The flight of hedge funds out of commodities

According to academic working papers, large speculators have no influence on commodity prices and the price fluctuations only reflect fundamentals. However, the recent developments in commodity markets show a different picture. Academic studies focus on the concept of Granger causality. The time series used in those studies are often the “commitment of traders” data and the price of the corresponding commodity future. Lagged values of the net positions of non-commercials would have to have a statistically significant impact on current commodity prices to assume that large speculators would Granger-cause commodity prices. If there is only a significant relationship between current values of the net position held by non-commercials and the current commodity prices, then the hypothesis of Granger causality is rejected and the academic researchers conclude that speculators have no impact on commodity prices.

This concept, however, is not appropriate to judge if speculators have a significant impact on commodity prices in efficient markets. An increase of the net position held by hedge funds is supposed to have an impact on commodity prices only in the next period. This would imply that increased demand for commodities driven by hedge funds would have no impact on prices now, but would lead to rising prices next week. This is an absurd assumption. Every student in microeconomics 101 learns that an increase of demand leads to an immediate increase in prices. The buying or selling of non-commercials has a significant influence on commodity prices. And the decisions of large speculators are not only driven by expectations how fundamentals will develop.

Commodity prices have declined over the board recently. In the case of energy and industrial metals, the fear of a global recession is one of the driving factors. For gold, the status as a safe haven also plays a crucial role. A global recession could have a negative impact on the demand for gold from the jewelry sector, but given the debt crisis in the eurozone and the troika of IMF, EU and ECB still having to decide whether Greece would receive the next tranche of bail-out funds, one would expect that gold would be relatively stable. Nevertheless, since early August, non-commercials have reduced the net long position in gold futures continuously. And gold could not escape the sell off, which drove gold to as low as 1,550$/oz last week.

For agricultural commodities, the development of supply caused by weather conditions should have a stronger impact on prices than demand changes due to slower GDP growth in the US and Europe. Nevertheless, also grain prices dropped due to position liquidations by hedge funds and other financial investors. The current harvest season as well as delays in planting of winter wheat in the US should have more a bullish impact on grain prices.

Therefore, we can conclude that changes in risk aversion or risk appetite of financial investors could have a stronger impact on commodity prices than the usual fundamentals. However, this does of course not imply that all commodities would fall by the same percentage change. While also gold could not escape the massive selling pressure, its price declined less compared to other precious metals, which have a higher share of total demand for industrial usage. In the case of platinum, a global recession would have an impact on platinum demand from the automotive industry for catalytic converters. Thus, gold traded above the price of platinum and the premium of gold widened to more than 100$/oz. There is no long-run equilibrium relationship between the prices of these two precious metals that would limit the price spread. Thus, the spread could even widen more, especially if stock markets fall further and economic data will be weaker than expected. However, a stabilization of stock markets and a stronger than expected US labor market report next Friday could also trigger a narrowing of the premium of gold over platinum.

The correction of precious metals reached bear market territory last week, i.e. a decline of 20% or more from the previous high. Some technical analysts and former gold bulls now call the end of the long-run bull market in precious metals. We can not rule out such a scenario, especially not in the case that European politicians remain stubborn and react furthermore only slowly to the risks of the debt crisis. The warning calls from US President Obama and his Treasury secretary Geithner are fully justified. However, the main scenario is one of slow growth in the US and Europe with the risk of a technical recession. Asian emerging economies still grow at high single digit growth rates. Thus, a plunge of levels seen in the second half of 2008 and early 2009 for precious metals is currently not the main scenario.