Commodity Flows ...
By Daniel Ahn
COMMODITIES HAVE ATTRACTED billions of dollars of The ‘information vacuum’ makes such bullish theories
investment from financial investors seeking exposure to plausible,whiletheinelasticityofsupplyanddemandpre-
itsdiversificationandreturnproperties.Weestimatethat ventsanimmediateinventoryresponsetopersuademar-
roughly US$98 billion of new financial inflows have kets otherwise. The traditional mechanisms that would
entered commodity index funds since January 2006 cause prices to return to true equilibrium levels-namely,
alone. The concurrence of record high and volatile com- efficient absorption of information and physical adjust-
modity prices and massive investment inflows on com- mentofmarkes-arethusweakintheshort-term.
modityexchangeshasledtoapoliticallychargeddebate The ‘herding’ behaviour of market participants also
aboutthecausalitybetweenthetwo. creates an opportunity for less informed financial
Many market watchers and politicians have taken the investors to distort expectations. The relative illiquidity
coincidenceofhighcommoditypricesandfinancialactiv- of commodity markets compared with other financial
ityas prima facie evidenceoftheroleofspeculativeactiv- markets allows large traders to create significant intra-
ity in driving up prices, particularly for oil. But other com- day price effects.
mentators have questioned the ability of purely financial However, the anonymity of markets allows participants
factorstoaffectapricethatisultimatelylinkedtofunda- topotentiallymisinterpretanuninformedinvestmentasa
mental supply and demand. A corollary of this is that bullishmovebyatraderwithsuperiorinformation.Ifpar-
prices driven above the fundamental equilibrium price by ticipants then ‘herd’ around this investment, prices can
speculators would cause a market imbalance and excess shifttoanewnon-equilibriumlevelbasedonmarketreac-
supply,whichmustappearininventorybuild. tionstoaninvalidsignal.Thecomplexityandimportance
Realityismorecomplexthaneitherideologicalextreme ofthedebatesurroundingfinancialactivityandcommod-
suggests. We argue that while prices must reflect funda- ity prices merit a more nuanced and rigorous approach
mentals in the long run, they can deviate considerably in based on hard data. Empirically, we find that past return
the short run because of price inelasticity, informational performance, as well as flight from equities, dollar weak-
imperfections,andbehavioural‘herding’. ness, and inflation expectations, has driven substantial
... roughly US$98 billion of new financial
inflows into commodity indices. Evidence of their effect
on price levels remains ambiguous, depending on the
inflows have entered commodity index methodofmeasuringspeculativeactivity.
funds since January 2006 alone
Absolute measures of index investment predict positive
price effects, but relative measures adjusting for market
Totaketheexampleofoil,supplyanddemandishigh- size do not. A panel approach comparing across com-
ly inelastic and difficult to measure precisely. The high moditiesratherthanacrosstimeseesapositiveeffecton
sunk costs necessary to open a new producing basin, returns.Also,indexinflowsseemtohaveapositive,albeit
suchastheCanadiantarsands,ortoupgradeinfrastruc- weak, effect on market volatility, in accordance with our
ture,suchasautomobilesandfactories,causesanon-lin- theoretical discussion. Also, all of the positive effects are
earresponsewithrespecttoprice.Theextremeinelastic- concentrated in the smaller commodity markets, such as
ityofsupplyanddemandcausesviolentpriceresponses agricultural goods, not the energy markets, which have
to small physical imbalances, making it difficult to for- receivedsomuchattention.
mulate price expectations. This inelasticity and non-lin- Thelong-termgrowthofcommoditymarketsduetothe
earity is a feature not just of oil markets but of many continuedinfluxofnewspeculativeinvestmentandcom-
other commodities, such as agricultural goods and met- mercialhedgingshouldeventuallyimproveefficiencyand
als.Commoditymarketsarealsonotoriouslyopaque.For diminish distortions. The global economy and its con-
oil, there is simply no credible data available for key sumers will enjoy the benefits of improved risk manage-
aspects of the fundamental balance, such as the mentopportunitiesandmoreliquidandefficientmarkets.
amount of Saudi Arabian spare capacity or the size of However, in the interim, the nature of commodity mar-
Chinese inventories. kets makes them prone to behavioural overshooting. We
The lack of insight into elasticities and fundamentals believe that devoting more thought and resources to
makesmarketanalystsuncertainabouteventhevalidity improvingtransparencyandunderstandingofthisimpor-
of their model structure. This model uncertainty forces tant and rapidly growing aspect of commodity markets
information-starved market participants to ‘herd’ and wouldprovideimmediatebenefits
•
copy the behaviour of others. The shortage of informa-
tion also leads market observers to focus inordinately on
Daniel Ahn isSeniorEnergyEconomist
the handful of available signals, such as weekly changes
withLehmanBrothers.
inUSinventories.
www.lehman.com
32 SEPTEMBER 2008 COMMODITIESNOW
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