London, 24 November 2009 

The flood of investment money into commodity indices since 2004 has fundamentally altered the behaviour of commodity prices, according to a landmark study by two prominent economists. 

In a working paper on "Index Investing and the Financialization of Commodities", Ke Tang, from China's Renmin University, and Wei Xiong, professor of economics at Princeton, examined the impact of investor flows on a wide range of raw materials inside and outside the leading commodity indices (see www.princeton.edu/~wxiong/papers/commodity.pdf )

Tang and Xiong found the influx of money since 2004 coincided with a sharp increase in the exposure of commodity prices to "market-wide" shocks (including the U.S. equity index and the trade-weighted dollar index) as well as increasingly strong correlations among the different commodities themselves (for example between oil and nonenergy commodities).

The effects were significantly stronger for commodities included in the popular Goldman Sachs Commodity Index and Dow Jones-UBS index than other raw materials that remained outside.

Differences between indexed and non-indexed commodities confirm that the influx of index money, rather than other factors, was responsible for the altered behaviour of indexed commodities.

The authors found the inclusion of a futures contract in one of the two leading indices led to increased "co-movement" with trading volumes for other contracts also in the indices.

The explanation: investors tend to trade in and out of commodities as an asset class, rather than responding to changing supply and demand fundamentals for individual raw materials. Once again, increased co-movement in trading volumes was much more pronounced for commodities in the indices than raw materials that remained outside.

Tang and Xiong noted the sharp rise in oil volatility last year accompanied a similar rise in the volatility of other commodity prices and the world equity index, a reflection of the world financial crisis in 2008. It was therefore very different from the previous peak in oil volatility during the first Gulf War in the early 1990s, when the spike in oil prices and volatility occurred in isolation.

The authors conclude that spillovers from "market-wide" shocks contributed significantly to the increased volatility in oil and other commodities last year. "The increasing presence of index investors in commodities markets precipitated a fundamental process of financialization amongst commodities markets, through which commodity prices now become exposed to shocks to financial markets and to other commodities," the said.

A New Asset Class is Born 

Prior to the early 2000s, few institutional investors (pension funds, trustees and others subject to the "prudent investor" rule in the United States) had any direct exposure to commodities, and commodity futures behaved differently from typical financial assets.

Unlike equities and bonds, which showed substantial co-movements with one another, commodity prices did not co-move with equities much or with each other. Speculation in commodity derivatives was restricted to a relatively small group of highly specialised investors, and commodity markets were largely segmented from the broader financial markets.

But the collapse of the stock market bubble in 2000 and the widely publicised research finding that there was a small, negative correlation between stock market returns and returns on a diversified basket of commodity futures contracts led to a belief commodity futures could be used to reduce portfolio risk. Indices and other commodity based products were promoted aggressively as a new asset class for prudent investors.

Commodity products have succeeded -- only too well. The inrush of institutional money has fundamentally altered price behaviour, undermining the properties that made them an attractive asset class in the first place.

Increasingly Crowded Trade 

Instead of the small negative correlation with returns on stock indices that prevailed before 2004, commodity futures now show an increasingly strong correlation with movements in world equity markets, undercutting their diversification effect.

The more money that has flowed into the commodity indices the stronger the connection has become. Tang and Xiong found the GSCI's exposure to movements in world equity markets increased in each of the years 2006, 2007 and 2008.

Prior to 2004, there was also a negative correlation between commodity prices and the U.S. dollar, although it was insignificant. But the exposure has since become much stronger. And on inflation, commodity prices showed no significant correlation with the U.S. consumer price index before 2004, but an increasingly close link since then.

The authors attribute the change to investors' inflation fears: "When index investors anticipate inflation to rise, they are likely to invest more in commodities, which in turn cause commodity prices to rise".

Fears have become self-fulfilling. Commodity prices have become correlated with inflation because investors think they should be, not because they were before. In another shift, prices for other commodities have become increasingly sensitive to movements in crude oil. The correlation between crude and soybeans, which hovered around zero before 2004, climbed steadily to almost 0.6 by late 2008. Small positive correlations with cotton, live cattle and copper before 2004 have also gradually risen to 0.5, 0.4 and 0.6. 

"Oil shocks are themselves spilled over to commodities in the grain sector," as well as other raw materials, and these spillovers are significantly stronger for commodities included in indices than for those that remain outside.

Three Transmission Channels

The authors identify three channels which cause commodityprices to behave more like other financial assets as the proportion of index investments in them increases:

(1) The value of a physical commodity or basket of futures is determined by its own expected cash flows and the discount rate applied to them. While cash flows are commodity specific, the discount rate fluctuates as market-wide appetite for risk waxes and wanes. Risk premia can have a big impact on how index investors value commodity positions and, as they account for a rising share of the market, a growing impact on prices.

(2) The price of one asset is affected by the price of others as investors rebalance their portfolios in response to "shocks". Since commodity index investors usually invest a large proportion of their portfolio in equities, commodity prices are exposed to stock market shocks through rebalancing. Similarly, overseas investors are exposed to changes in the U.S. exchange rate, so dollar shocks can force commodity price changes through portfolio adjustment.

(3) Institutional investors are not particularly interested in the prices of individual commodities, tending to take a more strategic approach. They move in and out of commodities in a chosen index at the same time, based on its performance relative to other asset classes.

"The index investors' strategic allocation exposes the price of an individual commodity to shocks to other commodities, such as oil, whose performance has a significant impact on the commodity indices," according to the authors.

As they note, producers, consumers and traditional speculators" only have a limited capacity to absorb the price impact of index investors' trades". So as the share of index investors increases so does their impact on price formation.

If the paper's findings are widely accepted, it could settle the acrimonious but futile debate between fundamentalists (who attribute all price movements to changes in physical supply and demand) and speculationists (who blame everything on price distortions caused by investment flows into thin and illiquid markets) by producing a more nuanced "middle way".

It would recognise that speculators are not driving commodity prices by hoarding physical crude oil and other raw materials (on tankers off the south coast of England or anywhere else) but that the volume of index money can, and demonstrably has, changed the way in which commodity prices behave.

Ends --

John Kemp is a Reuters columnist. The views expressed are his own