso EP might be 20 cents/lb higher than the New York ICE Arabica futures contract. So a seller in Colombia might quote their coffee as “ICE NY +20” FOB Colombia.” This difference is known as a ‘basis’ (see boxout).

Physical contracts nearly always exist independently of a futures contract, meaning such exchanges will usually still be made. “There is always scope for more to be paid, the exchange price just acts as a reference to establish a particular baseline from which the full price can be negotiated.”

Commodities such as cashews, which are not traded on the commodities exchange, do not have this baseline. In some markets, without this price being publicly available, it is likely that prices paid in exchanges will vary more widely. Some commodities that are not on the exchange, however, will have independent physical reference pricing from independent companies for buyers to refer to.

Do commodity exchanges bring higher or lower prices for farmers?

Thousands of kilometres away from the commodity exchanges in Dalian in China, Paris and Chicago, farmers of key agricultural commodities such as cocoa and coffee will see prices fluctuate many times in a year. But does the commodity exchange, by locking in futures for large companies, work well or ill for these stakeholders?

There can be benefits to farmers from the public availability of commodity prices, Moriarty suggested. Anecdotal evidence in the coffee sector attests to this.

“Because these prices are published and made publicly available, anyone with a smartphone can see how much the coffee itself is worth, which is a trend we have seen first in Brazil over 10 years ago and which is now spreading to most Latin American coffee-growing regions,” he told us.

When farmers are prevented from being paid the price their commodity is worth, it often isn’t large companies who prevent them getting it, according to Moriarty. “Typically, the problem has not been that the small-scale producers themselves are not paid enough by buyers in consuming regions, but that the middlemen such as traders or exporters or even cooperatives might be able to obfuscate the price to these small shareholders. It was often the case that these small producers were being paid a fraction of the publicly available ICE NY (the InterContinental Exchange in New York) futures price.”

In the West African cocoa trade, for example, growers are often paid a small fraction of ICE future prices because their governments often negotiate export contracts with overseas buyers. “This is where the disconnect between physical prices to producers and the exchange futures price typically occurs.

“Another increasingly common feature of commodity prices is the rising trend of direct sourcing, where small-scale producers can work with a buyer directly, cutting out the middleman and transacting directly with a buyer to fix a price that is often independent of the futures price.

“This is very common now in coffee, with things like organic, Fairtrade, and high quality speciality coffee increasingly transacted through a direct sourcing model like this, and buyers oftentimes prefer this as it looks nice from a PR perspective as well and provides peace of mind in terms of supply security.”

Will farmers see the impact of dramatic price fluctuations?

We have all heard of the recent drastic price increases in a range of commodities, particularly cocoa. Those with futures contracts from before the price rises will be safe. But will farmers on the ground feel the increased value of their own commodities?

It depends, Moriarty told us, on the sector in question. “In the case of coffee, it is quite likely that farmers on the ground will see a difference, however with a time lag introduced as farmers are paid from one harvest to the next, so they will see a benefit in the rising prices, but not until their next harvest is in the bag and sold on. Only large growers who actively hedge their sales using futures contracts will be best positioned to realise those full gains.”

He was not, however, so optimistic about cocoa. “In cocoa on the other hand, there is an indirect benefit – the governments in Cote d’Ivoire and Ghana recently raised farmgate prices to farmers by around 50% based on recent exchange movements. However, the futures prices have risen far more than that, hence the disconnect in that particular industry between the physical prices paid by large cocoa bean buyers, and prices earned by the farmers who produce the beans.

“It will therefore depend entirely on the industry, with cocoa being one of the least transparent markets; most other farmers in other industries will see a benefit if futures rise, but perhaps only when new crops are harvested and sold.”