Shedding light on price trends and implications

Commodities prices trends have historically been under the lens of regulators and the broader public due to their immediate implications for day-to-day life and the availability of cheap essential goods.

There are three important factors that typically fall under scrutiny: price volatility; price correlation with non-supply/demand factors; and price spikes, which may have strong political implications for food commodities, for example (especially for low-income users).

Price volatility

From looking at historical price trends, volatility is nothing new in commodities markets (Reinhart and Wickham, 1994) and ‘boom-and-bust’ cycles are common in historical price patterns (Cashin, et al., 2002). Due to its regular frequency, the long-term impact of commodities prices volatility has often been overlooked. Volatility is harmful for the economy and affects economic growth, as it reduces incentives for physical capital accumulation (Tiago et al., 2011). Volatility may affect the price pattern of commodities in the short-term or become a more structural long-term issue. Evidence of structural long-term volatile patterns has not been confirmed by the academic literature. Gilbert and Morgan (2010) find that long-term structural volatility is still relatively low, but that new factors now form part of the equation, in particular biofuel production, index investing, and climate change. Figure 25 also confirms that volatility is still in line with the historical trend, but is on a rise in the short term.

Whether more volatile patterns will be the norm in the years to come cannot be ascertained (Lee et al., 2012).

Figure 25. Historical real price volatility, 1925-2010*

Note: *Ten-years annualised rolling volatility.⁴⁷ Annual data. 1915=100 Source: Author’s calculation from Bloomberg, IMF, Morgan Stanley Commodities.

A long list of endogenous and exogenous factors, assessed in this report, such as supply cuts or restrictions to trade that have also caused food crises, have pushed volatility up in the last 10-15 years.

As Table 19 suggests, in recent years volatility has increased and remains stably above pre-crisis levels. The volatility peak was reached in 2008-2009 both for the food prices index and a general commodity return index (compiled by Thomson Reuters, Jefferies, Commodity Research Bureau).

47 σ =

, where j is any individual annual observation.

Table 19. Volatility analysis and S&P 500 correlation⁴⁸ Periods TRJ-CRB Total Return

Index volatility* FAO Real Price Index

volatility** CRB-TR Index / S&P 500 Annualised correlation

2000-2007 0.16 0.25 0.01

2008-2012 0.22 0.53 0.42

2008-2009 0.26 0.65 0.37

2010-2012 0.18 0.45 0.55

Note: Equally weighted averages of 1 year rolling volatility, as measured in footnote 47. *Daily data. **Monthly data.

Source: Author’s calculation from Thomson Reuters – Jefferies CRB index website, FAO Stats, IMF and Yahoo Finance.

Since inventories are more unpredictable factors for agricultural and soft commodities, low inventory levels and historically low stock-to-use ratios (especially for agricultural and soft commodities; see the following chapters) can drive volatile patterns, but there are also other key factors. Macroeconomic and money demand-driven factors are also leading drivers of price changes for all commodities (including agricultural ones; see Gilbert, 2012). However, the role of supply-driven issues, such as inventory levels and supply constraints due to delivery issues or government policies, should not be underestimated (see following chapters).

Correlation is not causation

Another important element, which has emerged in the aftermath of the collapse of major financial institutions, is the growing correlation between commodities prices and financial indexes (see Table 1 and Figure 26 for preliminary evidence).

Figure 26. CRB-TR & S&P 500 7 and 20 days volatilities and correlation, 1994-2012

48 See footnote 47.

Source: Author’s calculation from CRB-TR, Yahoo Finance.

While medium-term volatility spiked in 2009, but now gradually going back to pre-crisis levels for both 7 and 20 days time range, correlation with financial indexes, however, remains on average steadily higher than over the past two decades and evidence currently rules out their role as hedging device for portfolio allocation (Lombardi and Ravazzolo 2013). Unravelling the set of underlying causes behind this growing correlation is no easy task. Correlation (i.e. the co-movements between two variables) may have been driven by a common set of underlying factors that pushes both variables in the same direction. The two variables, however, may still be moving in the same direction independently. Conclusions reached by some authors (among others, Schumann, 2011; Finance Watch, 2012; UNCTAD, 2012) that financial investors are causing prices to move erratically because financial indexes are correlated to commodities indexes, may ultimately prove wrong (see Section 1.4).

A light earthquake may cause two buildings to fall down, one over the other, but this does not mean that the first building caused the collapse of the other. Both buildings may have been built with similar, poor construction materials and so may have fallen at the same time when the light earthquake hit. How the collapse happened has established an apparent link between the two that may not exist. The following sections and chapters on the single commodities markets will look at the interplay between financial and non-financial variables to clarify this link and assess the long-term impact on commodities price formation.

Price spikes

Market prices are a zero-sum game, where one party gains and the other one loses. In principle, if the price formation mechanism is not affected by illegal practices or distorted incentives, price levels should not be a factor for distortion in the marketplace. However, not all commodities are the same (i.e. essential goods) and not all market participants can participate in the market with the same level of means. The initial allocation (distribution) of resources matters, especially when there is a minimum level of rights and standard of life to be preserved. The 2007-08 spike in food prices is a case in point.

As confirmed above, highly volatile patterns and short-term price spikes in some food commodities in 2008 and 2009 generated anger and riots in many emerging markets, where income is barely enough to survive. These were also fuelled by other important political reasons that are not the subject of this report. Figure 27 confirms that prices of food commodities (in real and nominal terms) have reached a medium-term peak recently, due to important demand and supply factors that are discussed in the following sections.

Figure 27. FAO real and nominal Food Price Index, 1990-2013

Source: FAO Stats.

If we look at long-term real prices for the commodities in our report, there is a generalised growth of spot prices, but only five commodities markets have an annual average real price above historical levels (from 1975; see Figure 28). Common underlying factors that have boosted prices are discussed in following sections. Each commodity has its own market dynamics, however, so it may not be appropriate to bundle them in one analysis as price spikes may have been driven by significant trends in supply and demand fundamentals.

Figure 28. Long-term nominal and real spot prices for sample commodities, 1975-2012

Source: Author’s elaboration from World Bank. Note: World Bank Manufactures Unit Value Index deflator (representing 15 commodities countries with ad hoc weights, with base year=2005). Dashed line compares 2012 real price with historical trend. ⁴⁹

More historical price trends (Figure 29) confirm a recent heating up in price, but commodities have had noticeably higher spikes over the last century, both in price and volatility levels. In addition, before 2005, price patterns have been at a historical bottom for more than a decade and appear still below levels reached with the end of the Bretton Woods system and the oil crises during the 1970s.

Similar patterns in volatility and higher price levels can be traced back to the first oil crisis around 1973-74, which kept prices of agricultural at a higher level for some years (Radetzki, 2006;

Wright, 2011), and for most of the 1980s. Oil prices, in particular, have reached almost the same historical peaks of the second oil crisis (1979-1980), which has raised some fundamental questions about the sustainability of its production. Finally, there are often some important misconceptions over price levels. While volatility, which manifests itself in sharp price jumps or drops, should to some extent worry policy-makers, high price levels are not necessarily bad per se. Prices provide incentives for producers to increase cultivation areas and productivity as the population grows and supply strives to keep up. Higher prices may increase local production and self-sufficiency. Very often in the past, prices have been subsidised by government actions that have reduced over time the incentives to invest in innovation to increase productivity. Policy actions should take a cost/benefit approach when dealing with measures that can affect the ‘regular’ market price formation and should rather focus on abating barriers that do not allow prices to efficiently reflect actual market circumstances.

49 For crude oil, average spot price of Brent, Dubai and West Texas Intermediate, equally weighted; for natural gas, average between natural gas (Europe) import border price, including UK (as of April 2010 includes a spot price component; between June 2000 - March 2010 excludes UK), and natural gas (U.S.), spot price at Henry Hub, Louisiana; for iron ore (Brazil), VALE (formerly CVRD) Carajas sinter feed, contract price, f.o.b. Ponta da Madeira 1% Fe-unit for mt, prior to year 2010 annual contract prices; for aluminium and copper, LME cash forwards; for wheat, no. 1, hard red winter, ordinary protein, export price delivered at the US Gulf port for prompt or 30 days shipment; for corn, no. 2, yellow, f.o.b. US Gulf ports; for soybean oil, crude, f.o.b. ex-mill Netherlands; for sugar, International Sugar Agreement (ISA) daily price, raw, f.o.b. and stowed at greater Caribbean ports; for cocoa, International Cocoa Organization daily price, average of the first three positions on the terminal markets of New York and London, nearest three future trading months; for coffee, equally weighted average between International Coffee Organization indicator prices, other mild Arabicas, average New York and Bremen/Hamburg markets, dock, and Robustas, average New York and Le Havre/Marseilles markets, ex-dock.

Figure 29. Historical real prices (1915=100)

Note: Front-month rolling futures annual prices, CPI deflated.

Source: Morgan Stanley Commodities from Bloomberg and IMF.

1.3.3 The growth and development of commodities index investing and other financial