What’s driving changes in the price of food? Why do commodities markets seem so volatile? Is it supply and demand? Weather? Speculation? Financialization?

Millions of people around the world are looking for answers to these and related questions. They see the prices of commodities – basic foodstuffs, energy, metals and agriculture – seesaw from year to year. They wonder why and what it means.

Understanding key trends in the commodities markets is important. Misperceptions about the causes of price changes and volatility – and the role of commodity investing – can lead to poor policy decisions.

That’s what CommodityFACT.org is all about. It cuts through the conventional wisdom and pulls together – in one place – facts, data and research from government, academia and think tanks. It offers facts, not hyperbole… so that you can know more about these vital issues and why they are fiercely debated around the globe.

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What drives commodity price changes?

The evidence is clear: Fundamentals – including demographic changes and weather patterns that affect the supply and demand of commodities – are the key drivers.

As the G20 Study Group on Commodities has noted: “The large changes in physical supply and demand conditions provide plausible explanations for commodity price swings...Moreover, the prices of commodities that are only traded OTC…have risen as much as major commodity index components. This may suggest that changes in physical demand and supply, rather than growing financial investments, have been the main drivers of commodity prices.”

IOSCO also stated: “…reports suggest that economic fundamentals, rather than speculative activity, are a plausible explanation for recent price changes.”

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What is financialization and how is it affecting commodities markets?

Financialization is a term that some use to describe the purported growth in size and importance of the financial sector in the economy.

Such perceptions raise fears about the role and impact of finance in the volatility of commodity prices. A majority of academics and researchers have found that these fears are not grounded in fact.

Volatility is not higher now than in the 1990’s when general commodity prices were low. The impression of high volatility is mostly an artifact of daily changes around a higher price level; this impression disappears when the higher price level is compensated for by examining volatility as a daily percentage change.

As the Deputy Governor of the Bank of Canada stated, “…There is no clear evidence that this trend toward greater financialization has been significant determinant of the overall level of commodity prices.”

Two German academics echoed this finding: “We thus conclude that the increasing financialization of raw material markets has not made them more volatile.”

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Is speculation causing food prices to rise?

Speculators play an important role, taking on risks that others do not want. They anticipate fundamental factors and multiple costs of processing, as well as unpredictable risks across the political, economic, weather and technological spheres.

Speculators are an essential component of all markets, and are crucial to producers, manufacturers, distributors and end-users. Unfortunately, this activity and role is sometimes misunderstood. As two University of Illinois professors wrote in the New York Times, “…speculators are a convenient scapegoat for the public’s frustration with rising prices. That’s unfortunate because curbing speculation — and hobbling the ability of businesses that rely on futures markets to reduce their risk — is counterproductive.”

There is little evidence to suggest that speculation creates price changes. The CFTC, as well as the European Central Bank share this view. One leading academic says that despite the popularity of such views, they are unfounded. “As yet there is no serious theory, and certainly no serious evidence that speculators have distorted commodity prices.”

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Will position limits help reduce price volatility?

Position limits cap the amount that market participants can hold in certain commodities. Some have argued that position limits will curtail or reduce speculation, thus reducing volatility in food prices.

However, objective evidence that mandatory limits curb volatility is lacking. There is, though, much to suggest that such limits adversely impact liquidity and the functioning of markets.

The Economist has written, “There is good reason to worry that position limits will harm markets more than help them…Investors will become pickier about the contracts they enter into as a result of the limits, which may cause markets to become less liquid, worsening volatility rather than reducing it.”

And an EDHEC-Risk Institute paper noted that “Proposals to restrict speculation fall somewhere in the continuum of being a placebo to actually being harmful to the goals to which they aspire.”

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MIFID position limits: size matters

For European regulators, beginning work on a methodology for calculating commodity derivatives position limits must feel like entering a rabbit hole, where each turn leads to more choices and more tunnels, each leading further and further into the depths of the warren. To give that [&hellip…

April 22, 2014

Bad weather and expensive bacon

Too bad we can’t apply limits to weather shocks! Shoppers will have noticed some worrying changes to the cost of their groceries in recent months, with the prices of some supermarket favourites – coffee, orange juice, bacon – rising rapidly this year. But this might [&hellip…

March 6, 2014

Regulations a driver of change, not a response

Big, sweeping changes to any established market run the risk of unintended consequences, particularly when those changes result from multiple pieces of legislation and regulation, often written independently of each other and introduced more or less at the same time. The UK’s Financial Conduct Authority [&hellip…

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