Financial Investment, Speculation and Commodity Prices

Financial Investment, Speculation, and Commodity Prices

The commodity price boom of 2003-08 has raised a debate regarding the cause for the overly strong and sustained price increases in the commodities market. Certain theorists suggest that the financialization of commodity markets is the driving factor behind the price boom. The International Monetary Fund (“IMF”) article attempts to explain the influence that financialization has had on commodity price movement versus the traditional market fundamentals of supply and demand.

One theory behind the increased price of commodities is due to the greater number of noncommercial investors due to financialization. The financial instruments that facilitated the trade of futures commodities for such participants did not exist until early 2000. Noncommercial investors are now including commodity futures in their asset portfolios as speculative investments or to hedge against risk (spot prices are highly correlated to futures prices). The increase of noncommercial futures investors, many of whom ignore the fundamentals and are long-only, has increased the demand burden and therefore driven up commodities prices. Since 2003, the number of open futures contracts and trading volume has grown three fold over physical markets (check stat). This development has also caused an increase in risk premiums due to the non-fundamental trading activities employed by novice investors.

Another explanation theorists have for the swell in commodity prices due to financialization is the increase of index trading by institutional investors. Indexes are comprised of a fixed-weight portfolio of commodities futures and are designed to provide exposure to the commodities market. The portfolio manager’s primary responsibility is maintaining balance within the portfolio while ignoring market fundamentals (aka “Noise Trading”). This activity can have a destabilizing effect on the demand for the underlying commodities in the portfolio. The destabilization has led to increased volatility which is reflected in the commodity futures risk premiums.

The IMF suggests a different approach in assessing the impact of financialization. In broad terms, any price fluctuation can be attributed in market fundamentals and that it’s extremely difficult to establish significant relationships.

In reference to noise traders, the IMF article states there is no empirical evidence that these destabilizing efforts have had a direct impact on volatility. With the financialization of commodities, investors have greater access to liquidity, and aided price discovery (which is A method of determining the price for a specific commodity or security through basic supply and demand factors related to the market. For our reference) which would thereby decrease volatility. The IMF’s commodity price index indicates that there have