An Unresolved Issue

Reuters carried several stories (here, for example) which remarked on yesterday’s rally in copper prices, a move upward of over 8% in a single day, and a 24% gain since Christmas.  The move flies in the face of weak economic numbers (copper, as an industrial metal, is fairly sensitive to the economic cycle), a strengthening dollar over the period, and a rise in inventories.  So why did copper go up?  According to Reuters and others, the move up is linked to the reweighting of commodity indices which will occur mid-month. 

This is an interesting explanation.  For most of the first half of this year, the investment banks, which sponsored and promoted commodity index investing, vehemently denied that there was any link between investor buying of futures and the dramatic rise of commodity prices.  In a deeply flawed report, the CFTC (the regulatory body which governs commodity futures) also argued that the $300 billion or so in commodity index investments had no price impact, defying common sense.   An economist who testified before the House Agriculture Committee argued that, “in theory, there are an infinite number of contracts that can be written” without impacting price.  For those of us who don’t live in “theory” but live in the real world, assuming an infinite amount of capital to an infinite amount of participants doesn’t make a lot of sense.

The copper story reflects a growing recognition that index investing in commodities does indeed impact price.  If it is true for copper now, it must also have been true for oil when crude leapt over 50% in a matter of months.  It must have been true in March when, in an incident that the CFTC has yet to explain, the cotton market’s integrity was compromised, causing tremendous harm to the cotton industry.  There have also been widespread assertions that the exodus of hedge fund and investor pools from commodity indices have been partly responsible for the depth and speed of the decline in commodities; investment flows into commodity futures and swaps cause unnecessary volatility and harm in distorting prices both to the upside and downside.

Understandably, despite this growing recognition and body of evidence, among our policymakers this issue has been superceded by the general financial crisis.  It needs to be revisited, and the sooner the better.  The use of commodities as a core investment asset class is a flawed concept.  If this were only a matter among investors, like the dot-com frenzy of the late ’90s, it might not be a legitimate area of government involvement.  However, the price distortions caused by commodity index investing involves basic goods — food, energy, raw materials — that affect everyone, consumers and producers.  Moreover, these price moves disproportionately impact the world’s poor.  Distorted commodity prices can send policy makers false indications of inflation or deflation, leading to bad economic policy choices. 

It’s time to readdress this issue, both in the press and in the halls of Congress.  Did the use of commodities as an investment asset distort prices?  If so, what should be done to improve the integrity of these markets?

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2 Responses to “An Unresolved Issue”

  1. The Oil Stimulus « (in)efficient frontiers Says:

    […] (in)efficient frontiers Inefficient Frontiers: insight on our less-than-efficient markets and the risks of life on the investment frontier « An Unresolved Issue […]

  2. Listening to Gold « (in)efficient frontiers Says:

    […] commodities-as-an-asset class fad that had such a large impact on other commodities (see this earlier post).  Although gold is a component of most popular commodity indices, it is a relatively small weight […]

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