Its oh so quiet: On commodity volatility

Much attention recently has focused on the low level of volatility present in equity, bond, foreign exchange and commodity markets. Bloomberg Gadfly had this to say about commodities in particular, “The 90-day volatility of the Bloomberg Commodity Index touched its lowest level since November 2014 this month, driven by declines in energy, crops and precious metals. Volatility in spot gold has been running at levels almost unseen so far this century.”

While the fall in commodity price volatility is bad for trading businesses that thrive on price disconnects between commodities, regions and over time it is generally good news for consumers as they can now better plan their budgets and investments.

Some commentators have pointed to the spread of better data and social media as a reason for the drop in commodity price volatility. I think this is at best only a marginal factor in the current low volatility environment. Access to information may be better but most commodity markets are still very opaque and are still prone to the same fears and euphoria as they ever have been.

The danger of course becomes when low volatility becomes the new normal. Its then that businesses, governments and other make bad decisions based on a belief that prices will stay in a broadly stable range.

Whatever the explanation, low volatility will inevitably signal its own demise. This time is not different.

One of the 50 chapters in my book “Commodities: 50 Things You Really Need To Know” is devoted to discussing commodity volatility – printed in full below.

“What commodity prices lack in trend, they make up for in variance.” – Angus Deaton

 A crucial distinction when talking about commodity price volatility is that of variability and unpredictability. Prices exhibit variability for many reasons, but some price changes may be more predictable than others. For example, agricultural prices tend to be lowest during and soon after harvest, and highest immediately before harvest. Although seasonal changes are not exactly constant from year to year, they are often similar from one year to the next. Weather shocks, on the other hand, are typically unpredictable. Adverse weather conditions may lead to unpredictable changes in prices, especially if stocks are low to begin with.

Commodity prices tend to be more volatile than many other prices in the economy because, in the short term, both supply and demand are relatively price inelastic. Increasing commodity production takes time if new crops must be grown, mineral exploration undertaken or oil wells drilled. Similarly, it can take considerable time to change consumption habits, such as shifting from coal-fired electricity generation to gas or altering the share of more fuel-efficient cars. This sluggish response means that supply and demand shocks, whether it is an adverse weather event or a natural disaster, can result in large price movements. If demand grows faster than supply, then stock levels will run down, perhaps alongside higher commodity prices. The absence of a buffer means that in turn the market may now be more vulnerable to a further shock to demand or supply. Note that this does not mean that high prices are by necessity always correlated with high volatility.

In commodities, inventories may be measured in terms of “weeks’ consumption” – an estimate of the number of weeks of consumption that existing inventories can last. When inventories fall below a certain number of weeks, it breaches a psychological barrier in which people get nervous, and coupled with a strong transient shock (such as a strike at a mine or a crop failure affecting a particular season’s produce), this uncertainty may cause price volatility to increase.

Commodity price volatility is closely related to the ability to store the commodity. In the most extreme example in which the commodity cannot be stored for immediate delivery, such as electricity, prices are the most volatile. In terms of natural gas and oil, which can be stored but require specialised infrastructure, volatility is low when inventories are available, but spikes occur when infrastructure constraints are approached.

Metals and agriculture stand in sharp contrast to energy because they do not run into storage capacity constraints as quickly. For metals, all one needs is a parking lot and a chain link fence and you can stack the metals as high as you want. As a result, the volatility of non-energy commodities is generally lower and only spikes when inventories approach depletion.

The steepness of the commodity cost curve can also influence the volatility of a commodity. The commodity cost curve tends to influence commodity prices over the longer term. Different commodities have different shaped commodity cost curves depending on their underlying production characteristics. For example, iron ore has a particularly steep curve at the high end of the cost curve. In this example, so long as prices are relatively high and the whole cost curve is in play, iron ore prices are very sensitive to shifts in the supply/demand balance and so are subject to high volatility. As demand falls, the market quickly becomes less reliant on the higher cost producers and therefore the commodity price drops sharply because these producers are no longer required to satisfy demand.

High commodity price volatility tends to hurt producers the most, especially farmers who make all their investments in seeds, fertiliser and equipment at the start of the growing season, before the post-harvest price is known. If prices in the year ahead look unstable, farmers may invest less than usual, with the consequence that they no longer maximise profits and also produce less food to sell.

Commodity price volatility also presents a cost to the consumer of those commodities too. Thinking about a manufacturer of an essential widget for the iPhone, a significant change in the price of a significant input can negatively affect the economics of manufacturing and the commercial viability of the end product. Uncertainty over the cost structure of a business can deter investment because businesses are less able to budget for the future.

Commodity price volatility can also have implications for whole economies. Many commodity producing countries are significantly dependent on the production and the export of a handful of commodities. The performance of their overall economy, government revenues and hence the amount they have to spend on things like health and education will fluctuate with commodity prices.

At first sight, unstable food prices are likely to have a greater detrimental effect on consumers in low income countries. Here, food accounts for a large share of consumer spending, although people tend to have less access to banking facilities to be able to cope with the volatility. However, since different food staples are often substitutable, commodity price volatility may not be quite as damaging for consumers. For instance, changes in the price of one commodity are not perfectly correlated with changes in the price of another, so consumers may be able to adjust their purchases to take advantage of relative discounts.

Economies dependent on commodities for manufacturing and supporting service industries may also be exposed to commodity price volatility. As global supply chains become increasingly entwined and have moved towards “just in time delivery”, this has meant that volatility in primary commodities is likely to be transmitted through supply chains to the end consumer much faster than ever before.

The essential thing:

Commodity prices are inherently volatile, creating uncertainty for business, deterring investment and/or leading to less than optimal decisions.

My next book, on predictions and pundits in the commodity forecasting industry should be available to buy later in the summer.

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