# Commodity Prices — Who’s Holding the Cards?

Os economistas têm muitas mãos. Por um lado, eles podem declarar algo bom. Por outro lado, eles podem dizer, “Bem, não tanto.” Alguns deles podem ter até mesmo uma terceira ou quarta mão. O meu ex-patrão, ele próprio um economista, observou uma vez que ele desejava que ele poderia cortar algumas dessas mãos.

In the last couple of months, I plunged right into an ocean of economist hands as I sat down to do a minor research into this troubling phenomenon of skyrocketing food and commodity prices.

O primeiro “mão” apontou que a demanda por alimentos (and energy and commodities in general) subiu devido ao aumento dos padrões de consumo da população e mudanças nos gigantes emergentes da Ásia. A demanda e oferta paradigma conhecido explica o aumento dos preços, afigura-se. É tão simples como isso?

Por outro lado, culturas mais e mais alimentos estão sendo desviados para a produção de bio-combustível. É exigir o bio-combustível a causa raiz? Bio-combustíveis são atraentes por causa dos astronômicos preços do petróleo bruto, que fazem subir os preços de tudo. Is the recent OPEC windfall driving the price increases? E sobre os subsídios de alimentos em países ricos que distorcem o mercado a seu favor?

#### Supply Side Difficulties

When explaining the food prices, one economic opinion puts the blame squarely on the supply side. Ele aponta um dedo firme no mau tempo em países produtores de alimentos, e as medidas de pânico imposta à cadeia de suprimentos, tais como proibições de exportação e açambarcamento escala menor, que fazer aumentar os preços.

Looking at the bigger picture, let’s study oil as a proxy commodity and study its dynamics. Because of its effect on the rest of the economy, oil is indeed a good proxy.

In the case of oil, the dearth on the supply side is more structural, it is argued. The production capacity has stagnated over the last thirty years or so [1]. No infrastructural improvements have been made after the seventies. De fato, new methodological improvements are expensive for all the easy methods have been fully exploited; all the low-hanging fruits have been picked, por assim dizer.

The harder-to-reach “fruits” include deep sea explorations, crude oil from sand and, somewhat more tenuously, bio-fuels. The economic viability of these sources of oil depends on the oil price. Oil from sand, por exemplo, has an operating cost in the range of \$20 para \$25, as Shell’s CFO, Peter Voser is quoted as stating [2]. At \$100 a barrel, oil from sand clearly becomes an economically viable source. Bio-fuels also are viable at high oil prices.

The huge investments involved in exploiting these new sources and their unpredictable economic viability exert strong upward pressure on oil prices, purely from the supply side, regardless of the demand situation. Once you invest a huge amount banking on a sustained high oil price, and then find that the oil market has softened below your viability level, you have to write off the investment, forcing losses and consequent price hikes.

With the high level of oil prices, investments are moving into infrastructure enhancements that will eventually ease the supply side crunch. But these fixes are slow in coming and are not going to ease the current dearth for about a decade. Em outras palavras, the high prices are here to stay. Finalmente, so say the economists subscribing this supply side explanation of things.

#### Demand Spike

Although I personally find it hard to believe, people assure me that the exponential demand explosion in the emerging economies was completely unforeseen. My friend from a leading investment bank (who used to head their hybrids desk) told me that there was no way they could have anticipated this level of demand. I should probably shelve my scepticism and believe those in the know.

One thing I do know from personal experience is that the dynamics of a demand crash is different in emerging economies for a variety of reasons. Em primeiro lugar, identical movements in fuel prices have different impact in the overall spending pattern depending on the proportion they represent in the purchasing power of an average consumer. A 30% increase in the pump price, por exemplo, might mean a 5% reduction in the purchasing power to a US consumer, while it might mean 20% reduction for an Indian customer.

Além, retail fuel prices in India are regulated and supported by government subsidies. Subsidies act as levies delaying the impact crude oil price movements. But when the crude oil prices rise beyond a certain point, the subsidies become untenable and the retail fuel prices surge upward, ushering in instant demand crash.

I came across another view of the skyrocketing oil prices in terms of the Middle-Eastern and American politics. The view was that the Saudi oil capacity is going to increase by about 10% soon and the prices will drop dramatically in the first quarter of 2009. It was argued that the drop will come as boost to the new American president, and the whole show is timed and stage-managed with a clear political motivation.

#### Speculation

All these different opinions make my head spin. Em minha opinião não treinado, I always suspected that the speculation in commodities market might be the primary factor driving the prices up. Eu me senti vingado em minhas suspeitas quando li uma recente testemunho do Senado dos EUA, onde um gerente de fundo de hedge bem conhecido, Michael Mestres [3], shed light on the financial labyrinth of futures transactions and regulatory loopholes through which enormous profits were generated in commodity speculation.

Since speculation is my preferred explanation for the energy and indeed other commodity price movements, I will go over some of the arguments in some detail. I hasten to state that the ideas express in this article are my own personal views (and perhaps those of Michael Masters [3] também). They do not represent the market views of my employer, their affiliates, the Wilmott Magazine, or anybody else. Além, some of these views are fairly half-baked and quite likely to be wrong, in which case I reserve the right to disown them and bequeath them to a friend of a friend. (Também, see the box on Biased Opinions).

Masters points out that there is no real supply crunch. Unlike the Arab Oil Embargo time in 1973, there are no long lines at the gas pump. Food supplies are also healthy. So some new mechanism must be at work that drives up the commodity demand despite the price level.

Masters blames the institutional investors (pension funds, sovereign wealth funds, university endowments etc.) for the unreasonable demand on commodity futures. Since futures prices are the benchmark for actual physical commodities, this hoarding of the futures contracts immediately reflects in the physical spot prices and in the real economy. And as the prices climb, the investors smell blood and invest more heavily, stoking a deadly vicious cycle. Masters points out that the speculative position in petroleum is roughly the same as the increase in demand from China, debunking the popular notion that it is the demand spike from the emerging giants of Asia that is driving the oil price. Da mesma forma, bio-fuel is not the driver in food prices — the speculators have stockpiled enough corn futures to power the entire US ethanol industry for a year.

Although quants are not terribly interested in the transient economic drivers of market dynamics or trading psychology, here is an interesting thought from Mike Master’s testimony. A typical commodity trader initiating a new trade is pretty much insensitive to the price of the underlying. He has, dizer, a billion dollars to “put to work,” and doesn’t care if the position he ends up holding has five million or ten million barrels of oil. He never intends to take delivery. This price-insensitivity amplifies his impact on the market, and the investor appetite for commodities increases as the prices go up.

Most trading positions are directional views, not merely on the spot price, but on volatility. In a world of long and short Vega positions, we cannot expect to get a full picture of trading pressures exerted on oil prices by studying the single dimension of spot. Is there a correlation between the oil prices and its price volatility?

 Figura 1. Scatter-plot of WTI Spot prices in Dollar and its volatility. Although the plot shows random clusters at low spot levels, at price > \$75 (highlighted in the purple box), there appears to be a structure with significant correlation.

Figura 1 shows a scatter plot of the WTI spot price vs. the annualized volatility from publicly available WTI spot prices data [4]. Note than my definition of volatility may be different from yours [5]. À primeira vista, there appears to be little correlation between the spot price and volatility. Indeed the computed correlation over all the data is about -0.3.

Contudo, the highlighted part of the figure tells a different story. As the spot price climbed over \$75 per barrel, the volatility started showing a remarkable correlation (de 0.7) with it. Was the trading activity responsible for the concerted move on both prices and volatility? That is my theory, and Michael Masters may agree.

Hidden Currency Theory

Here is a dangerous thought — could it be that traders are pricing oil in a currency other than the once mighty dollar? This thought is dangerous because international armed conflicts may have arisen out of precisely such ideas. But an intrepid columnist is expected to have a high level of controversy affinity, so here goes…

We keep hearing that the oil price is down on the back of a strong dollar. There is little doubt that the oil prices are highly correlated to the strength of the dollar in 2007 e 2008, as shown in Table 1. Let’s look at the oil prices in Euro, the challenging heavy-weight currency.

 Figura 2. Time evolution of the WTI spot price in Dollar and Euro. The Euro price looks more stable.

At first sight, Figura 2 does appear to show that the price is more stable when viewed in Euro, como esperado. But does it mean that the traders are secretly pricing their positions in Euro, while quoting in Dollar? Or is it just the natural tandem movement of the Euro and WTI spots?

If the hidden currency theory is to hold water, I would expect stability in the price levels when priced in that currency. Mas, more directly, I would naively expect less volatility when the price is expressed in the hidden currency.

 Figura 3. WTI Volatilities measured in Dollar and Euro. They are nearly identical.
 Figura 4. Scatter-plot of WTI volatilities in Dollar and Euro. The excess population above the dividing line of equal volatilities implies that the WTI spot is more volatile when measured in Euro.

Figura 3 shows the WTI volatilities in Dollar and Euro. They look pretty much identical, which is why I replotted them as a scatter-plot of one against the other in Figure 4. If the Dollar volatility is higher, we will find more points below the red line, which we don’t. So it should mean that the hidden currency theory is probably wrong [6].

A good thing too, for nobody would be tempted to bomb me back to the stone ages now.

#### Human Costs

The real reasons behind the food and commodity price crisis are likely to be a combination of all these economic factors. Mas a própria crise é um tsunami silencioso que varre o mundo, como o Programa Mundial de Alimentos da ONU coloca.

Aumento nos preços dos alimentos, embora desagradável, is not such a big deal for a large number of us. Com a nossa primeira renda mundial, a maioria de nós gastar cerca de 20% de nosso salário em comida. Caso se torne 30% como um resultado de um 50% aumento dos preços, nós certamente não vai gostar, mas não vamos sofrer muito. Podemos ter de reduzir as corridas de táxi, ou multa de jantar, mas não é o fim do nosso mundo.

Se estamos no topo 10% income bracket (as the readers of this magazine tend to be), Podemos até não notar o aumento. O impacto dos altos preços dos alimentos no nosso estilo de vida será mínimo — dizer, a business-class holiday instead of a first-class one.

É uma história diferente perto da parte inferior. Se ganhar menos do que \$1000 um mês, e somos forçados a gastar \$750 em vez de \$500 em alimentos, it may mean a choice between a bus ride and legging it. Naquele nível, the increase in food prices does hurt us, and our choices become grim.

Mas há pessoas neste mundo que enfrentam uma realidade muito mais dura que os preços de atirar para cima, sem fim à vista. Their choices are often as terrible as Sophie’s Choice. Qual criança vai dormir esta noite com fome? Medicina para o doente ou o alimento para o resto?

Nós somos todos impotentes contra o rolo compressor das forças de mercado criando a crise alimentar. Embora não possamos realisticamente mudar o rumo deste tsunami silencioso, vamos pelo menos tentar não agravar a situação através de resíduos. Compre apenas o que você vai usar, e usar apenas o que você precisa. Mesmo se não podemos ajudar aqueles que, invariavelmente, passar fome, não vamos insultá-los por jogar fora o que eles vão morrer anseio por. A fome é uma coisa terrível. Se você não acredita em mim, tente um jejum de um dia. Bem, experimentá-lo mesmo se você fizer — por isso pode ajudar alguém em algum lugar.

#### Conclusões

Commodity speculation by institutional investors is one of the driving factors of this silent tsunami of rising food prices. Their trading strategies have been compared to virtual hoarding in the futures market, driving up real prices of physical commodities and profiting from it.

I don’t mean to portray institutional investors and commodity traders as criminal masterminds hiding behind their multiple monitors and hatching plots to swindle the world. The ones I have discussed with do agree on the need to curtail the potential abuse of the system by closing the regulatory loopholes and setting new accountability frameworks. Contudo, we are still on the rising edge of this influx of institutional funds into this lucrative asset class. Perhaps the time is not ripe enough for robust regulations yet. Let us make a bit more money first!

#### Reference and Endnotes

[1] Jeffrey Currie et al. “The Revenge of the Old ‘Political’ Economy” Commodities (Goldman Sachs Commodities Research), Março 14, 2008.
[3] Testimony of Michael W. Masters (Managing Member / Portfolio Manager, Masters Capital Management, LLC) before the Committee on Homeland Security and Governmental Affairs. Maio 20, 2008. http://hsgac.senate.gov/public/_files/052008Masters.pdf
[4] Cushing, OK WTI Spot Price FOB (Dollars per Barrel) Data source: Energy Information Administration. http://tonto.eia.doe.gov/dnav/pet/hist/rwtcd.htm
[5] I define the WTI volatility on a particular day as the standard deviation of the spot price returns over 31 days around that day, annualized by the appropriate factor. Using standard notations, the volatility on a day t is defined as:
$sigma (t) = sqrt {frac{1}{{31}}sumlimits_{t - 15}^{t + 15} {left( {ln left[ {frac{{S(t)}}{{S(t - 1)}}} right] - mu } right)^2 frac{{252}}{{31}}} }$
[6] Given that the correlation between EUR/USD and WTI Spot is positive (em 2007 e 2008), the volatility, when measured in Euro, is expected to be smaller than the volatility in Dollar. The expected difference is tiny (sobre 0.3% absoluto) because the EUR/USD volatility (defined as in [5]) é de cerca 2%. The reason for the counter-intuitive finding in Figure 4 is probably in my definition of the volatility as in [5].
[7] Monwhea Jeng, “A selected history of expectation bias in physics,” American Journal of Physics, Julho 2006, Volume 74, Issue 7, pp. 578-583. http://arxiv.org/pdf/physics/0508199

 Caixa: Biased Opinions As an ex-experimental physicist, I am well aware of the effect of bias. Once you have a favoured view, you can never be free of bias. It is not that you actively misrepresent the data to push your view. But you tend to critically analyze the data points that do not match your view, and tend to be lenient on the ones that do. Por exemplo, suppose I do an experiment to measure a quantity that Richard Feynman predicted to be, dizer, 1.37. I repeat the experiment three times and get values 1.34, 1.30 e 1.21. The right thing to do is to report a measurement of 1.29 with an error of 0.06. Mas, knowing the Feynman prediction (e, mais importante, knowing who Feynman is), I would take a hard look at the 1.21 trial. If I find anything wrong with it (which I will, because no experiment is perfect), I might repeat it and possibly get a number closer to 1.37. It is biases of this kind that physicists try very hard to avoid. See [7] for an interesting study on biases in physics. In this column, I do have a favoured view — that the main driver of the commodity price inflation is speculation. In order to avoid pushing my view and shaping my readers’ opinion, I state clearly that there is a potential of bias in this column. The view that I have chosen to favour has no special reason for being right. It is just one of the many “hands” popular among economists.
 Sobre o autor The author is a scientist from the European Organization for Nuclear Research (CERN), who currently works as a senior quantitative developer at Standard Chartered in Singapore. The views expressed in this column are only his personal views, which have not been influenced by considerations of the firm’s business or client relationships. More information about the author can be found at his web site: http://www.Thulasidas.com.

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