About Onions and Potatoes

Welcome to an introduction to the commodity market. Current critics about investment in the commodity exchange market made me curious about arguments from both sides of the discussion.Recent rising prices of commodities, which are – defined by investopedia.com – basic goods of producing industries like grains and metals, or as well onions and potatoes. In theory, there ought to be no difference between potatoes from one producer to another. Thus, the commodity exchange market does not take account of quality differences (these could be merely be reflected in the share price of companies using these raw materials and thus resulting quality products contributing to the company’s success).

The article “Dr Evil, or drivel?” published in last weeks Economist reports opposed views of the danger of commodity trades. Critics came so far to encourage Sarkozy to position for suppressing these kind of activities in G20 meetings.

Firstly, investigations in the Economist have shown that apparently investors for commodities don’t actually make up a large part of this market. Thus their impact could be neglected. Leaving this aside what could be their effect if their percentage would increase?

The article reports critics who question the appearance of rising stock and prices, simultaneously. Generally, one comes from the basic theory that demand rules the price. Though, last year copper price rise at a constant stock level “worried [many] that speculators were buying and hoarding the metal“. On the other hand it seems that no evidence of this was found.

Basically, the idea of why critics demand regulatory change is that investments in this market apparently create more volatility and as we are dealing here with basic raw materials on which producers and employees are dependent, these conditions should not hinge on investors moods.

Reading the Economist I came to the conclusion that this issue is more drivel than evil. Arguments countering critics are initially the simple lack of evidence. Further, the article adds no difference between commodity movements of those traded on exchange and those which are not. Actually, the author proposes metals dealt on the exchange seems to be less volatile, as investors have the option to set limits to assets involved in the trade and so are sold automatically as soon as the price rises that much that the percentage of assets is breached. This process even stabilises the market, reasons The Economist.

The pursuit of a diversified portfolio gives another reason to participate in this business. Theoretically, the article suggests this market contributes to such a portfolio, as “price movements are uncorrelated to shares and bonds.”

A short note to help common sense: physical deliver is rare when trading with commodities – no inventory is removed from the supply chain.

Finally, a careful statement to conclude: the commodity market has the potential to “cause price swings“, but as no evidence has been brought up, regulators should be careful in setting restrictions, yet keep an eye on this market.

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5 Responses to About Onions and Potatoes

  1. Thank you for the post olexa, because the issue about commodities is getting more important.
    But one could be wondering whether the statement in the Economist – that commodities are uncorrelated to shares – is true.
    Investors could argue against this suggestion by taking the nature of an economic cycle into consideration:
    – in times of a recession or depression (at least in its initial phases), shares tend to slump due to a decrease in demand which in turn leads to diminished business activity and returns.
    – In this situation, companies will then demand less ressources for production, which might lead to a decrease in the prices of commodities.

    Thus, it seems to be quite problematic to say that commodities are not correlated at all.

  2. rudi2020 says:

    Interesting one.
    Learn more about commodities in this intersting video about commodity basics:

  3. bravenewloock says:

    On one hand, I agree with Kizzel, as the demand for commodities is strongly related to the overall economic situation – on the other hand, I think that you’re right with the comment that in investor trades, physical delivery does not take place. A 2008 study by the International Monetary Fund however indicates a strong relation between economic situation and commodity prices.

  4. olexa5 says:

    Most probably this statements was based, as introduced, on a theory. But you two are completely right I believe, thanks for clarifying this issues for us.

    An article in the Telegraph though referes the similar: (http://www.telegraph.co.uk/finance/personalfinance/6498738/Watch-the-fuel-price-commodity-shares-are-heading-up.html)
    “Although they do go through periods when they perform just like equities, over the long term, commodities are uncorrelated, which means they can play a useful part in a diversified and balanced portfolio.”

  5. Pingback: What’s up in 2011? | BraveNewFinance.

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