Opportunities of the Commodity Markets - Research Paper Example

 A Description of Commodity Markets Introduction A commodity market refers to a physical marketplace for buying, trading and selling primary or raw products. Commodities are divided into two main types: soft and hard commodities. Hard commodities are normally natural resources that should be extracted or mined such as oil, rubber and gold. Agricultural products and livestock such as corn, pork, soybeans, sugar, coffee and wheat are categorized as soft commodities (Chunrong, Arjun and Song, 584). Raw products become traded on commodities exchanges, which are regulated. Commodities are bought and sold in contracts that are standardized. Buyers and sellers engage themselves in the future markets essentially to enter future contracts to evade risks or speculate instead of the mere exchange of physical goods. Financially, the commodity markets have been converted into bonds and equity markets (Buyuksahin, Haigh and Robe 93). A description of commodity markets from a financial economic perspective Commodities market requires the existence of established standards opposed to spot markets where inspection of commodities is involved. A future contract is a form of derivative instrument, or contract, where two parties agree to transact a given set of physical commodities or financial instruments for future delivery at a set price. If one buys a future contract, he or she is virtuously agreeing to purchase something that has not yet been produced by the seller. That is the reason why future contracts are used as financial instruments not only by consumers and producers, but also speculators. The future commodity markets give buyers and sellers a chance to manage price risks, for commodities they will need to buy or sell at a later date (Gorton and Geert 60). Today’s financialisation of commodity market plays a crucial role in the trading of agricultural commodities. Since ancient times, individuals have assigned economic values to livestock and other agricultural products such as sheep, cows, and wheat. The current commodity market is more standardized with specific descriptions of commodities, sizes and delivery dates. In many occasions, commodity trading is always confused with futures trading; however, there are minor differences. Commodities refer to goods, which can be traded between two people. Futures, however, are contracts between buyers and sellers of products that give specifications on the amounts, grades, and quality. Commodity futures operate on an exchange e.g. Chicago Board of Trade or Chicago Mercantile Exchange. In the financial perspective, Market participants are classified by the Commodity Futures Trading Commission. I. Commercials; this entails the production, merchandising, or processing of a commodity. For instance, an ethanol producer and a corn farmer are both commercials since they all uses corn as their raw material. Commercials make use of the commodity markets to protect against the price of a given commodity, making a move that can negatively affect the price they can sell their goods. II. Large Speculators; they are mostly hedge funds, commodity trading advisors, and banks that trade in the commodity markets for speculation purposes (Gorton and Geert 66). III. Small Speculators; they include individual commodity traders who involve in trading for their own accounts or through commodity brokers. The commodities that can be financially traded are unlimited. Some of the commodities traded today include grains, energy products, meat and livestock, metals etc. These commodities are traded as futures that are listed on commodity exchange. The exchanges responsible for commodity futures traders include: I. London Metal Exchange II. Intercontinental Exchange III. New York Mercantile Exchange IV. Chicago Mercantile Exchange V. New York Board of Trade VI. Chicago Board of Trade, among others. Most of the commodities trading take place in the form of contracts; however, spot trading also takes place. Spot trading is normally carried out in wholesale businesses where cash is exchanged for an immediate delivery of goods. In a commodity forward contract, two individuals agree to exchange goods at a future date at a given price defined today. This price is called the forward price. Prices of commodities are extremely interdependent. The prices of commodities have hiked over the past many years due to increased consumption in the emerging economies such as Brazil, China, and India. The demands for fuels such as ethanol and gasoline have also pushed the cost of raw materials e.g. corn and oil higher. An individual can easily gain in the commodity markets by trading these co-dependent relationships (Carter and Smith 112). In the mid 19th century, businessmen in the United States began organizing market forums to ease the process of buying and selling commodities. These central market locations provided a convenient place for buyers and sellers to meet, set quantity and quality standards, and establish business rules. Agricultural commodities were commonly traded, but with the availability of buyers and sellers, all products can be traded on the market. During the Great Depression in the year 1933, the Commodity Exchange, Inc was established in the New York City through the coming together of four exchanges: the Hide Exchange of NewYork, the New York’s Rubber Exchange, the National Raw Silk Exchange, and the National Metal Exchange (Korniotis 125). The major commodity markets are in the USA and the United Kingdom. In India, there are 25 renowned future exchanges, of which three are nationalized multi commodity exchanges (Korniotis 134). After approximately three decades, the Indian government has allowed forward transactions in commodities through the use of Online Commodity Exchanges. High commodity prices were characteristics of the global economic boom since the year 2003 to mid 2008 (Radetzki 59). When the worldwide financial crisis started, and the Great Recession set in, prices rose up, and the end of the commodity boom was imminent. Commodity prices returned to normal in the early periods of recovery, and by the end of 2010, the cost of many products was close to or above pre crisis peaks. Apart from oil, whose price is usually affected by increased political supply risks, products lost part of their luster when the international economic activity slowed in 2011. The recent weakness of price may reflect the state of the global economy. There is no doubt that, financial projections in terms of prices are of help in the commodity markets. They frequently fail to predict either the persistence or direction of price changes. In the financial view, it is proper to look into commodity market developments from the era of the worldwide financial crisis in regards to the research on the origins of commodity price booms, which puts emphasis on the interaction of supply and demand shocks and low inventories as the major force behind booms (Carter and Smith 89). On the demand side, the continual acceleration in economic growth, in developing and emerging economies, was a major force during the price boom in the early 2000s (Radetzki 63). This persistent growth acceleration in economies that entirely depend on commodities than in advanced economies increased the demand of commodities even as it waned in highly developed economies. The growth rates in the international demand for commodities were considerably higher during the last decade as compared to the 1980s and 1990s. The Great Recession and the global financial crisis only dented the growth performance in developing economies, whose industrial activity and real GDP quickly recovered to pre crisis trends. Macroeconomic policies accelerated recovery in developing countries and emerging market, especially in China. Stimulus policies also fueled the commodity intensive investment that prompted much of the recovery in commodity markets. These developments propose that the international financial crisis has not essentially changed the demand scenario in commodity markets. The per capita income in major emerging economies remains at a point where commodity demand increases as income rises. There is a significant distinction between supply shocks, supply response to increase demand, and the unexpected disruptions to commodity production. Supply shocks were essential in some recent price surges, particularly for major grains in 2006-2007 and 2010 (Erb and Campbell 93). For instance, the food price surge in the mid 2010 was triggered by weather disruptions, wildfires and drought in Kazakhstan, Ukraine, Russia, and later in Asia which experienced floods. The international response in price in respect to a supply disruption depends on the size of inventories which can act as buffers and also how much production declines. The interaction between supply disruptions and the low initial stocks over the last decades has been a considerable factor in extensive food price surges. The reduced the stocks in respect to consumption; the unwilling inventory holders would be required to sell at any given price. The quantity of food relative to consumption reduced considerably during the last decade. Inventories in the 2008 food price peaks were lower as compared to those during the 1973 food and commodity price boom. Favorable harvest in the year 2008, 2009, 2010, and 2011 refilled stocks, but continued demand have hindered rebuilding of inventories and commodities remain relatively low. Since the cost and availability of credit affects the cost of maintaining inventory, it can be arguable that, the financial crisis is one route cause of low food inventory levels in many countries. Financial conditions have not hindered inventory accumulation of crude oil or base metals. Inventories started rising fast when the Great Recession began as demand reduced faster than supply and spot prices fell. As a result, this changed immediately as stimulative measures took hold and market participants appeared willing to absorb the excess supply (Henderson and Neil 246). The slow response of producers to the unforeseen increase in commodity demand was another factor that promoted the rise in commodity prices before and after the Great Recession. The high cost of developing related reservoirs and deposits also contributed to the great recession. Hydrocarbon investment and mining have been booming free of credit and financing constraints which affected many potential borrowers. Implications In effect, the financial real rates of interest play a crucial role in influencing the real prices of agricultural and even mineral commodities. In the real interest mechanism, the financial aspect shows a strong relationship between rates of interests and commodity prices. Of course, the prices of commodities generally hike whenever rates of interest fall and the commodity prices fall whenever interest rates rise. In this mechanism, the relationship between interest rates and commodity prices occur in various channels. This means, high rates of interests decrease the storable commodities’ prices in various channels. First; via increasing the extraction incentives today instead of tomorrow establish the rates at which gold is mined, livestock herds are culled; forests are logged, and oil is pumped. Second; via reducing the desire of firms to carry inventories, establishes oil inventories kept in tanks. Third; channel through heartening speculators to reallocate from spot commodity contracts to Treasury bill, which is the so called financialisation of commodities. Fourth; the channel involving appreciating the Domestic currency, which in turn reduces the internationally traded commodities’ prices in domestic value and that would occur even if the value has not dropped in terms of foreign currency. All these four financial mechanism operate harmoniously to trim down the real prices of commodities in the market (Radetzki 57). However, the decrease in rates of interest lowers the price of carrying inventories as well as raising the prices on commodities. The financial view, which demonstrates the relationship between interest rates and commodity prices, can be explained in some theory model. In the overshooting model of exchange rates, a monetary contraction raises the real rates of interest in a temporary manner, whether through a climb in the nominal rates of interest, or a drop in estimated inflation, or both. The prices of real commodities fall until the commodities are broadly stated as undervalued. In this case, the commodities are so undervalued that future appreciation is expected. The undervaluation occurs with other benefits of holding inventories, especially the convenience yield, which becomes satisfactory to counteract the high levels of interest rates plus other carrying inventories’ costs, storage costs and other risk premiums. It is until then when expected profits are in equilibrium that firms become willing to invest in inventories regardless of the high carrying costs. Afterwards, the common levels of prices adjust in regard to changes in the money supply. In that case, the real financial supply, real rates of interest, and real prices of commodities in the long run go to where they were Erb and Campbell 89). Indeed, there are implications for the commodities’ pricing. In the commodity market, the wide trend in prices of commodities gets determined through the fundamental of demand and supply. However, the functioning of the financial market in which commodities become traded demonstrates the possibility to influence pricing in many ways. In any case, the flows of financing for activities involving commodity trading have impacts on the efficiency and liquidity of commodity markets. Commodity financialisation has the potential to shape the degree of first hand volatility in the commodity markets. In particular, the prominent trading houses as well as the physical trading functions of some big investment banks, play an increasingly vital role in quite a number of commodity markets. There is no doubt that, failure of large trading houses in the world or a given nation can cause a crisis in the global commodity markets and even in the domestic commodity markets. The losses incurred by a trading house via the positions such a trading house has taken in commodity markets present considerable knock-on effects within the financial system. Of course, commodities being traded can potentially act as a key connection between the real economy and the financial system. Movements in the prices of commodities may sometimes pose a threat to the financial institutions, which direct funding to commodity-trading activities. For instance, the central element involving the financing of commodities in regard to the 2008 economic crisis was the escalating participation of chief global investment banks. These global investment banks ensured access to comprehensive funding of commodity markets, which offered the commodity markets cheaper funding as compared to other commodity markets that never received such funding. The rationale is that, large investment banks in a nation or globally is important in the array of commodity related activities and especially during an economic downturn. In crisis situations, they offer a prominent share of lending to dealers of commodity. They become a central role as dealers within over-the-counter derivatives within commodity markets. In the current economic situations, the prominent financial institutions are highly involved in the commodities’ physical trading via holding physical inventories, commodity storage, generating supply chains through shipping and establishing markets in commodities. Similarly, the commodity trading houses in the global arena hold inventories of commodities and stock them over time, transfer them all over the world, and structure markets within both physical commodities plus their derivatives. Of course, trading houses would prove to perform similar roles as the financial institutions, but the main essence is that such trading houses require financing from the financial bodies so as to facilitate their operations. Traditionally, the financing would generally be through syndicated bank lending which is secured by commodity inventories. It can be stressed that market-making and arbitrage becomes fundamental in tying all commodity markets as a single market. With these activities, significant liquidity to markets of commodities is provided, and when such financial fundamentals work properly, commodity prices are brought in line with the supply and demand activities. It is a fact that broad movements within commodity prices in long periods of time reflect the supply and demand fundamentals even at an international level (Erb and Campbell 95). It is feasible that, in many circumstances, the financial forces can amplify movements in prices, which can be driven primarily by other vital financial forces, which contribute to volatility e.g., the exaggeration in the prices of oil. Whatever the case, the shift of investors towards commodities can be facilitated by financial novelties. This has notably been through the upcoming of index funds, and then later a multiplicity of exchange-traded funds. In the recent past, high frequency trading has become an aspect of commodity markets, just like in the financial markets. With such developments, commodities in the markets have increasingly turned into liquid financial assets, which can be accessed by the wider range of investors. As a result, the plenty of investment funds into commodities enhances further commodity innovations. There is no doubt that the increasing prices and pervasive bull commodities markets signify that there exists a rising scarcity of hard commodities. Dynamics in the commodity markets exist since securitized commodity-linked tools can be now considered as investment instead of risk management instruments. The main notion is that commodities markets have been gradually financialised. In other words, the commodity markets have been converted into bond and equity markets. It can be admitted that, excessive financial growth or the expectation of afterward financial growth demonstrate an immediate increase in prices of commodities as well as resulting in rapid inflation (Henderson and Neil 235). It can be widely argued that; most commodity prices become sticky with the short run and then reflect financial growth in the long run. With such views in the relationship between the financial and commodity markets as addressed in this paper, it can be affirmed that, commodity markets can be analyzed in the financial perspective. Works Cited: Buyuksahin, Bahattin, Haigh Michael, and Robe Michel. Commodities and equities: Ever a “market of one”? Journal of Alternative Investments 12.1 (2010): 76-95. Print. Carter, Colin, and Smith Aaron. “Commodity Booms and Busts,” Annual Review of Resource Economics 3.1 (2011): 87–118.­ Print. Chunrong, Ai, Arjun Chatrath, and Song Frank. On the Co movement of Commodity Prices. American Journal of Agricultural Economics 88.3 (2006): 574-88. Print. Erb, Claude, and Campbell Harvey. The Strategic and Tactical Value of Commodity Futures, Financial Analysts Journal 62.2 (2006): 69-97. Print. Gorton, Gary, and Geert Rouwenhorst. Facts and Fantasies about Commodity Futures. Financial Analysts Journal 62.1 (2006), 47-68. Print. Henderson, Brian, and Neil Pearson. The Dark Side of Financial Innovation: A case study of the pricing of a retail financial product. Journal of Financial Economics 100.1(2011): 227-247. Print. Korniotis, George. Does Speculation Affect Spot Price Levels? The Case of Metals with and without Futures Markets. Finance and Economics Discussion Series 2009-29, Divisions of Research & Statistics and Monetary Affairs. Washington, D.C.: Federal Reserve Board, 2009. Print. Radetzki, Marian. “The Anatomy of Three Commodity Booms.” Resources Policy 31.1 (2006): 56–64.­ Print. Read More