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The mid-2000s marked the start of a trend of steeply rising commodity prices, accompanied by increasing volatility. The prices of a wide range of commodities reached historic highs in nominal terms in 2008 before falling sharply in the wake of the financial and economic crisis. Since mid-2009, and especially since the summer of 2010, global commodity prices have been rising again. These developments coincide with major shifts in commodity market fundamentals, particularly in emerging economies which are experiencing fast growth, increasing urbanization and a growing middle class with changing dietary habits, including an increasing appetite for meat and dairy products. In addition, in an attempt to reduce the use of fossil fuels in energy consumption, a range of food crops are now being used in the production of biofuels, which is being promoted in a number of countries including those of the European Union (EU) as well as the United States. The related conversion of land use from crops for food to crops for biofuel production has also affected the prices of food crops. At the same time, a decline in the growth rates of production and productivity, partly due to the adverse effects of climate change, has adversely affected the supply of agricultural commodities. However, these factors alone are not sufficient to explain recent commodity price developments; another major factor is the financialization of commodity markets. Its importance has increased significantly since about 2004, as reflected in rising volumes of financial investments in commodity derivatives markets — both at exchanges and over the counter (OTC). This phenomenon is a serious concern, because the activities of financial participants tend to drive commodity prices away from levels justified by market fundamentals, with negative effects both on producers and consumers. There is considerable empirical evidence that points to financial investors’ impact on commodity prices: • A number of studies find evidence of commodity price bubbles. Analyses show that position-taking by index investors, that passively replicate the price movements of an index based on a basket of commodities, has an impact on price developments, particularly of crude oil and maize. The fact that these effects are persistent — especially in the case of crude oil — points to the presence of herd behaviour. Whereas index investors were identified as significant price drivers prior to the financial crisis, the importance of money managers (e.g. hedge funds), that follow more active trading strategies and take positions on both sides of the market, has increased since then. This is reflected in the very close correlation between price changes and position changes of money managers since 2009, which is as high as 0.8 in the oil market. Indeed, it has been estimated that speculation currently accounts for as much as 20 per cent of the oil price. • Cross-market correlations between currency and commodity markets have increased recently, and point to factors other than fundamentals that are driving commodity prices. Information flows in other financial markets increasingly influence the dynamics of commodity futures. In addition, an analysis of the reactions of commodity prices to announcements of economic indicators shows that, within minutes of an announcement, commodity prices react in a similar manner across different commodity markets that do not have much in common. * The behaviour of commodity prices, especially oil, over the business cycle has changed fundamentally. In earlier business cycles commodity prices and equity prices evolved differently. Increases in commodity prices did not occur until well after the trough. In the most recent business cycle, on the other hand, oil prices surged immediately after the trough, even before share prices started to rise. This surge was based simply on the expectation, not the actual occurrence, of an upswing. . . . Investors have been engaging in commodities trading for the purpose of portfolio diversification ever since it became evident that commodity futures contracts exhibited the same average returns as investments in equities, while over the business cycle their returns were negatively correlated with those on equities and bonds. The empirical evidence for this finding emerged from an analysis of data stretching over a long period, from 1959 to 2004 (Gorton and Rouwenhorst, 2006). . . . Commodity futures contracts were also found to have good hedging properties against inflation (i.e. their return was positively correlated with inflation). This is because they represented a bet on commodity prices, such as prices of energy and food products, which have a strong weight in the goods baskets used for measuring current price levels. . . . Furthermore, investing in commodity futures contracts may provide a hedge against changes in the exchange rate of the dollar. Most commodities are traded in dollars and commodity prices in dollar terms tend to increase as the dollar depreciates. Measured in a currency basket, commodity prices are generally less correlated with the dollar; indeed, the sign of the correlation is reversed (IMF, 2008: 63). This suggests that changes in the value of the dollar against other currencies may partly explain the negative correlation between the prices of dollar-denominated commodities and the dollar. . . . The most recent decline in world industrial output is known to have been by far the strongest of all downward cycles in the past 35 years. The sharp drop of 12 per cent from the peak makes other recessions seem like mild slowdowns in comparison (figure 20). However, in spite of the very low utilization of global industrial capacities at the beginning of 2009, the upward pressure on prices in commodity markets was much stronger than with similar positions of earlier business cycles — a development often overlooked by observers. Anticipation of recovery by the financial markets seems likely to have played a disproportionately significant role in this current bout of commodity price inflation. The strong impact of financial investors on prices, which may be considered “the new normal of commodity price determination”, affects the global business cycle in a very profound way. Commodity price inflation endangers a smooth recovery to the extent that it provokes a premature tightening of monetary policy. It has already played an important role in the tightening of Chinese and Indian monetary policy since early 2010, and in the first interest rate hike since the beginning of the crisis by the European Central Bank (ECB) in April 2011. . . . A comparison of the business cycles shows that commodity prices and share prices moved in opposite directions during the previous identified business cycles (figures 21-23). By contrast, there has been a remarkable synchronization of share price and commodity price movements in the most recent cycle (figure 24). . . . The fact that monetary policy reacts to price pressure stemming from rising commodity prices, rather than to bottlenecks in industrial production, points to a worrisome aspect of the impact of financialization that has so far been underestimated, namely its capacity to inflict damage on the real economy as a result of sending the wrong signals for macroeconomic management. . . . A broker reported noticing a greater involvement of financial players in physical trading and physical traders in financial markets. According to him, after a sharp decline of activities (reflected in outstanding notional amounts), banks that had closed down their trading desks were now back in the market. However, the risk appetite had declined. At the same time there was more liquidity on the exchanges than before the crisis, which was being provided by banks, hedge funds and managed funds. He noted that commodities were more and more perceived as “currency” while there was a crisis of fiat money. The broker also observed increased volatility in commodity markets due to large inflows of money from financial investors but also to high leverage in derivatives markets compared with the physical market. Not only had the volatility of the flat price increased, but also that of the spreads.
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This study (UNCTAD/GDS/2011/1), reproduced here for non-profit educational purposes, was prepared by the UNCTAD secretariat for Arbeiterkammer Wien (Austria). It was prepared by a research team consisting of Heiner Flassbeck (team leader), Director, Division on Globalization and Development Strategies, David Bicchetti, Jörg Mayer, and Katja Rietzler (independent consultant). Pilar Fajarnes and Nicolas Maystre provided specific inputs. Makameh Bahrami helped with the data. The study was edited by Praveen Bhalla.
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