Fluctuations in commodity prices, particularly in crude oil prices, have been hotly debated in recent years. Some argue that underlying market fundamentals, especially the unexpectedly strong demand shock attributed to continued strong economic growth in Asia and other emerging economies, is the main reason for the resurgence of commodity prices and for the fluctuations in prices since 2004. Others argue that speculative activity in commodity derivatives markets is the main force behind surging commodity prices. They further claim that commodities have become a new asset class in investors’ portfolios, and prices are now more affected by macroeconomic news rather than by commodity-specific physical market conditions.
Policy makers have responded with a slew of proposals to control futures market activity. Aside from the questions that such measures raise in terms of market function, liquidity, price discovery and ultimately price volatility, they are premised on a view that commodities traded on futures exchanges are intrinsically more volatile than those which are not. This is problematic.
The Onion Futures Act, which has prohibited the trading of onion futures in the US ever since it was passed in 1958, is a good example illustrating why volatility cannot be reduced by merely prohibiting some traders or all futures contracts. Empirical research suggests that prices and volatility in onion markets were higher post-Act than before the Act’s implementation. A more recent example can be found in India, which banned financial trading in most agricultural products – yet found out that prices continued to rise in 2008.
In order to compare price movements and volatility between non-exchange-traded commodities and crude oil prices, we constructed a weekly spot price series for an equally weighted basket of non-exchange-traded commodities. By focusing on non-exchange-traded commodities, we seek to ensure that the fluctuations of the basket’s price do not stem from changes in the activities of financial institutions in commodity futures markets. Our composite basket includes seven commodities: rice, coal, manganese, rhodium, cadmium, cobalt and tungsten. Although futures exist on rough rice and Appalachian coal, the CFTC’s Commitments of Traders reports show that the open interest and the number of traders in these contracts are small, therefore we also include these commodities in our index to allow a more diversified index across commodities.