The deeper reasons for the great commodities sell-off

Supply and demand are key factors in the current commodities slump, but so are fundamental shifts in financial markets and global trading strategies.

The across-the-board sell-off in commodities that has accelerated through the second half of this year is unusual both in its severity and its lack of discrimination, raising the question of whether there is more at play than conventional fundamentals.

That’s not to say that the fundamentals don’t explain lower prices in all the major commodities.

China’s slowing growth rate, the Eurozone’s sluggish, faltering state, and Japan’s slide back into recession would all point to lower commodity prices.

The impact of the weakening of demand on prices would inevitably have been exacerbated by the explosion in supply that occurred during the years of the China-inspired commodity boom, which to a large degree is continuing.

Whether it is oil, coal, iron ore or copper (perhaps to a lesser degree) commodity markets are experiencing increasing oversupply, with inevitable consequences for prices.

The abruptness and severity of the decline, and the fact that no commodity has escaped a beating, however, suggests there may be other influences overlaying the fundamentals.

One of the developments in markets over the past decade and a half -- but particularly in the post-crisis period since 2008 -- has been the emergence of purely financial players in commodity markets, fuelled by the extraordinary availability of extremely cheap credit as a result of the unconventional monetary policies pursued by the US, Europe and Japan since 2008.

Whether it is hedge funds establishing carry trades, exchange-traded commodity funds offering investors direct exposures to commodities they might otherwise not be able to obtain, or Chinese businesses using commodity inventories as collateral to get access to finance, there’s been a major increase in financial and speculative activity in commodity markets.

The emergence of those financial players has been visible in the increased volatility of commodity markets as sentiment has moved from “risk on” to “risk off” and vice versa in the post-crisis years.

The gathering slide in commodity prices this year has “coincided” with the shift in the US Federal Reserve’s monetary policies, with the quantitative easing programs that saw its balance sheet expand by about $US3.5 trillion ending in October, and the markets now looking forward to the first increase in US official interest rates sometime next year.

It has also occurred against the backdrop of a withdrawal from commodity trading by the major US banks in response to, not just the looming Basel III capital requirements, but the introduction of the Volker Rule in the US, with its prohibition on principal trading. JP Morgan Chase, Deutsche, Morgan Stanley and their peers have been exiting the once-lucrative activity.

That probably represents a major withdrawal of liquidity from commodity markets, which would tend to exaggerate trends in prices.

As the declines in prices have accelerated, it would also flush out the exchange-traded funds, particularly those using derivatives and leverage to offer investors a synthetic exposure to commodity indices. Given the rout in commodity prices, there would inevitably have been a lot of investors pulling their funds from the ETFs, which would amplify the impact on prices.

The opacity of the shadow financial sector make it impossible to determine with any level of precision the extent of the role, if any, that purely financial activity has been playing in the great commodities sell-off. The suspicion, however, is that it is material, albeit not the primary driver.

At the fundamental level, the steepness and pace of the declines in prices is probably, over the longer term, a positive. It will clear out high-cost uneconomic supply within a truncated timeline relative to what might have occurred had there been a more orderly retreat in prices over a longer period.

If there is an implosion occurring within the financial overlay in the market that causes prices to over-shoot, that’s also likely to contribute to the bringing forward of the point at which those prices begin to stabilise at their new, much lower, post-boom levels as the speculative froth is blown away and the fundamentals reassert themselves through a better balance of supply and demand.

There are, obviously, going to be some unpleasant consequences for economies, companies and individuals because of the sheer severity and speed of the decline. That tends to happen when booms, and the sub-economic and speculative activity they generate, bust.

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