Thursday, March 31, 2011

Volatility: Not Unique to Exchange-Traded Commodities*

Fluctuations in commodity prices, particularly in crude oil prices, have been hotly debated in recent years. Some argue that underlying market fundamentals, especially the unexpectedly strong demand shock attributed to continued strong economic growth in Asia and other emerging economies, is the main reason for the resurgence of commodity prices and for the fluctuations in prices since 2004. Others argue that speculative activity in commodity derivatives markets is the main force behind surging commodity prices. They further claim that commodities have become a new asset class in investors’ portfolios, and prices are now more affected by macroeconomic news rather than by commodity-specific physical market conditions.

Policy makers have responded with a slew of proposals to control futures market activity.  Aside from the questions that such measures raise in terms of market function, liquidity, price discovery and ultimately price volatility, they are premised on a view that commodities traded on futures exchanges are intrinsically more volatile than those which are not. This is problematic.
The Onion Futures Act, which has prohibited the trading of onion futures in the US ever since it was passed in 1958, is a good example illustrating why volatility cannot be reduced by merely prohibiting some traders or all futures contracts. Empirical research suggests that prices and volatility in onion markets were higher post-Act than before the Act’s implementation. A more recent example can be found in India, which banned financial trading in most agricultural products – yet found out that prices continued to rise in 2008.
In order to compare price movements and volatility between non-exchange-traded commodities and crude oil prices, we constructed a weekly spot price series for an equally weighted basket of non-exchange-traded commodities. By focusing on non-exchange-traded commodities, we seek to ensure that the fluctuations of the basket’s price do not stem from changes in the activities of financial institutions in commodity futures markets. Our composite basket includes seven commodities: rice, coal, manganese, rhodium, cadmium, cobalt and tungsten. Although futures exist on rough rice and Appalachian coal, the CFTC’s Commitments of Traders reports show that the open interest and the number of traders in these contracts are small, therefore we also include these commodities in our index to allow a more diversified index across commodities.

   A visual comparison of the non-exchange-traded commodity price index, as well as crude oil price series, supports the notion that, starting in 2003 and more strongly after 2004, a demand shock pushed upward the prices of most commodities. A large change in the growth rate of the index is visible, with sustained growth and few price decreases from 2003 to August 2008. More importantly, prices for non-exchange-traded commodities rose faster than crude oil prices between 2006 and 2008. The plot also shows that commodity prices (of both crude oil and non-exchange-traded commodities) declined sharply amid the economic contraction of autumn 2008 and stabilised after 2009. Interestingly, one could argue that the fall in crude prices to below $40/bbl in early 2009 was something of an under-shoot, and that subsequent recovery has been more in line with the strengthening evident across commodities in light of the economic recovery. Across the commodities, we see that some non-exchange-traded commodities prices have risen more than the crude oil price. While rhodium and cadmium experienced more than a 2000% change in prices when measured in percent change between the highest and lowest observed prices between 2000 and 2010, crude oil prices rose by 663% on the same basis.

In terms of volatility, measured by the one-year moving average standard deviation of prices, the plot also shows that volatility in both crude oil prices and non-exchange-traded commodities rose sharply after 2006.

Non-exchange-traded commodities’ index volatility experienced a large spike in early 2007 while crude oil prices were still relatively stable. That being said, unusually high volatility in commodity markets post-2007 does not appear unique to crude oil traded on exchanges. Other commodities that are not traded in exchanges experienced similar fluctuations and price surges in the second part of 2000s. Moreover, volatility declined for both crude and non exchange-traded commodities once again through 2010.  This is not to say that the trading of futures and derivatives contracts on exchanges has no impact on price levels and volatility. But it does suggest that a more holistic and refined set of policy responses than simply ‘driving out the speculator’ may be needed to achieve more stable and predictable markets.

*IEA Oil Market report March-2011

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