Monday, August 8, 2011

The Rise in Commodity Prices: Speculation or Fundamentals?

Commodities include items like rubber, corn, copper, cotton, and oil. Their prices have been rising sharply in the last couple of years. Brett W. Fawley and Luciana Juvenal of the St. Louis Fed investigate "Commodity Price Gains: Speculation vs. Fundamentals." They argue that fundamentals are more important, while leaving open the possibility that speculation might have made some contribution.

Start by looking at the increases that have occurred. Notice that the vertical axis of the graph is an index number with January 2005 set equal to 100, and the vertical scale runs up to 600. 

It's easy to come up with supply and demand reasons to explain the increase. Reasons on the supply side seem especially relevant to agricultural commodities: "In a report on the pre-recession spike in food prices, the Food and Agriculture Organization of the United Nations (FAO) identified numerous reasons why stock levels have been falling by an average rate of 3.4 percent per year since the mid-1990s. ...  [T]he price impact of low stocks becomes magnified when stocks reach critically low levels. For all of these reasons, low stocks in food and other crops mean that the weather disruptions faced in 2010 were all that much more significant. For example, the 47 percent increase in wheat prices in 2010 was largely attributable to drought in Russia and China and to floods in Canada and Australia. High cotton prices can be traced, in part, to floods in China (the largest producer) and Pakistan (the fourth-largest producer). In many cases, the high prices in one market have spilled into other markets because of the competition between crops for the same land and growing resources."

Reasons on the demand side--especially increased demand from emerging economies like China and India--seem especially relevant for nonagricultural commodities like metals and energy. Here's a figure showing rising demand for copper and aluminum in China and India.

If speculation was driving up the price of commodities, how would it work? Presumably the mechanism would be that agents in the market are expecting prices to rise, and so they would build up stocks of the commodities to sell in the future. But as they build up these stocks, the quantity supplied in the market is decreased, and so prices could spike. Low interest rates could contribute to such build-ups in stocks, because they decrease the opportunity cost of holding such inventories. But a difficulty with this explanation is that: "Broad declines in aggregate commodityinventories, however, cast doubt on thecurrent importance of this effect."

It does seem clear that additional capital has been heading into commodity markets. "According to
Barclay’s, index fund investment in commodities increased from $90 billion in early 2006 to just under $200 billion by the end of 2007. ... [H]owever, the true impact of speculative inflows on underlying commodity prices remains debatable. ... Factual inconsistencies are numerous. For example, inventories should have risen between 2006 and 2008 according to the bubble theory, but they actually fell. Other reasons for discounting this theory include: • arbitraging index-fund buying is fairly easy due to its predictable nature, • commodity prices rose in markets with and without index funds, • speculation was not excessive after accounting for hedging demand, and • price impacts across markets were not consistent for the same level of index fund activity."

The underlying issue here is that price bubbles are easier to envision in markets like real estate than in commodities or in futures markets. "Commodity markets, however, do not meet the usual theoretical criteria for a bubble. ... [T]heory holds that bubbles are limited to markets such as real estate, where the good in question has a long lifespan, is hard to sell before you own, and buying and selling is
costly in terms of time and money."