A new vision for agriculture
momagri, movement for a world agricultural organization, is a think tank chaired by Christian Pèes.
It brings together, managers from the agricultural world and important people from external perspectives,
such as health, development, strategy and defense. Its objective is to promote regulation
of agricultural markets by creating new evaluation tools, such as economic models and indicators,
and by drawing up proposals for an agricultural and international food policy.
Focus on issues

Don’t blame the physical markets:
Financialization is the root cause of oil and commodity price volatility

United Nations Conference on Trade and Development (UNCTAD)

Agricultural markets have become highly financialized since the early 2000s, in an environment marked by the deregulation of financial transactions in these markets. According to a UNCTAD document published on September 18, “the volumes of derivatives linked to commodities are now between 20 to 30 times the actual production”1. For Heiner Flassbeck, Director of the Division on Globalization and Development Strategies of the UNCTAD, such financialization is “the leading root of oil and commodity price volatility”. In fact, it cannot be denied that agricultural commodities are now an investment among others for the portfolio management strategies of financial investors, who base their outlays on other factors than physical supply and demand of agricultural products. Agricultural markets have therefore become intricate anticipatory markets, a trend that exacerbates the intrinsic volatility of agricultural prices even more. As a consequence, it is crucial to strengthen the regulation instruments of agricultural markets, similarly to the measures recently adopted by the United States and the European Union2, and make sure that every financial center throughout the world implements similar measures to prevent the introduction of a lowest bid tax policy at the international level.

momagri Editorial Board

The sharp price movements of many primary commodities, including oil, have fuelled intense debate about the causes of the price hikes and possible remedies. 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. Despite a growing body of evidence on the destabilizing influences emanating from financial markets, the “real economy” explanations still dominate the debate. It is not commonly recognized 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. But with the volumes of exchange-traded derivatives on commodity markets now being 20 to 30 times larger than physical production, 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. […]

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, the biggest oil producers undertake remarkable efforts to stabilize 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.

Financial investors lead the herd: “keep them doggies rolling”

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 (Institute of International Finance, 2011). Consequently, the volumes of exchange-traded derivatives on commodity markets are now 20 to 30 times greater than physical production (Silvennoinen and Thorp, 2010). Similarly, financial investors, who accounted for less than 25 per cent of all market participants in the 1990s, now represent more than 85 per cent; in some extreme cases, they represent all commodity futures market participants (Masters, 2008).

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 financialized commodity markets should follow the prices on other purely financial markets. […]

Significant positive co-movements of the returns of the futures contracts of oil or a broad range of other soft commodities with futures contracts on the United States stock market at high frequencies appear up to one-second intervals. Clearly, these very short-term commodity price movements cannot be justified by the changes in supply and demand in specific markets. Fundamentals for the United States stock market and commodities markets differ greatly, and different fundamentals cannot induce similar price movements simultaneously, continuously and consistently for the past few years across all the markets investigated. Indeed, given the large selection of commodities considered, different behaviours would have been expected due to the seasonality, industrial usage and specific physical commodity market dynamics. However these differences have not been observed.

While fundamentals cannot explain these price co-movements, the stock market and commodities do share one common, critical feature: the dominant position of financial investors. In the current period of great economic uncertainty, news about the evolution of the world economy and political announcements has a huge impact on the activities of herds of financial investors whose position-taking in commodity derivatives markets follows market sentiments or expectations, and much less so the fundamentals.

An enlightening example is to be found in the course of this year. After briefly rebounding in early 2012, commodity investments turned negative in the second quarter. According to Barclays Capital (2012), investors withdrew $8.2 billion from commodity investments in May 2012 in what was described as “something approaching a stampede ... evoking memories of 2008”. But more than any rumours of war preparation here or better-than-expected macroeconomic news there, the evolution of oil prices has coincided with that of the European stock markets and the evolution of political decisions and rumours in the eurozone. […]

Time to recognize the pervasive impact of financialization

Due to the increased participation of financial players in those markets, the nature of information that drives commodity price formation has changed. Contrary to the as- sumptions of the efficient market hypothesis, the majority of market participants do not base their trading decisions purely and independently on the fundamentals of supply and demand; they also consider aspects related to other markets or to portfolio diversification to be important. This introduces spurious price signals into the market.

Moreover, in a situation of widespread herding in financial markets, the assumption of an atomistic market, in which participants trade individually and independently of each other on the basis of their own interpretation of fundamentals, no longer holds. The price discovery market mechanism is seriously distorted. Prices can move far from levels justified by the fundamentals for extended periods.

Because of these distortions, commodity prices in financialized markets do not provide correct signals about the relative scarcity of commodities. This 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.

1 CNUCED. « Don’t blame the physical markets: Financialization is the root cause of oil and commodity price volatility ». CNUCED, Policy Brief 25. The original document is available from http://unctad.org/en/pages/newsdetails.aspx?OriginalVersionID=276
2 Please see momagri’s article “Defining a new regulatory framework for agricultural commodity derivatives markets”, http://www.momagri.org/UK/editorials/Defining-a-new-regulatory-framework-for-agricultural-commodity-derivatives-markets_1034.html
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Paris, 19 December 2018