Fields of Dreams: The rich history and evolution of the oldest alternative investment

By: Ranjan Bhaduri, AllAboutAlpha.com Editorial Board, and Bart Scagnelli, AlphaMetrix Alternative Investment Advisors.

Nine thousand years ago, farmers in the Middle East began to cultivate a primitive ancestor of what we now know as wheat. Similarly, ancient Mayans bred early forms of corn, and several strains of rice developed in ancient China. But the mass production and surpluses of grain that made international trade possible was largely due to the increased concentration of people within small geographic areas, such as cities. Little did they know, the plants that these farmers labored so hard to sew, plow, and harvest would expand and evolve to become one of the planet’s most influential commodities – and a key part of many alternative investment portfolios (largely via futures and other derivatives – see related post).

The history of international grain trading is, in a sense, a history of modern civilization. As the ripple effects of social, economic, and technological changes have shaped the history of civilization, grain traders have responded to and sometimes driven these changes through innovation and creativity. Grain traders have played a large role in creating organized commodity exchanges, where CTAs and hedge funds can utilize grain as part of a larger, diversified portfolio. Like the farmers of the ancient Middle East, modern traders and investment managers must recognize the powerful market forces at work in order to turn a profit.

Grain Trading in Ancient Times

As the ancestors of modern grains were spreading across Europe and the rest of the world, the growing number of cities across the planet began to consume more food than the surrounding areas were able to produce. The distribution of population was one of the first and most important drivers of grain trading. The massive appetite of cities created an opportunity for rural communities to sell their surplus grain and purchase imported goods, which sometimes provided them with a diversified diet and an improved quality of life. Likewise, the differences in supply and demand between rural communities and urban areas created an opportunity for traders to exploit the differences in prices and generate profits. The Roman system of cities, roads, and trade routes represented the golden age of the early grain trade. But the cost of transporting the large amounts of grain necessary to generate profits limited the extent to which grain could be traded for much of its history.

The technological improvements of the Renaissance period also had an important affect on the grain trade. For example, advances in shipping allowed grain to be transported more cheaply and efficiently. The centuries-long process of refining strains based on their suitability for particular environments improved the reliability and abundance of harvests. Similarly, the popularization of bread as a form of subsistence created a new demand for grain.

The ability of grain traders to profit from price discrepancies was greatly aided by the introduction of railroads and the settlement of the American prairie land. New shipping routes made possible through canals and locks also brought down the cost of transporting grain across great distances. The industrial revolution re-concentrated populations around major cities in such a way that created even sharper price differences across geographic areas. Finally, new manufacturing techniques allowed companies to process the raw commodity faster than was ever thought possible.

The 20th Century and Global War

Like the social, technological, and economic changes that affected the grain trade in the past, the onset of global war had a massive effect on the international dynamic of grain trading. The amount of wheat exported from the U.S. jumped from 4 million tons in 1913 to 9 million tons in 1921. This number continued to grow as post-World War II Europe relied on U.S. grain for much of its food supply. In the middle of the 20th century, some major grain producers included the United States, Canada, Argentina. Major grain-producing regions were also home to commodity exchanges, which became the home of grain traders as we know them today.   If you traded grains in Winnipeg in 1938, for example, you will recall the scene below (via the Manitoba Historical Society).

Grain Trading Today

Some of the trading strategies commonly used by traders today have their roots in the older, less formal grain trading forums. These forums included the businesses and markets around the ports of Europe and the U.S. Big grain trading firms were teaching their employees arbitrage strategies long ago, and the development of regulation and trading forums associated with grain were very much influenced by these same companies. The grain trade has also grown to include rice, soybeans, oats, and even palm oil.

Like the farmers who originally cultivated primitive grain strains, modern traders must attempt to forecast the weather. But now grain traders often find themselves estimating the extent to which grain will be over-cultivated. Over the past hundred years, humans have found creative new ways to use grains. We have used it for fuel, to feed our livestock, to sweeten our foods, and even to manufacture non-edible products. But the genetically modified super-crops have driven the bushel-per-acre yield of grains through the roof, and many traders find themselves shorting grains in anticipation of falling prices because of overproduction.

According to a recent agricultural conference in Chicago, almost 90 million acres of corn is expected to be harvested in America in 2010, as well as 78 million in soybeans, and 53 million in wheat. The price of wheat futures is encouraging grain storage through higher prices in deferred contracts. Soybeans are a little more promising as a strong demand continues to originate from China, but prices are still expected to stay flat until 2013, and there is not an aggressive increase in acreage. The upcoming corn crop is uncertain as well, but many traders expect demand to rebound after the global recession drove prices down in 2008-2009.

Grain traders can benefit from a careful examination of the history of grain production, and how these changes have affected supply and demand. They must look beyond the weather, and take into account social, political, and technological changes that could have substantial effects on markets. Additional production can be expected from improvements in gene modification technology. But this production may also be effected by government intervention in the form of farm subsidies. Changes in eating habits will also have important effects on demand, as will the possible increase in bio-fuels.

Grain traders have historically adapted to the changes in market conditions, evolving to survive in new environments like the plants whose fruit they trade. A key to maintaining this survival will be learning from the past, and anticipating the forces just beyond the horizon.

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