By Sreekumar Raghavan
We all learnt in our basic economics lessons that price is a function of demand and supply. If supply and demand is all that matters in economics, you can teach this discipline to even parrots, they say. So economists came up with different other variables (often mathematical to make it incomprehensible to laymen) that may affect prices and created new models.
However, it looks like the traditional Economic Theory is insufficient to explain price behaviour of commodities in an era dominated by futures trading worldwide. The text book theories were created when futures trading hadn't attained such huge volumes nor the financial markets had this kind of depth. When crude oil prices shooted to $150 levels two years ago, the blame was entirely put on speculation not fundamentals. When natural rubber prices recently rose to Rs 250 and above in Indian markets, the blame was put on futures trading which is driven by speculation. One expert panel headed by a chief minister of western Indian state of Gujarat has recommended ban on futures trading in essential commodities.
One view is that millions of dollars are being pumped into commodities by hedge funds, ETFs and financial markets as return from other investments dwindled. The European Commission has pointed out that while global metals and minerals markets generally follow a cyclical pattern based on supply and demand, the 2002-2008 period was marked by unforeseen high prices triggered by soaring demand in emerging countries.
"Currently, worldwide consumption is picking up after a slowdown due to the economic and financial crises, and is forecast to grow steadily in the coming years, due to continued strong demand from economies such China and India. However, in recent years, commodity markets have experienced increased volatility and unprecedented price movements that cannot always be linked to changes in supply and demand."
"This trend can be perceived in all major commodities, including energy, metal, mineral, agriculture and food markets. And there is a growing consensus that excessive speculation on commodity derivative markets plays a major role in spurring volatility."
Sujiro Seam, deputy director for food security and economic development at the French Foreign Ministry points out that such volatilities mean a disconnect between price evolution and fundamental elements of the markets. Thus acutal production, consumption or stocks of commodities no longer determine the prices.
Take the case of the $4 bn exchange-traded fund PowerShares DB Agriculture Fund, that tracks 11 commodities from corn to soybeans and cattle. Corn, soybeans, sugar and live cattle together account for half of the funds value, other holdings include cocoa, coffee, hogs, wheat and corn. As in gold, silver and metals, in agriculture too, the activity by major funds are being blamed for volatility in prices.
These are the conventional determinants of demand follow:
1. Income 2. Tastes and preferences 3. Prices of related goods and services 4. Buyer's expectations about future prices 5. Number of Buyers
Now a sixth determinant can be added- the amount of speculation in a specific commodity created by inflows from financial markets.
Therefore, experts have advocated greater transparency in financial markets to curb speculation in commodities and check price volatilities. The legendary George Soros in an article published in the Financial Times pointed out that Dodd-Frank Act passed by US Congress in July 2010 will pave the way for mining and exploration companies to report how much they paid to governments by way of royalties and other expenses in the nations in which they operate. This in turn will force the government in those countries to utilise the proceeds from natural resources to raise the social welfare measures for its citizens including access to schools, sanitation, public health, roads and market access.
The significant question that now emerges is whether to dump our old price theory? May be the next Nobel Prize awaits the one who actually builds a good case study of financial markets, futures trading and its impact on commodities.
http://www.commodityonline.com/news/Good-bye-fundamentals-large-funds-drive-commodities!-36987-3-1.html
