Commodity inflation

Why are the prices of so many commodities rising in an economy that seems to remain quite weak?

% change

butter 35

coffee 21.8

cocoa 20.2

copper 89.1

corn -8.3

cotton 38.6

gold 32.1

hogs 2.7

oats 13.4

oil 63.2

lead 81.9

palladium 75.9

platinum 61.7

silver 59.1

steel -0.9

sugar 73.6

tin 22.5

wheat -26.6

zinc 55.4

average 37.4

euro 12

The table at the right summarizes the percent change between January 6 and November 11 in the cash prices of 19 commodities reported in the Wall Street Journal (downloaded via Webstract). The average commodity in this list has appreciated 37% since the start of the year.

A recent
paper by Ke Tang and Wei Xiong
documents an increasing tendency for commodity prices to move together over the last few years. A decade ago, what happened to oil prices was largely unrelated to movements in most other commodity prices. The graphs below show how the correlations between oil prices and the prices of four representative commodities have increased significantly over time.


Correlation (using a rolling sample beginning one year before indicated date) between returns on oil and specified commodity. Source:
Tang and Xiong (2009).
wei1.gif



One explanation I often see in the popular press is that movements in commodity prices are driven by changes in the value of the dollar relative to other currencies. However, the magnitude of movements in commodity prices greatly exceeds the size of changes in the exchange rate. For example, the table above shows that since the start of this year oil prices have increased five times as much as the dollar price of a euro; see also Steve Gordon’s graphs. While the depreciation of the dollar is part of the story, most of the explanation must be found elsewhere.

Another important factor is resurging real economic growth outside the United States, which produces pressures for both the dollar to depreciate and the real price of commodities to appreciate. According to this theory, the increasing correlations between commodity prices results from the fact that countries like China are so much more important for the world economy today than they were a decade ago.

A third explanation is that investors are making increasing use of commodities as an investment class. Although Treasury Inflation Protected Securities offer a hedge against an increase in the U.S. consumer price index, they don’t offer protection for foreign investors against depreciation of the dollar. Insofar as increases in the prices of commodities like oil may depress real economic activity, holding commodities as an investment also offers useful diversification against risks to equities. Particularly when interest rates are low, there is an incentive to hoard physical commodities as an investment vehicle.

The paper by Tang and Xiong proposes that the increased use of commodities as a financial investment accounts for the increasing correlation among commodity price changes over time. In support of that claim, they note the growing popularity of investment strategies based on the Goldman Sachs Commodity Index or the Dow Jones Commodity Index. Tang and Xiong document that correlations among commodities included in the indexes have increased faster than those not included. For example, one of the regressions they estimate relates the return on commodity i to equity returns, bond yields, the value of the dollar, and oil prices, where the coefficients are allowed to grow with time at different rates before and after 2004, and with different trends on these coefficients estimated for commodities included in indexes as for those excluded. The figure below shows their estimated time path for the coefficient on oil prices comparing the indexed and non-indexed groups.



Coefficient relating return on average commodity to return on oil as a function of time for commodities included in the GS or DJ indexes (top curve) and those excluded (bottom curve). Source:
Tang and Xiong (2009).
wei2.gif



For any of the explanations in this third class, one of the important challenges is to reconcile the story of commodity speculation with supply and demand for the underlying physical commodity. If we propose that speculators have driven the price of the commodity up, the physical quantity demanded should decline as a result. In order to be sustained, a coherent speculation-based theory of commodity price appreciation requires increased physical storage of the commodity.

The solid black curve in the figure below plots the typical U.S. crude oil stocks (excluding those held in the Strategic Petroleum Reserve) for each week of the year, based on the average over 1990-2007. The red line gives the actual values for 2008, which were significantly below the historical average, particularly in the spring of 2008 when oil prices were rising so dramatically. Those below-normal inventories were one reason I focused on what was going on to the fundamentals of supply and demand in trying to understand the behavior of oil markets in the first half of 2008.



Weekly U.S. crude oil ending stocks, excluding SPR, in thousands of barrels, from EIA. Black line: average over 1990-2007. Red: 2008. Green: 2009.
oil_inv_nov_09.gif



On the other hand, inventories of crude oil this year, shown in green above, have been substantially above normal, meaning that in the absence of that oil going into storage, we would have expected to see lower oil prices than we currently have.

Moreover, much of the current stockpiling may be taking place outside the United States. For example, Yves Smith noted this story from Bloomberg last August:

Copper, nickel and other base metals stockpiled by speculative Chinese investors including pig farmers may be sold when “market sentiment turns,” said Scotia Capital Inc.

A price surge and easy bank credit this year encouraged pig farmers, stock brokers and businessmen to buy copper and nickel for speculation, Liu Na, an analyst with Scotia Capital, wrote in a note dated Aug. 17, citing reports from the state-owned China Central Television….

“These stockpiles are in ‘weak hands’ as speculators have no real use for base metals,” Liu wrote. “When the market sentiment turns, they are very likely to turn into quick sellers, especially when the bank’s money is involved.”

I also found this November 3 story from the Financial Times of interest:

Gold prices continued to rise on Wednesday extending the all-time highs which followed India’s central bank bought 200 tonnes of the precious metal, swapping dollars for bullion as the country’s finance minister warned the economies of the US and Europe had “collapsed”.

India’s decision to exchange $6.7bn for gold equivalent to 8 per cent of world annual mine production sent the strongest signal yet that Asian countries were moving away from the US currency.

Policy-makers in the Federal Reserve have traditionally thought of inflation as a broad movement in all wages and prices, which to some extent is under their control, and viewed changes in relative commodity prices as outside their control. I believe that this is not the correct understanding of the current situation. Concerns about inflation, particularly on the part of foreign dollar-holders, are likely to show up first in the relative prices of internationally traded commodities. Insofar as these relative price changes can be destabilizing in themselves, it cannot be wise for U.S. policy-makers to ignore them.

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42 thoughts on “Commodity inflation

  1. Bob_in_MA

    The four charts graphing the correlations between commodity pairs all begin during a period of commodity price deflation, at least in real terms. What if the 2003-2009 period were compared to 1960s-70s?
    The argument of the true commodity bulls is simply that we are in a period where there will be a massive increase in demand for commodities due to the continuing large increase in average income in China, India, Brazil, Indonesia, etc. There’s no question the size of world-wide consumer society is increasing quite rapidly, yet the majority of the populations China and India have yet to make the leap.
    It’s a pretty compelling argument. Of course, there was a pretty compelling argument in 1975, too. Yet within a few years commodities began a 20 year slide.

  2. wally

    The Treasury and Fed’s extreme measures have shoveled a lot of money out the door.. but they cannot control where it goes. It has not gone into the general economy and produce growth and gradual inflation; it goes into a few hands – where it is excess liquidity – and has been hoarded or used for speculative gambling, which the current commodity bubbles are.
    This lumpiness is a social problem, perhaps, or maybe unwise choice of stimulative measures by the Fed. Maybe the world doesn’t revolve around big banks after all.

  3. Adam_Smith

    “In order to be sustained, a coherent speculation-based theory of commodity price appreciation requires increased physical storage of the commodity.”
    This would be axiomatic if speculators had to take immediate physical possession of their commodity purchase but need not be true given the existence of futures and futures options contracts. In this case the the quantities purchased for speculation may be notional rather than physical and in no need of storage.

  4. Nemo

    The simple explanation is that 0% interest rates have created a “dollar carry trade” fueling speculative bubbles in everything.
    How do you think Goldman Sachs is generating record profits even while the global economy remains a smoldering wreck?

  5. Get Rid of the Fed

    wally said: “The Treasury and Fed’s extreme measures have shoveled a lot of money out the door.. but they cannot control where it goes.”

    How about the treasury and fed have shoveled a lot of low interest rate debt out the door and that has led to speculation in financial assets whether they be commodities, real estate, stocks, and/or even the debt itself just so long as it does NOT lead to wage inflation? Maybe price inflation targeting is really about targeting wages?

    Anybody care to link that to excess financial pay?

    If financial speculators need an interest rate of 7% or higher and lower and middle class consumers “seem” to need extremely low interest rates, does that mean there is a wealth/income inequality problem???

  6. Get Rid of the Fed

    “Why are the prices of so many commodities rising in an economy that seems to remain quite weak?”

    How about because the fed wants to maintain negative real earnings growth on the lower and middle class without price deflation happening?

  7. Gregor

    The notion that oil prices are either driven, derived, or set in part by global inventory levels of oil is a model that works up until the point that the Hotelling Rule kicks in. When that happens the pricing of oil will transition more fully to the futures curve, and spot prices will no longer be driven by simple rationing of current supply and demand. After all, oil doesn’t spoil. There is no intrinsic reason for it to be priced based on stock levels, or immediately deliverable supply.
    More broadly, however, and to the point of this post it strikes me as quite rational that global capital would want to exchange paper for commodities regardless of stockpiling or near term demand, at a time of broad currency debasement.
    G

  8. JDH

    Adam Smith: We are talking about the price that a real consumer pays for a real product that is physically consumed. Is it your position that the price that the consumer pays has no consequences for the physical quantity demanded? If not, what happens to the physical product that is produced but no longer consumed?

  9. ppcm

    A powerful market speculation has to be driven through symbiosis between the assets holders and the derivatives, prices have to be an exponential curve as a teeser, off index are on a lower indifference curve and no wonder,
    Is money supply an additional fertiliser to commodity prices increase ?
    If so only M1 on the euro side,as M3 is shrinking, is it a dollar carry trade ?
    http://www.ecb.int/pub/pdf/mobu/mb200911en.pdf
    As it is, a large swing up of the commodities prices P13 followed by the same on the producer input price P51 chart 23 not factored in the CP cf P 13,47 and well cushioned by the compression of labour cost P51 chart 23.
    But not to forget all commodities speculation are digestive the same in 2008:
    Bloomberg Commodities climbed 8.8 percent this year after slumping 36 percent in 2008, their biggest drop in half a century, based on the Reuters/Jefferies CR
    Of course copper as used mainly in the housing is a good leading indicator of the on going powerful economic recovery.

  10. RN

    There is no (or very little) dollar “carry trade”. A carry trade means you want to sell dollars to hold other higher-yielding assets for a time with the goal of selling them back for dollars.
    This time, investors have used dollars to buy better quality assets, which they’ll hold.
    There won’t be a massive inflow back to the dollar unless there’s another financial panic (we’ll see what the CRE situation brings), or unless interest rates normalize (unlikely to happen for years, a la Japan).

  11. flow5

    Stagflation (business stagnation accompanied by inflation), is increasingly powerful (and will become even more so-permanently). The FED can only try to control prices (irrespective of supply), it cannot lower the unemployment rate by buying T-bills (that mandate reflects utter naivete’).
    Contrary to economic theory, the lags for monetary flows (MVt), i.e. proxies for (1) real-growth and (2) inflation, are always exactly the same length. However, the lag for nominal gdp varies widely (the FED’s target?).
    Rocs in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact (not date range); as demonstrated by the clustering on a scatter plot diagram).
    From Feb. 2006 until July 2008, the FOMC pursued a consistently tighter money policy. In fact, the rate-of-change in the volume of legal reserves (one proxy for inflation), fell for 29 consecutive months (out of a possible 29, or sufficient to wring inflation out of the economy).
    Its only been in the last 12 successive months (since Sept. 2008), that it was necessary for the FOMC to switch from its tight monetary policy, to the extraordinarily easy monetary policy in force at present. Easy money is here defined as a growth rate of aggregate monetary demand (money times velocity) in excess of the growth rate of product, and service output.
    There’s no ambiguity. Because of these different lags, any additional stimulus by the FED will drive up the gap between (1) the rate-of-change in the proxy for inflation, and (2) the rate-of-change in the proxy for real-growth (it will increasingly induce stagflation).
    The FED has no option. This economy cannot begin to recover until Oct. 2010.

  12. Lord

    This is a fairly attractive method to lessen foreign dollar demand, lower the dollar, create some inflation to offset deflationary tendencies, and rebalance trade. It is movement in the right direction, one we should applaud.

  13. rjs

    instead of “shoveling money out the door” to people who spend their money & buy commodities, the Fed is shoveling it out to those who invest in them…what could be so dificult to understand about that?

  14. Michael Cain

    “The Treasury and Fed’s extreme measures have shoveled a lot of money out the door.. but they cannot control where it goes.”

    Indeed. Twenty-five years ago, limits on capital flows, high transaction costs associated with stock and bond purchases, and sane lending standards were in place, and the Fed knew where the money would go: loans to expand domestic firms, hire additional labor, etc. All of those are gone, so the classic wage/price inflation feedback loop is also gone. But cheap money still leads to inflation, just in different places: tech stocks, telecom fiber, and houses to name some of the obvious ones.
    Everyone knows where the cheap money NEEDS to go, but the people in charge and many of those who advise them simply refuse to acknowledge that the mechanisms that would direct it there have been dismantled.

  15. VennData

    Who handles the brokerage accounts of your typical pig farmer? Who loans them the money? Who ships for them (is it publicly traded?) Where do they store those billions of tons of copper, is it a HK-base REIT? Is there a pig farmer ETF? ETN? How will this affect Macau’s gaming equities?
    What are the pig farmers moving into now? What are they moving into next? Do you know of a pig farmer I can talk to? And what are they doing with their pigs?

  16. Spry

    Excellent post professor.
    I agree that the fed should keep their eye on commodity price inflation. But as you suggest “… changes in relative commodity prices as outside their control” Do you have any ideas on what form of action would be appropriate on behalf of the fed?
    How about a simple announcement, something like “The recent run up in commodity prices is worrying and the fed will monitor this actively and act as necessary to deal with this situation.” ?

  17. Bob_in_MA

    JDH: We are talking about the price that a real consumer pays for a real product that is physically consumed. Is it your position that the price that the consumer pays has no consequences for the physical quantity demanded? If not, what happens to the physical product that is produced but no longer consumed?
    If speculators were to bid up the future price of oil in 2011, someone wishing to arbitrage the spread between that price and the spot price would need to find physical storage. But one form of storage, available to producers, is to simply to not pump the oil.
    If speculators can raise the future price of oil, they could influence present production, and ipso facto the spot price, without the need for additional storage, right?

  18. Shan

    Another important factor is resurging real economic growth outside the United States, which produces pressures for both the dollar to depreciate and the real price of commodities to appreciate.

    Not only resurging growth if it’s there, but the sharp drop in demand for virtually everything due to some sort of global financial disturbance could have contributed to the increase in correlation between various commodities. Some of the recent price rise could be commodities markets generally recovering to something more reflective of supply and demand, after being pushed below equilibrium by some transient financial forces.

  19. Jeffrey Knoll

    The size of the dollar currency exchange is in the trillions of dollars. The size of the silver investment market is only about 20 billion. Thus a small decrease in the value of the dollar could lead to a corresponding large increase in the value of silver if all of that money is directed to silver. I am not sure however about the total size of all the commodities listed in this article. But if their total size is much smaller than the size of the currency market, then I would expect a 12% decrease in the value of the dollar to correspond to a larger percentage increase in the value of the commodities.

  20. John Barrdear

    Is there a third possibility?
    The traditional story: Americans worried about US inflation
    Prof. Hamilton’s story: non-Americans worried about US inflation (because they hold US dollars)
    What about?: non-Americans worried about non-US inflation
    That fits nicely with the anecdotes of Chinese pig farmers hoarding base metals and has a fairly simple outline: Originally because America was importing so much and now because of the carry trade, there is high demand for non-US currency. Central banks want to defend their currencies and so print money local money and take the proffered US dollars into reserve. That new local money will push up inflation and private agents, recognising that fact, seek to hedge against it.

  21. Pat

    Professor,
    A logical conclusion of your two arguments (not in the same post) is that too much stimulus from the Fed may kill the US recovery:
    1. too much liquidity leads to speculations that drives oil and commodity prices higher; and
    2. higher oil and commodity prices not due to higher domestic demand post dangers to US recovery.
    Counter intuitive, not that there is anything wrong with it … In fact, I find both arguments compelling …

  22. StatsGuy

    Hamilton writes:
    “One explanation I often see in the popular press is that movements in commodity prices are driven by changes in the value of the dollar relative to other currencies. However, the magnitude of movements in commodity prices greatly exceeds the size of changes in the exchange rate.”
    The answer is the Yuan-Dollar link, which is anchoring the dollar. Commodity price movements (as well as other assets with international exposure) increasingly reflect the anti-dollar carry trade, which is an implicit bet that the Yuan must revalue.
    The deviations between historical price dynamics and recent price dynamics reflect the use of commodities as an arbitrage vehicle (a store of value) since direct currency arbitrage is difficult due to capital controls. And gold simply cannot absorb that much liquidity…
    This strongly implies that _after_ the Yuan revalues, the gap will close.
    Here’s the long version of this argument:
    http://blogsandwikis.bentley.edu/themoneyillusion/?p=2688#comment-8987

  23. Tom

    The media aren’t doing a very good job of explaining why China and Hong Kong are so prone to asset price inflation in this situation. The main point here is that their resistance to appreciation of their currencies relative to the US dollar is forcing them into excessive monetary stimulus. This is true of any country with a dollar peg. When they intervene on their currency markets to buy dollars and thus depress the value of their domestic currency, they do by spending freshly created domestic currency. In this way, they have committed to a sort of lock-step with the Fed – as much as it debases the dollar, they must follow suit and debase their currencies.

  24. Adam_Smith

    JDH:
    We are not talking only about the price that a real consumer pays for a real product that is physically consumed. If there is a futures market in the commodity a seller is not obligated to hold and store the quantity contracted for pending delivery. Many, I think most, outstanding contracts are sold by speculators who close out their positions with offsetting purchases before the delivery date. The futures markets, however, strongly influence the “physicals” or spot market price. For example, a farmer who could deliver 5000 bushels of corn today at $3.90 a bushel may choose instead agree to sell at $4.00 a bushel a month later. This removes supply from the physicals market allowing the price there to rise.
    The basic point is that speculation easily detaches prices from physical supply.

  25. JDH

    Adam Smith: You can talk about whatever you want. But what I am talking about is the price of the physical commodity that is physically consumed, for example, the price you pay to put gasoline in your car.

    Cash prices of commodities are going up– that’s what I’m seeking to understand.

    Cash prices for commodities can not be detached from the quantity that is physically consumed.

  26. RicardoZ

    JDH wrote:
    On the other hand, inventories of crude oil this year, shown in green above, have been substantially above normal, meaning that in the absence of that oil going into storage, we would have expected to see lower oil prices than we currently have.
    Professor,
    This depends how you measure “normal.” I would say that oil prices are right in line with inflation expectations. The price of a bbl of oil is still in the 12-15 ratio range relative to an ounce of gold. Oil is more closely linked to gold because there is little that has to be done to oil to make it useful. Other commodities have to be fashioned into workable products.
    JDH also wrote:
    Concerns about inflation, particularly on the part of foreign dollar-holders, are likely to show up first in the relative prices of internationally traded commodities. Insofar as these relative price changes can be destabilizing in themselves, it cannot be wise for U.S. policy-makers to ignore them.

  27. robt0536

    Adam Smith wrote:
    *******
    “”In order to be sustained, a coherent speculation-based theory of commodity price appreciation requires increased physical storage of the commodity.”
    “This would be axiomatic if speculators had to take immediate physical possession of their commodity purchase but need not be true given the existence of futures and futures options contracts. In this case the the quantities purchased for speculation may be notional rather than physical and in no need of storage.”
    *******
    Yes, but the resultant pressure on the futures relative to spot in that case would cause a contango which would then incentivate arbitrageurs to step in and store physical vs shorting futures. In fact, that’s what the farmer case you cite later is exactly about. He’s storing it for a month. And that’s precisely *how* — and the only way how — the futures market impacts the spot market.

  28. GNP

    Excellent post. Agree with concluding sentiments.

    Would add that the Federal Reserve should monitor asset values. Even if inflationary expectations do not increase, bubbles in assets and commodities can apparently destabilize given recent experience. Formally adopting inflation targeting would help because it would ideally de-emphasize the current mandated obsession with constant robust material growth.

  29. RicardoZ

    There is a very interesting article over at KITCO.
    http://www.kitco.com/ind/Field/nov112009.html
    In his article, “Zimbabwe: A Fresh Start,” Alf Field opens with this paragraph.
    In February 2009 Zimbabwe was the only country in the world without debt. Nobody owed anyone anything. Following the abandonment of the Zimbabwe Dollar as the local currency all local debt was wiped out and the country started with a clean slate.
    It is now a country without a functioning Central Bank and without a local currency that can be produced at will at the behest of politicians. Since February 2009 there has been no lender of last resort in Zimbabwe, causing banks to be ultra cautious in their lending policies. The US Dollar is the de facto currency in use although the Euro, GB Pound and South African Rand are accepted in local transactions.
    Field continues:
    Credit financing activities are starting to revive. Visa credit cards are once again operating successfully in Zimbabwe, others will surely follow. Banks have had both sides of their balance sheets devastated by hyperinflation and now have no lender of last resort to call on. They are understandably cautious in lending the deposits that are slowly filtering back into the system. Banks also lost much of their equity capital. Barclays Bank survived because it had 40 branches where the bank owned the real estate and had a strong parent. These properties plus some foreign currency holdings represent the equity capital on which the bank currently operates.
    In a country with no debt, only assets, people and companies are under geared. With the ultra cautious lending policies of the banks, there is a huge opportunity for foreign investors in the credit purveying industry.
    There has been a sharp rise in economic activity since February. Real wages have risen substantially compared to a year ago. Whatever workers were paid in Zimbabwe Dollars during the hyperinflation bought virtually nothing. Now even the minimum wage of around $100 per month allows for basic purchases. A 10kg bag of maize meal, a staple in the local diet, costs $3.50 and lasts for two weeks. Demand for products and services is increasing rapidly.
    Compare this with what Jude Wanniski wrote about Germany’s hyper-inflation in Chapter 7 “The Stock Market and the Wedge” in his book, “The Way the World Works,” written in 1976.
    The effect of this hyper-inflation was to wipe out all domestic debt denominated in reichsmarks. This included the bonds Germany floated internally to finance World War I, and also all mortgages and contracts made in RMs….The currency stabilization was possible because government tax revenues did not have to cover internal debt finance, there no longer being internal debt. The savings and financial assets of the German people were wiped out, but so of course were their debts, and their human capital intelligence, skills, and resourcefulness- remained.
    Contrary to the experience of Zimbabwe the Allies forced Germany to continue paying reparations and foreign debts so that even with a budding domestic recover through the miracle of human capital the nation continued in stagnation.
    It is amazing how the Zimbabwean experience right in the middle of an American economic failure exposes in real time the illusion of the current US economic policies. We are making the same monetary mistakes Zimbabwe made only they were a little quicker at it and so failed sooner.
    What this all this proves is that the currency is not the important thing in a recovery. A currency simply lubricates transactions. And if the currency fails the people still have their “human capital” as Jude put it. They will simply find another currency to replace the old failed currency.
    But will we have to go through the pain and agony of a hyper-inflationary failure of the currency to ever pull ourselves out of this mess?

  30. Chris of Stumptown

    Professor Hamilton,
    May I propose a fourth possibility for the correlation? Oil costs are an input for the other commodities. As the price of oil rises, it becomes a higher portion of the cost of production on the other commodities. As the price of oil rises, correlation of the assets rises as they all become increasingly driven by this common factor.

  31. Tom

    Explaining the recent commodity price increases is easy and has been done a zillion times already: increased money supply, increased public spending on commodity-consuming projects, Chinese stockpiling, a small rebound of private consumption, and in some cases production cuts.
    Speculators and worriers are not important to this story. Some get ahead of the trend, but if the trend weren’t there, they would be making losing bets, or buying unnecessary insurance.
    A more interesting question is where is this trend headed? Will the Fed dramatically reduce monetary stimulus after March as the planned end of its asset purchase plan implies? I think not, as that would expose the federal deficit and lead to sharply higher interest rates. So I see plenty of liquidity pushing these asset bubbles, and at the same time, a very unusual general awareness that they are bubbles. That’s a recipe for severe market volatility.

  32. garyl

    There have been 40 billion dollars of investment flows into commodity funds and etfs so far this year (source JP Morgan). This is greater than any prior full year. The meats (hogs and cattle) which are essentially non-store able, have substantially underperformed most store able commodities. The meats have to respond to immediate supply and demand while most other commodity futures do not. The high correlations have something to do with the weak dollar and probably more to do with the total money flows.

  33. Michael Roberts

    A simple explanation is that demand fluctuations (or expectations about future demand) are driving today’s price fluctuations, where in the past supply fluctuations drove the bulk of commodity price fluctuations.
    Supply shocks tend to be relatively idiosyncratic to the particular commodity. In contrast, demand, especially now, is a much more aggregate phenomenon.
    But these ideas together and you get more commodity price correlation.
    I’d call it an early sign of recovery, or at least the market expecting recovery, much like the stock market. Hence the buildup of inventories. Despite the speculative component this doesn’t seem like a bubble to me.
    But why should recovery make us worry too much about inflation? A little inflation couldn’t hurt much right now, could it? If so, how?

  34. Adam_Smith

    robt0536:
    The original argument was: “If we propose that speculators have driven the price of the commodity up, the physical quantity demanded should decline as a result. In order to be sustained, a coherent speculation-based theory of commodity price appreciation requires increased physical storage of the commodity.”
    My farmer example was a bit different. In that case the speculative increase in price caused some current supply to be witheld. Granted, the effect is to increase the supply in storage either way. However, I am not ready to agree that witholding, or release, of supply in response to futures prices is the sole mode of arbitrage between futures and physicals markets. Buyers and sellers of physicals can settle on prices based in part on perceptions influenced by futures prices. My farmer, prompted by a rising futures price, could have simply held out for a higher bid and suceeded because his buyer did not find an attractive alternative in the futures.
    It is well and fine to cite supply and demand as determinative of an equilibrium price but prices in real markets can be in disequilibrium for arbitrarily long periods of time. The “force” of supply and demand, if we want to call it that, can be especially weak in certain markets and I believe that to be the case in many commodity furures markets including those for energy. Variation in futures prices, easily driven by variation in speculative interest independent of real supply and demand, leaks by arbitrage into the physicals markets prices.
    Bottom line: there need be little causal connection between speculative increases in a commodity’s price and amounts held in storage.

  35. Great Bear

    I want to add to Adam_Smith’s comment on the connection between speculative buying and inventory buildup. The speculative theory could have two versions, one strong form and one weak form.

    The strong form goes like this. When the capital flow from financial investors pushes up the commodity prices, say oil price, consumers realize that the price increase is due to buying pressure and they respond by cutting consumptions. We see inventory buildup here because consumers disagree with financial investors about the outlook of future economic fundamentals. The inventory buildup provides a clear indication of the speculation effect argued by JDH. But the effect could also come out in a weaker form when folks are not sure about future fundamentals.

    Here is a weaker form. When oil price hits $147 last summer, consumers took that as a strong signal for the world economy going strong. As a result, they are confident about their own job perspectives and therefore comfortable with consuming the same amount of oil at the $147 price. But, this year, it is clear to the consumers that the world economy is still in a recession. They are not willing to consume much oil even though the price is only in the $70s and far below the peak a year ago. That’s why the inventory is piling up.

    The point is that when the economic fundamental is unobservable, consumers use oil price as a useful signal, but speculation-driven investment flow could potentially jam the signal if they do not realize the regime change in the game. Oil price is not simply determined by supply and demand of oil any more, but also by a whole set of financial factors. Ignorance about this is dangerous because consumers could end up over-spending and central banks tighten up monetary policies without realizing that the economy is sliding down, just like in the early part of 2008.

    Great Bear

  36. Kay4

    Inflation could hurt the public. Many people are tightening their budgets if the dollar is worth less how will many of them will have to cut down more.

  37. GNP

    A couple of comments and observations on data follow.

    - Coal, electricity and natural gas are absent from the table.

    - Spot cash prices indicate paid prices but may vary widely from paid prices due to the use of long-term contracts and hedging strategies.

    - Much stockpiled oil eventually headed to market is apparently stored offshore. Earlier, this year, idle oil tankers in Europe and Asia were used to stockpile oil. Am not aware of comprehensive numbers.

  38. Kaleberg

    The answer would have been obvious to a medieval philosopher. We are in a time of cares, of dearness. This is different from a fames, or time of famine, just as it is different from a time of plenty.
    A 19th century materialist philosopher would have explained it by way of population pressure. When times are good, populations grow. When populations grow, labor and manufactures get less expensive but land and the produce of land, mineral and vegetable, grow more dear.
    A modern feminist philosopher would have no problem explaining it. The Industrial and Feminist Revolutions have slowed the population boom-bust cycle. As things stand, the position of women has not risen quickly enough to reap the benefits of industrialization.
    We’ve been going through this cycle for a thousand years now. There is nothing new or surprising.

  39. ohwilleke

    I look at the commodity numbers and see big increases in imported commodities and no similar changes in domestically supplied ag commodities (with the exception of butter).
    Given that government actively meddles to stablize exchange rates, but does not actively intervene on a day to day basis in the commodities markets, I’m more comfortable with the Euro futures being artificially weak, than I am with a more elaborate explanation for why the commodities futures are artificially inflated.

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