Monday, August 24, 2015

Economy: The De-Financialization Of Commodities

(Drivebycuriosity) - Oil and other commodities are under pressure. The Bloomberg Commodity Index dropped to the lowest level since 1999. You can find a lot of explanations for the price collapse in the media. But I think one reason is underestimated: The financialization of commodities is coming to an end - the de-financialization of commodities.

I used to work for an online service in Germany. Part of my job was to provide commodity news, writing frequently reports about oil, natural gas, industrial metals and agricultures. Commodities were en vogue. Banks and a bunch of pundits proclaimed the "super-cycle" for oil, metals and agriculture (barrons). They claimed that commodities will get scarce and expensive because supply would rise slower than demand, especially from China & other emerging countries. A large number of users (readers of the online service) were betting on rising prices for oil and other commodities. These traders, as they call themselves, bought financial instruments, so-called bank certificates, which where tied to commodity prices.

The traders were of part of a huge speculation movement.  Hundreds of hedge funds, specialized commodity funds and others invested into the commodity sector in the hope of further rising prices. They bought directly - or indirectly via ETFs & bank certificates - financial contracts (futures) which are backed by commodities (financialization). So oil and other commodities became assets which are traded on financial markets like stocks, currencies and bonds. The provider of these futures bought physical oil and made contracts with miners and farmer to buy their mining output and harvests in the future. Some hedge funds rent oil tankers, pump them full with oil and sell futures, which imply the physical oil delivery sometimes in the future.

The financialization pumped billions of dollars into the commodity sector and created an additional demand for oil and other materials which drove prices upwards. Rising prices allured more speculators who followed just the trend (momentum players).  For years commodity speculation looked like a oneway street. As a result from 2004 through 2014 (with a break in 2008/09)  prices for oil and other commodities were higher than in the decade before and higher than justified by the fundamentals (production costs and physical demand). The elevated prices over many years animated suppliers to produce more, they also curbed the demand (driveby). Therefore we see now surpluses on the markets for oil, industrial metals and some agricultures and the speculative bubble popped.

It looks like that the financialization of commodities came to an end. It seems that the price collapse - caused by a continuous overproduction - is disencouraging the speculators. Since last year many hedge funds and other speculators are reducing their speculative commodity positions, since then they are selling or at least buying less financial instruments backed by commodities. As a result the additional demand - which has kept commodities artificially  expensive for years - is disappearing and the sales of many speculator are squeezing prices downwards. I believe that we are are back on the long term (secular) trend of falling commodity prices which is driven by technological progress and factors like ingenuity, frugality and profit orientation (jstor  driveby).

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