Issue 1: What drives commodity prices?

Volatile commodity prices have spawned a plethora of reports by government agencies, academics and researchers. From these efforts, it is clear that fundamentals factors that affect the supply and demand of commodities are the key drivers. These factors include demographics, weather, trade flows, production quotas and export controls. Here’s the evidence that supports this view:

European Commission First Interim Report

  • “Both the oil price increases seen in recent years and the price fall over the past weeks have been mainly driven by demand and supply factors.”

G-20 Study Group on Commodities Report

  • “Assessments of the impact of financial investors on commodity prices remain inconclusive. Large changes in physical supply and demand provide plausible explanations for commodity price trends over the past several years and existing literature finds limited signs of investors causing sustained deviations from ‘fundamentals’.”
  • “The large changes in physical supply and demand conditions provide plausible explanations for commodity price swings…Moreover, the prices of commodities that are only traded OTC and not included in the standard commodity indices — such as coal and iron ore — have risen as much as major commodity index components. This may suggest that changes in physical demand and supply, rather than growing financial investments, have been the main drivers of commodity prices.”
  • “The results of empirical studies are inconclusive regarding the impact of financial investors on the level, volatility and correlation of commodity prices. There is limited evidence that financial investments have had a persistent impact.”

HM Treasury Report

  • “Nevertheless, taken together the available evidence suggests that derivative investors are not driving price increases and, although there is insufficient evidence to conclusively rule out any impact, it is likely to be only small and transitory relative to fundamental trends in demand and supply for the physical commodities.”

Interagency Task Force on Commodity Markets Interim Report

  • “The Task Force’s preliminary assessment is that current oil prices and the increase in oil prices between January 2003 and June 2008 are largely due to fundamental supply and demand factors. During this same period, activity on the crude oil futures markets – as measured by the number of contracts outstanding, trading activity, and the number of trades – has increased significantly. While these increases broadly coincided with the run-up in crude oil prices, the Task Force’s preliminary analysis to date does not support the proposition that speculative activity has systematically driven changes in oil prices.”

IMF Report

  • “Despite recent financial innovation in commodity markets, such as indexing, which has allowed investors to benefit from rising commodity prices without having to maintain physical inventory holdings, there is little discernable evidence that the buildup of related financial positions [in commodity markets] has systematically driven either prices for individual commodities or price formation more broadly.”
  • “…the current commodity price boom has, broadly speaking, reflected the interaction of strong demand, low inventory and spare capacity levels, slow supply expansion in key sectors and adverse supply shocks.”

OECD Technical Report

  • “…a number of economists have expressed skepticism about the bubble argument, citing logical inconsistencies in bubble arguments and contrary facts. These economists argue that commodity markets were driven by fundamental factors that pushed prices higher. The main factors cited as driving the price of crude oil include strong demand from China, India, and other developing nations, a leveling out of crude oil production, a decrease in the responsiveness of consumers to price increases, and U.S. monetary policy. In the grain markets, the diversion of row crops to biofuel production and weather-related production shortfalls are cited, as well as demand growth from developing nations and U.S. monetary policy.”
  • “In sum, the weight of the existing evidence clearly tilts in favor of the argument that index funds did not cause a bubble in commodity futures prices.”

Paper Presented at the Southern Agricultural Economics Association Meetings

  • “There is little evidence that the recent boom and bust in commodity prices was driven by a speculative bubble. If speculation by long-only index funds did impact commodity futures prices, it is not evident in the empirical evidence available to date. Economic fundamentals, as usual, provide a better explanation for the movements in commodity prices. The main factors driving prices up in the energy markets included strong demand from China, India, and other developing nations, a leveling out of crude oil production, a decrease in the responsiveness of consumers to price increases, and U.S. monetary policy.”

Steve Johnson, Financial Times

  • “However the existence of speculators has allowed politicians and campaigners to paint them as bogeymen and blame them for rising food prices. Removing speculation from the equation would simplify matters and, come the inevitable next spike in food prices, leave policy makers and special interest groups no option but to address the real issues that are causing demand to outstrip supply – namely an ever-spiralling (and increasingly wealthy) global population, climate change and, in too many cases, degradation of soil quality due to over-intensive production.”
  • “Given the huge importance of food security, the benefits of this scenario would massively outstrip the potential loss of a small source of return to the investment community.”

Department of Economics Report, University of Michigan

  • “We develop a structural model of the global market for crude oil that explicitly allows for shocks to the speculative demand for oil as well as shocks to the flow demand and flow supply. We show how one can identify the forward-looking element of the real price of oil with the help of data on oil inventories. The model estimates allow us to reject explanations of the 2003-08 oil price surge based on unexpectedly diminishing oil supplies (as in the peak-oil hypothesis) and explanations based on speculative trading. Instead, we find that this surge was caused by fluctuations in the flow demand for oil driven by the global business cycle.”
  • “…the largest and most persistent fluctuations in the real price of oil since the 1970s such as the oil price increase in 1979/80 were driven primarily business cycle fluctuations affecting the demand for crude oil. Of particular interest in this paper has been the oil price increase from 2003 until mid-2008. We were able to provide direct evidence against the popular view that the sharp increase in the real price of oil during this period (and in 2007/08 in particular) was driven by speculation among oil traders.”
  • “Hamilton (2009) recently has cast doubt on explanations of major oil price increases based on shifts in speculative demand during previous oil price shocks episodes. He observed in particular that following the outbreak of the Persian Gulf War in August 1990, oil inventories did not increase as one would have expected in response to a positive speculative demand shock. At the same time, the absence of a sharp decline in oil inventories in August of 1990 is inconsistent with the view that the price increase reflected a negative oil supply shock.”

Craig Pirrong, The Wall Street Journal

  • “The unprecedented run-up in oil prices is painful for consumers around the world. But the focus on speculation is misguided, and represents a convenient distraction from an understanding of the real, underlying causes of high oil prices — most notably continuing demand growth in the face of stagnant production, supply disruptions and the weakening dollar.”

Dwight R. Sanders and Scott H. Irwin, New York Times

  • “Over all, there is limited evidence that anything other than economic fundamentals is driving the recent run-up in commodity prices. The main driving factors in the energy markets include strong demand from China, India and other developing nations, a lack of growth in crude oil production and United States monetary policy. In the grain markets, driving factors are, in addition to monetary policy and demand from developing nations, the diversion of row crops to biofuel production and unfavorable weather that has hurt harvests.”

IOSCO Report (March 2009)

  • “These reports suggest that economic fundamentals, rather than speculative activity, are a plausible explanation for recent price changes.”

The Oxford Institute for Energy Studies Analysis

  • “The available evidence illustrates that oil price movements between 2003 and 2010 are largely explicable in fundamental terms…”
  • “…the vulnerability to potential instability derives from the structural character of the market, not simply from the presence of speculative financial investors.”

European Central Bank Working Paper

  • “First, some authors note that fundamentals and more specifically increased demand from fast growing developing countries – which are accounting for larger and larger shares of annual oil consumption growth – are playing an important role. While some large developing countries have been growing rapidly for years, and in some cases decades, a combination of rapid industrialization and higher commodity intensity of growth, coupled with rapid income per capita growth, has increased significantly their oil demand.”
  • “One of the counter arguments that recently prices reflect fundamentals rather than speculation is the question “Where are the stocks?” Along this line of argumentation, if speculators were the main force pushing oil prices far above the level justified by fundamentals, excess supply should be observed.”