The commodity bubble

In its recent Bulletin, the RBA has a new piece of research that questions the role of financialisation in commodity prices. The research has some spectacular charts and ultimately concludes that new financial instruments “short-run price dynamics for some commodities, the level and volatility of commodity prices appear to be primarily determined by fundamental factors.” I both agree and disagree with this conclusion. Let’s take a look.

The paper begins by outlining the evidence for fundamental drivers of commodity prices:

The substantial increase in commodity prices over the past decade has been supported by a number of fundamental drivers. One of the most significant has been the shift in the composition of global growth over this period, as emerging market economies – particularly China – have come to prominence as the engines of world growth. Since these emerging market economies are generally at a relatively commodity-intensive stage of development, there has been a corresponding shift in global demand towards commodities as these countries industrialise and expand their infrastructure (Graph 2). Food prices have also been affected by economic development, with the composition and volume of food intake changing as per capita income in these economies rises, generally resulting in a shift away from grains towards higher protein foods such as livestock and dairy, which have high resource footprints.

These trends are likely to continue for some years. At the same time, supply has struggled to keep pace with the unexpectedly rapid rise in emerging market demand over the past decade. Relatively low and falling real commodity prices throughout the 1980s and 1990s resulted in low levels of investment in production capacity for some commodities. Given the long lead time to bring new production online for many commodities – such as the time to undertake mineral exploration and subsequently build a new mine – prices have increased substantially in order to clear the market, prompting a pick-up in investment.

Weather-related disturbances – droughts, floods, cyclones – in some key producer countries have also boosted the prices of a number of agricultural commodities over recent years. The imposition of export bans (often in response to food security concerns) has further contributed to global supply shortages of some food stocks at times. In addition accidents and natural disasters have periodically reduced output at mines, including for copper and coal.

To place the recent price movements in a historical perspective, such a sharp increase in real commodity prices has not been seen since the 1970s (Graph 3). Following the 1970s episode, real commodity prices fell for most of the subsequent two decades. While oil and metals prices are quite high in real terms by historical standards, regaining or exceeding their levels of 40 years ago, real agricultural prices remain well below their previous peak.

All very neat and no doubt correct. And the charts are spectacular. But where’s the evidence? One chart of Chinese steel intensity and a couple of throwaway lines about bad weather disrupting supply is not proof that global commodity demand is fundamental. At least show me some evidence of increased storm activity.

What about some simple measurements of aggregate global consumption of a few chosen commodities (or all of them for that matter). There are some figures on production and exports later in the paper but no time series so we can’t gauge changes in production. How can we conclude fundamental drivers are at work without these raw data on supply and demand? More worryingly, the use of just one data point to encapsulate demand, Chinese steel consumption per capita, hints that it might be an article of faith with the bank.

Section two of the paper then moves to show the increase in commodity price volatility:

The recent increase in the level of commodity prices has been accompanied by a significant rise in the volatility of commodity prices (Graph 4). While price signals play an important role in boosting future supply and allocating existing supply, volatility in prices can hinder this process by generating uncertainty about future price levels. The primary focus of this article is on price volatility occurring over a period of months or longer, as this is the frequency at which it can materially affect firms’ investment and production decisions. Shorter-term volatility is not inconsequential, however, as it can cause disruption within financial markets.

The recent increase in commodity price volatility raises two related questions: how does commodity price volatility typically compare to that of other prices? And how unusual is the current level of commodity price volatility?

Starting with the first question, commodity prices do tend to be more volatile than many other prices in the economy because in the short term both global supply and demand for commodities are relatively price inelastic. For example, increasing the level of production takes time if new crops must be grown, mineral exploration undertaken or new mines built.

Similarly, it can take considerable time to change consumption habits, such as shifting from coal-fired electricity generation to gas, or altering the share of more fuel efficient cars in the outstanding stock of automobiles. This sluggish response means that supply and demand shocks, due to weather events or natural disasters for example, can result in large price movements in order to clear the market.

The higher volatility of some commodity prices is also related to the fact that many commodities are traded in transparent, continuously priced markets – in contrast to many other goods and services. These commodity prices can thus reflect news and changes in economic (and financial) conditions more quickly than do consumer prices, which manifests as higher average volatility.

Fair enough, all sound economics and points I’ve made myself many times. (As a quick aside, if the RBA agrees that inelastic supply responses lead to increased volatility then why does it see Australia’s ‘housing shortage’ only supporting higher prices?)

Section 2 of the paper then examines the evidence for increased financial activity in commodities:

It has been suggested that, in addition to fundamental supply and demand factors, the activity of speculators in financial markets may have played a significant role in contributing to the increase in the level and volatility of some commodity prices in recent years. This section describes the growing presence of financial investors in commodity derivative markets, while the next section examines the evidence of the effect of this growth on observed commodity price dynamics over the past decade.

Financial markets provide a useful complement to physical commodity markets because they allow consumers and producers to hedge their exposures to movements in commodity prices. These markets exist precisely because prices can be volatile, and allow uncertainty about future price movements to be managed. For example, a farmer could purchase a forward contract at the time of planting a crop, to give certainty about the price that will be received upon harvest. Financial investors provide additional liquidity to these markets, and can improve price discovery.

In theory, there should be a relationship between futures prices and spot prices determined by the ‘cost of carry’. This is the opportunity cost of buying and holding a good or financial instrument versus purchasing a futures contract for delivery in the future. In the case of commodities, holding a physical commodity can incur large storage costs, complicating the ability of arbitrage to maintain the relationship. To the extent that such a relationship does hold, any increase in volatility in futures markets could lead to greater volatility in the spot market. However, the relationship also means that if supply and demand factors underpin the spot price, the futures price will be unable to significantly deviate from this fundamental price for an extended period of time.

Well…I’m buggered if I know. But it seems to me that if you only trade futures, perennially rolling over your holdings before maturity and never actually taking physical delivery of the underlying commodity then all of this economic rationalisation ceases to matter. As reader Lionel Hutz has commented:

…these guys simply don’t seem to understand that if you have a market in contango, with a large enough spread, and buyers who need to take physical delivery, then spot prices rise to the point where the buy and store arbitrage is removed.

Anyways, I welcome feedback on this point.

Back to the RBA paper, the argument then proceeds through some nice circumstantial data showing the increased size of commodity derivative markets:

We then move to the conclusion of the paper:

While the role of financial investment in commodities has clearly increased over the past decade, this does not necessarily imply that financial investors have significantly altered price dynamics. A number of factors suggest that, at least for most commodities, the effect has been small.

First, price increases have been just as large for some commodities that do not have well-developed financial markets as for those that do. For example, the prices of iron ore and coal, which do not have large derivatives markets, have increased by as much as prices for most commodities that are actively traded in financial markets (Graph 8). These price increases reflect broad fundamentals, being underpinned by strong demand (particularly from China) and supply constraints. Similarly, the falls in prices during the global financial crisis are consistent with the sharp fall in global growth at that time

I just have to ask at this point, does the absence of significant levels of derivatives for certain commodities necessarily imply that speculation is impossible in those markets? In the rules of dialectic, this is known as the false analogy. Back to the paper’s conclusions:

Second, there is significant heterogeneity in price behaviour between commodities, even among those that have large, active derivatives markets. For instance, the prices of oil and natural gas have diverged significantly in recent years, particularly since the start of 2009, despite the associated derivatives markets both growing strongly over recent years (Graphs 6 and 9). The divergence is due to the rapid growth in supply of natural gas in the United States (where these prices are measured) due to technological developments in the shale gas sector. This suggests that even where there has been a large increase in financial investment, fundamentals remain the dominant factor determining commodity prices (except perhaps in the very short run).

Third, the recent increase in the correlation between commodity prices and other financial prices – which is commonly cited as evidence that financial speculators are affecting prices – is not unusual in a historical context. Episodes of increased correlation between commodity and equity prices have occurred in the past at times when financial investment played little, or no, role in commodity markets (Graph 10). This indicates that asset and commodity prices tend to move together more closely when they are affected by common shocks, such as during the Great Depression period and late 1970s. This is unsurprising given the large swings in global demand and supply during these periods, which are fundamental drivers of both equity and commodity prices. The most recent episode is thus not unusual in this regard, given the very large global shocks that occurred; the early 2000s, when the correlation between commodity and equity prices was almost zero at a daily frequency, is not an appropriate benchmark for the crisis period.

We really need to define our terms here. What are these “fundamentals”? We began the paper by describing how it is that markets that have inelastic supply have increased volatility. The reason for that is that as the supply shortage is recognised, regular buyers begin to hoard, and speculators move in to take advantage of higher prices. Buyers then hoard more and speculators buy more still. Prices rise until supply responds (usually over responds) and prices crash. Hence volatility. It’s is logically inconsistent for this paper to simultaneously claim that there is reason to the volatility but no speculation in that reason. If fundamentals are as strong as this paper supposes, then it is silly to not expect speculators to be jumping all over commodities. Back to the conclusions:

Fourth, the evidence of a relative increase in the price correlation between commodities that make up the major commodity indices – and which ar correlations. While this supports the argument that index fund behaviour affects the price dynamics of on-index commodities, the effect appears to be quite short-lived. The increased correlation among commodity prices more broadly suggests that other (fundamental) market forces tend to dominate.

Fifth, there has not been a large increase in commodity inventories that we would expect to accompany speculation-driven price rises. The available – albeit limited – data show that global inventory levels for a range of commodities have been declining and are currently below their long-run averages (Graph 12). That said, it is possible that the producers of extracted commodities – such as oil – effectively control their ‘in the ground’ inventories by limiting production. This is difficult to gauge.

Not that difficult. Media reports in the past six months have aroused suspicions that J.P. Morgan has been busy spruiking copper prices even as rumours swirl that its traders have cornered that same market. Barclays has recently been accused of cornering lead. And Hetco Brent. There is also China’s great pile of iron ore and its myriad copper scams. Also, in grains, the UN FAO has reported that:

In its 2009 Trade and Development Report, the United Nations Conference on Trade and Development (UNCTAD) contends that the massive inflow of fund money has caused commodity futures markets to fail the “efficient market” hypothesis, as the purchase and sale of commodity futures by swap dealers and index funds is entirely unrelated to market supply and demand fundamentals, but depends rather on the funds’ ability to attract subscribers.

a) The lack of reliable and up-to-date information on crop supply and demand and export availability
b) Insufficient market transparency at all levels including in relation to futures markets
c) Growing linkage with outside markets, in particular the impact of “financialization” on futures markets
d) Unexpected changes triggered by national food security situations
e) Panic buying and hoarding

Back to the RBA’s final conclusion:

Finally, the academic literature on this topic has generally not supported the proposition that financial investors significantly affect commodity prices over longer time horizons. A number of empirical studies, including by the Commodity Futures Trading Commission, OECD and the IMF, find minimal evidence of speculators’ positions driving prices.

See above.

Obviously I suspect there is a large role being played by speculators in current commodity price hikes. Ironically, I draw this conclusion on precisely the same economic principle that the RBA uses to dismiss the possibility. Do I know for certain? Nope. The RBA’s paper, however, has done nothing to persuade me otherwise.