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FINANCIALISATION TO BLAME FOR COMMODITY PRICE VOLATILITY A latest UN report further strengthens the thesis that financialised markets strongly influence the volatility of commodity prices rather than demand and supply. By
Kanaga Raja The financialisation of the commodity markets, with investors betting on price trends across a broad range of markets rather than fundamental changes in supply and demand in a single market, are mainly to blame for commodity price volatility, according to the United Nations Conference on Trade and Development (UNCTAD). In a policy brief (No. 25 of September 2012), UNCTAD said that commodity prices in financialised markets do not provide correct signals about the relative scarcity of commodities. In the policy brief, based on a forthcoming Discussion Paper, UNCTAD said that this behaviour (contrary to the efficient market hypothesis of trading based on supply/demand information), where the investors are betting on a certain price trend during the period of their investment in commodity assets, "impairs the allocation of resources and has negative effects on the real economy". "To restore the proper functioning of commodity markets, swift political action is required on a global scale," UNCTAD recommended. At a media briefing where he drew attention to the policy brief, Heiner Flassbeck, Director of the UNCTAD Division on Globalisation and Development Strategies, said that the physical markets are not driving the most important physical prices, noting for instance that the oil market is a highly financialised market and that the oil price is not driven primarily by supply and demand for oil, but by considerations in the financial markets. Referring to his earlier discussions with the Organisation of Petroleum Exporting Countries (OPEC) on the issue of oil supply, Flassbeck said that the organisation, in particular its member Saudi Arabia, has even tried everything to stabilise the oil market, sometimes against the organisation's short-term interests. "But it doesn't work," Flassbeck said, adding that this is due to the "quantitative influence of financial markets", which has been getting stronger over the last five or six years. Pointing to some illustrations in the policy brief, he said that ten years ago, there was more or less no correlation between the stock index, the global commodity index and the oil price, but "now we have an extremely strong correlation". "This cannot be explained without giving the financial markets a clear dominance over the physical aspects of this story," said Flassbeck. "This is absolutely clear. I don't know how one can still ignore it, or can deny the influence of the financial markets." "We have to urge the politicians again to look at this problem because how can we go on in this anyway extremely fragile economic situation with commodity prices that are detached from supply and demand," he said. According to the UNCTAD policy brief, the sharp price movements of many primary commodities, including oil, have fuelled intense debate about the causes of the price hikes and possible remedies. Despite a growing body of evidence on the destabilising influences emanating from financial markets, the "real economy" explanations still dominate the debate, noted UNCTAD. "Growing demand from large developing economies and frequent supply shocks, such as adverse weather and export bans, are generally accepted as more tangible factors that explain volatility, rather than the hundreds of billions of dollars of bets placed on expectations of temporarily rising prices." It is not commonly recognised that demand from financial investors in the commodity markets has become overwhelming during the last decade. Of course, supply and demand shocks can still move commodity prices time and again. However, from around $10 billion in commodity assets around the end of the 20th century to a record high of $450 billion in April 2011, the volumes of exchange-traded derivatives on commodity markets are now 20 to 30 times greater than physical production. As a result, the influence of financial markets has systematically transformed these real markets into financial markets. "This calls for strong and prompt policy and regulatory responses in the financial markets, rather than in the physical markets." According to the brief, commodity prices remained high and volatile in 2011 and through the first half of 2012. In the case of crude oil, for instance, the average price of UK Brent (light), Dubai (medium) and West Texas Intermediate (WTI) in July 2012 was 65% higher than the averages reached during the commodity price boom of 2003-2008. The price of oil has fluctuated significantly, rebounding at the beginning of this year and dropping sharply in the second quarter. By the end of August 2012, oil prices had regained what had been lost during the second quarter, notwithstanding faltering growth prospects for the global economy. "Price volatility has long been a major feature of commodity markets, given the tightness in many global commodity markets and the inelasticity of demand. While commodity-specific shocks have played a key role in the past, especially on the supply side and in the oil market, this factor lacks persuasive power today." When political shocks occur, UNCTAD noted, the biggest oil producers undertake remarkable efforts to stabilise prices and to compensate for falling supply by stepping up production in other areas. Rapidly, but steadily growing demand for a range of commodities, especially in emerging economies, does not explain the huge swings recorded in many of these markets from quarter to quarter. Moreover, many commodity prices across all major categories, such as for metals, agriculture and energy, are clearly moving today in tandem, and this trend excludes explanations based on shocks in single markets. "Hence, questioning the very functioning of contemporary commodity markets is inescapable." Undeniably, a major new element over the past few years is the greater presence of financial investors in all these markets. At the beginning of the new century, investment in commodities (or their derivatives) became one part of a larger investor portfolio allocation. This resulted in a significant increase of commodity assets under such management, from less than $10 billion around the end of the last century to a record high of $450 billion in April 2011. Consequently, said UNCTAD, the volumes of exchange-traded derivatives on commodity markets are now 20 to 30 times greater than physical production. Similarly, financial investors, who accounted for less than 25% of all market participants in the 1990s, now represent more than 85%; in some extreme cases, they represent all commodity futures market participants. "These investors treat commodities as an asset class, which means that they are betting on a certain price trend during the period they are invested in commodity assets. They do not trade systematically on the basis of fundamental supply and demand relationships in single markets, even if shocks in those markets may influence their behaviour temporarily." In general, however, their decisions to buy and sell are rather uniform (herding) and are driven by the same kind of information that is available for other financial markets. As they hold by far the largest positions in the commodity markets, it is undeniable that they exert considerable influence on the price movements of those markets. Hence, the prices on financialised commodity markets should follow the prices on other purely financial markets. UNCTAD said it had reported a strong correlation of the prices in several commodity markets with prices in other speculative financial markets as early as 2009. If anything, the correlation has become stronger since then. The policy brief in turn made a number of recommendations, including: -- Increasing transparency in physical markets. Providing better and more timely data on fundamentals; -- Improving transparency in commodity futures exchanges and over-the-counter markets. Providing more data on market participants and position-taking, at least to regulators; -- Tightening regulation of financial investors. This could include the suppression of certain vehicles for investing in commodities, the imposition of position limits and a ban on proprietary trading by financial institutions that are involved in hedging the transactions of their clients. Internationally coordinated measures. -- Introducing a transactions tax system. This could generally slow down financial market activities, in particular high-frequency trading. -- Establishing schemes to deal with speculative bubbles. Market surveillance authorities could be mandated to intervene directly in exchange trading on an occasional basis by buying or selling derivatives contracts with a view to averting price collapses or deflating price bubbles. Such intervention could be considered a measure of last resort to address the occurrence of speculative bubbles if reforms aimed at achieving greater market transparency and tighter market regulation are either not in place or prove ineffective. – Third World Network Features. -ends- About the writer: Kanaga Raja is the Editor of the South-North Development Monitor (SUNS) in Geneva, Switzerland. The above is an edited version of an article which appeared in SUNS #7442, 21 September 2012. 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