The upward pressure on energy and other commodity prices worldwide has been because of the “sluggish response of production to rising demand, particularly for energy and metals and minerals,” according to a United Nations report issued Thursday. However, the influx over the last three years of a large number of speculators with no interest in the commodity itself “may have distorted” near term and futures prices.
In its 280-page annual report, economists with the UN Conference on Trade and Development stated: “There are indications that producers have been more conservative in their investment plans than in previous commodity booms. This underinvestment is partly the result of their expectations of a price correction to more historical levels and their fears that the long period of low prices toward the end of the 1990s might recur.
“Higher prices have also been due to rising production costs as a result of increased energy costs, particularly for aluminum, and the need to explore in more remote areas and exploit deeper deposits.”
These higher commodity prices have attracted more investment from financial markets, such as hedge funds, pension funds, investment funds and insurance companies, the report noted. “Interest in commodities as an asset has increased owing to expectations of a depreciating dollar, and because they provide a hedge against inflation…The increase in commodity investment activity in 2005 is reflected in the 8.1% growth in the volume of global futures and options trading in agricultural commodities, energy products and nonprecious metals.”
For example, the report noted, funds under management that track commodity indices, such as the Goldman Sachs Commodity Index, have risen from about $1 billion in 2000 to more than $80 billion today.
Still, the authors noted that commodity futures exchanges, “which are usually natural reference points for physical trade, help the price discovery process and provide price risk protection from uncertain price movements,” and they would not function without speculation.
“Under normal conditions, speculation by a large variety of participants with differing views on market and price developments plays a significant role, as it tends to increase financial and market efficiency.” But the report noted that in the past three years, “changes in the pattern of commodity speculation may have distorted” near-term and futures prices, which affected the functioning of commodities markets. Most recently, speculators “with no stake in the commodity sector, and using exotic financial vehicles, have become important players.”
As “gloominess” for traditional financial products has grown, “commodities have been considered an attractive asset class,” especially for portfolio diversification. “Thus, investors seeking both a low correlation with traditional asset classes and above-average returns have suddenly rerouted massive financial flows to comparatively thin commodity markets.”
The cash flooding into some commodities markets has had a positive impact on many industries, supporting “major mining and energy companies,” and “providing them with resources to invest in exploration and increased production capacities while giving them a comparative advantage” over smaller competitors that have been less attractive to speculators.
However, there is a negative side as well, the report noted. Price instability has made it difficult for some commodity-driven producers to strategically plan, “especially with commodities that take a few years to be produced and to reach the marketplace…It is becoming increasingly difficult for producers to hedge, since the ‘normal’ correlation between the physical and futures prices has been, at least temporarily, destroyed.”
To read the report, visit www.unctad.org/en/docs/tdr2006_en.pdf.
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