Yves Smith sends us to a three-part series on the "financialization of commodities" by Michael Frankfurter, a commodities industry analyst. The series is quite long (as articles go) and it gets a bit technical in the second article, but it's worth the effort. Frankfurter ultimately argues:

Rising prices and a widespread bull market in commodities should indicate that there is a growing scarcity of hard assets. However, traditional forces of supply and demand cannot fully account for recent prices. To be precise, the normal price-inventory relationship has been altered. This is the assertion of an expanding list of bona fide hedgers, commodity professionals and economists. Specifically, dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has been causing a self-perpetuating feedback loop of ever higher prices.
Essentially, Frankfurter's argument is that the commodities market has been slowly "financialized" (that is, made to look like the equity and bond markets), and that this has allowed excessive amounts of money to pour into commodities futures, which increases volatility, induces speculation, etc. It's a bit like "hot money" for commodities:
In a slowing global economy hit by a major credit crisis and reeling from a falling dollar, it is likely that money flows seeking safe haven in hard assets is the key driver of recent volatility.
His argument is much more complex and I can't really do it justice, so I won't try to summarize the entire thing. But I do want to highlight Frankfurther's reminder that commodities futures are unique instruments, and are not equities or bonds (to be honest, I probably needed this reminder myself):
Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated. Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, the same cannot be said about commodities. As noted by Greer (1997), the inherent problem is that commodities are not capital assets but instead consumable, transformable and perishable assets with unique attributes. Hence, speculative trading, by definition any commodity trading facilitated for financial rather than commercial reasons, likely results in “zero systematic risk.” The conundrum is that for every buyer of a futures contract there is a seller—sine qua non, there is no intrinsic value in futures/forward contracts—they are simply agreements which commit a seller to deliver an asset to a buyer at some place/point in time.
On the whole, I found Frankfurter's argument pretty persuasive. While I don't think the "financialization" of commodities is the sole driver of the commodities boom by any stretch of the imagination, I'm ready to assign it a decent role.

8 comments:

Anonymous said...

So is the current run-up a "bubble"?

James said...

If you're right, then what is Krugman missing?

Economics of Contempt said...

Well, Krugman is talking specifically about oil, whereas Frankfurter is really talking about agricultural commodities. But Krugman also doesn't believe there's a bubble in agricultural commodities. I think he's wrong there.

Trading volume on agricultural commodities contracts has exploded over the past year (over 50% higher, YoY), which is a traditional sign of a bubble. Krugman would say that futures prices have to equal spot prices at some point, so a run-up in futures prices will eventually be tempered by spot prices. But there are important feedbacks in futures/spot prices. In agricultural commodities, the higher trading volume on the futures market increases price volatility, which increases the price of crop insurance for farmers, and therefore increases final spot prices. Krugman tends to wave off such factors in the interest of simplicity. That's a mistake, in my opinion.

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