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.

Comments

  1. Great dissection H&H, I often get the feeling that the RBA confuses quantities and prices. Just because China will consume more coal and iron each year for the next decade, does not mean that the prices will rise with quantity produced/consumed.

    In fact, once many of new mines come on board in Australia, South America, (and I’ve heard Mongolia), supply will be greatly increased to match this growing demand at much lower prices.

    • Personally, I’ve never thought price movements of iron ore and coal as speculative but more ‘opportunistic’ and yes, largely correlated with demand. Both can get stockpiled by receivers for a number of genuine logistical/production reasons. To me there is a difference. Semantics possibly!

      It is still up to a couple of years off until new production comes on line in any significant way and I’ve said before, the majors really have it wrapped up for some time in terms of grading and efficiency of production. IMO it is unlikely that current prices are achievable medium-long term (hopefully I’m wrong). Kloppers recently maintained that current pricing for next two years was expected. But, assuming there is no global collapse, demand over time (even with new production coming on line) should be healthy enough to sustain reasonable (but not record?) prices.

      The BoJ report Lionel Hutz linked to was well worth reading.

      High frequency trading & commodities:
      http://www.reuters.com/article/2011/06/17/us-commodities-highfrequency-idUSTRE75G0MT20110617

      Outlook for steel market May 2011:
      http://7marketspot.com/archives/2999

  2. If a commodity is showing signs of going parabolic then historically it will be a bubble, and end badly.

    The FT LME story I’ve added shows there are other forces at play by by restricting supply to drive the price up, and make a good income from storage; the usual suspects are involved; well this is the allegation.

    In the case of Iron Ore I’m not sure if the RBA mentions the change from fixed contract to spot price, and how the Treasury were surprised by the tax revenue from that. This is another issue driving the bubble for Iron Ore at least IMO; market forces, but ….

    Also as the USD has been de-based vi QE, and investors have moved to commodity investments, and never intend to take physical delivery. In the case of silver e.g. the COMEX is about 10-15% of the worlds physical delivery, yet it controls the spot price for silver some how. I’d be happy if someone can answer that.

    For COMEX grains e.g. in 2010 the prices rose in the order of 60% or more. You can say more demand, but why are European farmers paid not to produce by the EU?

    If anyone can prove there is no speculation in commodities I’d love to read that and see the proof.

    http://www.ft.com/intl/cms/s/0/8abd092a-97e7-11e0-85e9-00144feab49a.html#axzz1PQjK8CA1

  3. As per a comment I made elsewhere, the bank of japan provided a much more detailed analysis, in so far as going beyond just plotting some prices and quantities. Also the RBA charts seem quite selective. For example chart 12 which is supposed to show that stockpiles haven’t been rising, is restricted to some food crops. I follow base metals and minerals and metal stockpiles have definitely been rising at the same time as prices. Given the wealth of data the RBA has available they seem to have cherry picked it to try and support a pre-determined conclusion.

    • It’s an interesting observation that stockpiling of metals, such as copper do indeed increase (generally) as the price rises. One would have thought it makes much more sense to stockpile when prices are very low.

      You can check out graphical representations of invesntory levels on investmenttools.com

  4. This is the worry I have about a carbon trading scheme – It could become just another speculating mechanism for Goldman Sachs and the Treasury/RBA will produce a “move along, nothing to see here” report, which will then be endorsed by various bank economists in the MSM.

  5. Julian Simon would be rolling in his grave.

    All of this is a justification of the RBA’s position that Australia has no option but to ride the commodities boom-bust cycle. They don’t have a Plan B, so that have to prove that Plan A cannot fail.

    • “They don’t have a Plan B, so that have to prove that Plan A cannot fail.”

      Lorax it all goes back to the comment you made about when we look back on this time period they will be looking atwhy did the Aussie govt make the decisions they did during this time. You said something along those lines.

  6. I think volatility and sharp increases in commodity prices are being driven by the Yuan peg, rather than speculation. To give an example… Imagine Australia fixed the AUD at .50 USD: Each time the US eased monetary policy, the RBA would have trouble sterilizing the excess liquidity caused by speculative inflows and secondly, monetary policy would need to stay excessively loose to maintain the peg. Due to the tax, lending, economic structure etc., it’s a fair bet that this would cause an even bigger bubble in housing. Replace Australia with China and housing with commodities, and it becomes clear what’s happening. Because the Chinese economy is completely geared around buying industrial commodities for fixed asset investment, whenever the peg comes under pressure, commodity prices rise.

    Also I think speculators buying futures can only influence spot prices if a steep contango scares the physical delivery buyers into bringing forward and increasing their purchases (hoarding). I can’t see how speculation in futures, by itself can cause spot prices to rise. If physical demand doesn’t also rise, the prices of futures contracts will correct and the speculators bets won’t pay off.

    • lets say an arbitrager can make money on a commodity up to a bid of $100. The guy that needs the physical commodity needs to bid $100.01 to win the bid.

      The presence of an arbitrage creates a larger number of buyers on the spot market.

      So all you need is for people requiring physical delivery to be bidding with arbitragers and the spot price to be raised up to the point where the arbitrage is washed away.

      If there is less demand for physical delivery then the arbitragers win the bid and we see rising stockpiles due to the buy and carry strategy — which is what we do see, certainly in some markets.

      • I suppose that could happen. But that sort of speculation would only drive commodity prices higher over a short period.
        If you look at the timing of the commodity spikes in early 08 and last year they happened at exactly the same time as the yuan peg was coming under pressure and China was overheating. I just reckon 80% of the story is the Yuan peg.

      • Well I actually think that higher commodity (metals) prices prior to the GFC were less speculatively driven.

        I disagree that a rise in the spot price would be for a short period — if futures remain high, spot prices remain high, based on that mechanism/model.

        and we seem to have long commodity ETFs providing plenty of grist for ongoing high futures prices.

  7. Refined metal is mobile store of value if you are concerned ‘fiat’ is being abused and you need flexabity to move wealth around the world. Real estate is not portable.

    Metal can be used as security for finance when finance for other assets is being controlled/limited.

  8. MontagueCapulet

    Even if commodity prices simply reflect Chinese demand, that demand may be bubble-driven. A lot of people seem to take it as a given that China will consume more steel each year for the next decade or two. But the Chinese government is currently trying to discourage new steel mills as they believe there is overcapacity.

    In order for the rate of steel consumption to continually increase the rate of construction has to continually increase. Which itself requires a constantly increasing level of investment in infrastructure. Since the level of fixed investment is already freakishly high it is likely that it will peak in the next few years, and steel consumption with it.

    Once steel consumption plateaus supply will soon come into balance for iron ore and prices will fall, which will likely lead to a similar correction in other metals.

    Some pundits will tell you this won’t happen for another twenty years because China hasn’t reached the same level of steel use per capita as Japan or South Korea. So what? There is no iron law that says Chinese growth will continue until their GDP per capita is similar to South Korea or Japan. Growth has to be earned. Stuctural reforms are required before China can get to $16k per head, let alone the $30k per capita of Japan.

    They may get there eventually, but it is not a birthright. And there is nothing to say they can’t have a Great Depression along the way, like the USA did.

    • Good summary MC – what is sometimes forgotten is that many “bears” on China realise are not saying “all is over”, but that similarly to the rise of the British and US empires, there will be large corrections (or Depressions) along the way.

      The major problem is that Australia is leveraged to this – the Chinese will come out the other side of a soft or hard landing and keep going, but there is no buffer (e.g SWF/well-educated capitalised and low-debt/high savings economy)

      • Don’t worry, even Fanboys see hurdles. But at the end of the day, all will be sweet.

      • Is China certain to become a great, 21st century hegemon in the mould of Britain in the 19th century or 20th century America? They’ve been there before for sure, but history doesn’t work like that. Why aren’t the Egyptians or the Mayans or the Romans still leading the pack?

        Don’t bet your horses on China’s inexorable rise. Its challenges are real and profound. Stratfor does a good analysis on this, especially insofar as geopolitics and geo/ecological limitations are concerned.

  9. “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.”

    Of all the existential financial questions out there, the impact of institutional speculation of the physical market has to be the easiest to answer empirically—-just gather a bunch of undergrads. Create a mini-commodities economy around as “powdered lemonade” for a lemonade stand. Develop a cash delivery-only market market. Introduce excess liquidity and futures, watch what happends.