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.

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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.

Buy the book Commodities: 50 Things You Really Need To Know from Amazon (US and UK), iBooks, Barnes and Noble, Google and Kobo.If you like the book please leave a review on Amazon. Reviews really do make a difference. Thanks.

The calm before the storm?: A little known commodity market where all eyes are on the hurricane season

It’s just been Hurricane Preparedness Week in the US, and while that might not mean too much for anyone living outside of striking distance of the US Gulf coast or Eastern seaboard, it is important for commodity markets.

Oil (and to a lesser extent gas) of course get all the attention. A look at a seasonal oil price patterns shows frequent spikes during the hurricane season (June to November), and although the risk has subsided in recent years as shale extraction has become more dominant, the risk of a disruption to supply remains.

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Related article: The changing of the seasons

The other main commodity market affected by hurricane activity is orange juice. futures. Florida (the second largest orange producer after Brazil) has been in the eye of many storms that have significantly damaged its crop.

And so this is about the time of year that traders typically make seasonal long bets ahead of the hurricane season. Historically, July has typically been the second strongest month with prices on average up by 1.5% (rising ~60% of the time) as market participants prepare for the risk of disruption ahead.

The last time that hurricane’s severely damaged the states  crop was in 2004-05. In 2004, three hurricanes — Charley, Frances and Jeanne — hit the citrus-growing regions of Florida while in 2005 Hurricane Wilma did more damage to the areas. The hurricanes crisscrossed the state in such a way that nearly every acre with citrus groves was affected in some way. In the worst case, trees were uprooted, while in other instances nearly ripened fruit was blown off trees or trees were damaged. Previous to that, the last devastating storm was Hurricane Andrew in 1992.

Expectations matter. And so orange futures prices could move higher over the next couple months as traders try to price in the expected degree of damage risk from hurricanes.

This year at least the risk is looking relatively low. According to Colorado State University’s Tropical Meteorology Project, a “weak to moderate” El Niño is expected to limit tropical storm development over the Atlantic basin for the 2017 hurricane season. Note that the estimated probability of El Niño forming has declined in recent weeks, from almost 70% to below 50% currently.

The university predicts a total of 11 named storms for this year’s hurricane season. Only four of these storms are predicted to be hurricanes; two of these are predicted to be major hurricanes — reaching Category 3 to 5. They estimate that there is a 24% chance a major hurricane will make landfall on the East Coast.

The devil is in the detail however. Even though overall hurricane activity may well turn out to be lower than normal, all Florida needs is one major storm (a return of Charley, Frances and Jeanne) to devastate the crop once again.

For now at least the coast is clear.

 

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Is the main driver of industrial metal demand about to shift into reverse?

The Chinese manufacturing purchasing managers index is closely watched for signs of an uptick in demand for commodities. The reason for this is that it gives a forward view of the potential demand for industrial metals such as copper, nickel and aluminium and to a lesser extent energy and agricultural commodities. Since the start of 2016 all the signs have pointed up as Chinese manufacturing activity surged higher, and metal prices have followed in lockstep.

But what if there is a more important, even more forward looking indicator of potential demand?

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A recent note from PIMCO highlights the role that credit plays as a leading indicator. China’s “credit impulse,” as its known measures the change in the growth rate of aggregate credit to GDP, bears close watching: It has tended to lead the Chinese manufacturing Purchasing Managers’ Index (PMI) by 9-12 months and the U.S. Institute for Supply Management’s (ISM) manufacturing index by about 14 months.

Whats been happening to the credit impulse? Here’s PIMCO.

The sharp downturn in the Chinese credit impulse starting in 2016 portends a material drag on Chinese growth in the year ahead. Looking back on the past three years, the Chinese credit impulse turned positive sometime between late 2014 and mid-2015. Given China’s exchange rate volatility in August 2015, it took longer than normal for credit to gain traction. The Chinese credit impulse peaked in March 2016 and slowed sharply after the second quarter. It is only now that the impact of that reduced stimulus should be felt. PIMCO has already factored credit-related drag into its Chinese growth outlook, but the decline in the credit impulse has been sharper and more extreme than many expected.

The question now is not if China slows, but rather how fast. Equally important perhaps is the extent to which commodity prices will correct lower, especially in light of the current enthusiasm about the potential strength of the global growth cycle. The impending slowdown in China could be compounded by ongoing government efforts to rein in shadow bank credit; the cost of policy mistakes rises once the credit impulse goes into reverse.

All of which means the outlook for industrial metals could look a lot bleaker in the second half of 2017.

Related article: Where do we stand in the commodity cycle?

Buy the book Commodities: 50 Things You Really Need To Know from Amazon (US and UK), iBooks, Barnes and Noble, Google and Kobo.If you like the book please leave a review on Amazon. Reviews really do make a difference. Thanks.