What Can One Learn About the Crude Oil Market from the Onion Market? (Micro, Ch. 5)

Onion Futures

There are none.

The bulbous root is the only commodity for which futures trading is banned. Back in 1958, onion growers convinced themselves that futures traders (and not the new farms sprouting up in Wisconsin) were responsible for falling onion prices, so they lobbied an up-and-coming Michigan Congressman named Gerald Ford to push through a law banning all futures trading in onions. The law still stands.

And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings.

Amazing, onion farmers and Congress panic in 1958 with the Senate Committee arguing that

...speculative activity in the futures markets causes such severe and unwarranted fluctuations in the price of cash onions…[that a] complete prohibition of onion futures trading [is necessary] in order to assure the orderly flow of onions in interstate commerce...

and for going on fifty years onion futures are banned.  Makes me want to cry.

More here on the banning of futures markets .  (A report from 1956 indicates that the fluctuations at that time were due to an attempted swindle.)

Hat tip to Newmark's Door

Activity:

Earlier this year, 2008, there was much worry in the news and among consumers paying then record high gasoline prices about the effects of oil speculators in the crude oil market.  Well it turns out there is at least one market in the U.S. where the law bans all futures trading: onions.  

Read the underlying short article in Fortune hyperlinked above.  You should also realize that at least some people who buy futures contracts are speculating in the commodity in question.

Questions:

1.) What did you learn from Chapter Five in the Cowen/Tabarrok textbook about what speculation and futures trading will do to market price?   Do speculation and futures markets affect how much and how frequently prices change?

2.) What do the Marginal Revolution post and the Fortune article tell us has happened to onion prices in the 50 years since futures in onions were banned?  What do you expect the ban on onion futures trading has done to the risk and production of onion growers?

3.) What would you expect to happen to crude oil and gasoline prices if Congress banned futures trading in crude oil?  How would this effect the economy overall?

Answers:

1.) In Chapter Five of the Cowen/Tabarrok textbook we learn that speculation moderates changes in prices.  Speculation will lead to the price of a good not changing as much, and will make the good more available during times it is scarcest.  Speculators raise the price of a good today if they expect its price to rise, but that leads to the price being lower that it would have otherwise been in the future.

2.) The article points out, “the volatility in onion prices makes the swings in oil and corn look tame,” as we would expect from reading Chapter Five in the Cowen/Tabarrok textbook.  Specifically, the article discusses that since 2006, while oil prices at that time of the article, June 2008, were up 100%, and corn had risen 300%, onion prices rose 400% between October 2006 and April 2007 due to weather related crops reductions, then crashed 96% by March 2008 on overproduction and then bounce back up 300% by April 2008.

At least one person in the onion market recognizes that it would likely operate with less volatility, if a futures trading were legal.  Bob Debruyn of Debruyn Produce, a Michigan-based grower and wholesaler says, "I would think that a futures market for onions would make some sense today, even though my father was very much involved in getting rid of it." 

Since onion growers can not lock in a price for their production, onion growing is riskier than other crops.  Thus we might see less onion production due to this extra risk.

3.) The inference that students should draw is that crude oil and gasoline prices would likely be more volatile as onion prices are, if Congress were to act to try to stop speculation in the crude oil market. 

Most of us do not have a large demand for onions.  Onions are not a huge part of our budgets, even if we run a restaurant.  Products from crude oil, particularly gasoline are a different story.  Gasoline is an important item in many consumers’ budgets.  It is an important part of transportation costs of many other goods.  Crude oil is important in heating many consumers’ houses.  Thus wide fluctuations in crude oil prices would be much more disruptive to the economy than similar fluctuations in onion prices have been.  So a Congressional ban on futures trading in crude oil would cause more volatility in crude oil and gasoline prices and would be disruptive to the economy.

Comments

[Travis]

I am only a novice, but what is your reccomendation on how to deal with the potential for gaming the system. I understand that futures in general are in no way different from the potential to influence any other market, but as I understand it futures can allow for a greater manipulation of prices by groups of people utilizing the lack of transparency in the futures market and that fact that it can be heavily leveraged. If it is more or better regulation I fear that this will limit participation and continue the incentives to abuse the system.