(Repeats March 25 story with no change to text)
By John Kemp
LONDON, March 25 A thoughtful new paper from
researchers at the University of Illinois marks a significant
step forward in research on how commodity futures prices are
Until recently, the academic and policy debate about futures
price formation has been locked in an acrimonious and polarised
standoff between market fundamentalists, who insist all price
moves reflect supply and demand fundamentals, and those writers
who blame speculators for every rise in food and fuel prices.
Both views tend to be coloured by the policy outcomes
researchers favour. Anti-poverty campaigners focus on the role
of speculation because they want governments to impose more
controls on the cost of food and fuel. Free-market economists
stress the role of fundamentals to deny governments any
ammunition to meddle.
Both positions are extreme and unconvincing.
Now Xiaoli Etienne, Scott Irwin and Philip Garcia have
published an innovative paper examining the evidence for
temproary price bubbles in markets where prices are otherwise
driven by fundamental factors.
According to the authors, futures prices for grains,
livestock and soft commodities like sugar have all exhibited
multiple bubbles over the last four decades, with bubbles more
common in the 1970s and again in the 2000s than during the 1980s
Bubbles pre-date the rising popularity of indexing
strategies and the "financialisation" of commodity markets.
There is no evidence bubbles have become more frequent or larger
following the entry of more financial investors into commodity
futures markets since 2005.
"Bubbles existed long before commodity index traders arrived
and the process of commodity market financialisation started,"
according to a paper on "Bubbles in Food Commodity Markets: Four
Decades of Evidence" presented at an IMF seminar in Washington
on March 21.
In fact most of the biggest and long-lasting bubbles
occurred in 1971-76. Financialisation may have ensured
bubble-like price movements are now smaller and reverse more
"Compared to the post-2000 years, speculators and irrational
traders (may have) played a greater role influencing prices in
the 1970s because markets were less actively traded. The arrival
of new traders in recent years, coupled with a dramatic increase
in trading volumes, has increased market liquidity, apparently
reducing the frequency of bubbles," the authors write (here).
The persistence of bubbles remains perplexing. The authors
speculate bubbles may be driven by herding behaviour, momentum
trading or other "noise traders".
"One possible explanation may be that markets are sometimes
driven by herd behaviour unrelated to economic realities ... As
markets overreact to new information, commodity prices may thus
show excess volatility and become explosive."
"It may also be that there are many positive feedback
traders in the market who buy more when the price shows an
upward trend and sell in the opposite situation. When there are
too many feedback traders for the markets to absorb, speculative
bubbles can occur in which expectations of higher future prices
support high current prices."
"It may be fads, herding behaviour, feedback trading, or
other noise traders that have long plagued futures markets were
highly influential in recent price behaviour. Recent empirical
evidence does suggest that herding behaviour exists in futures
markets among hedge funds and floor participants."
The paper concludes with an appeal for more research to
identify the source of bubble-like price behaviour.
GREAT LEAP FORWARD
In most other asset classes, it is now accepted market
prices are basically driven by fundamentals, especially in the
medium and long run, but in the short term can department from
them, sometimes significantly, as a result of speculative
As billionaire investor Warren Buffett noted in 1988 about
the hardline believers in efficient market theory: "Observing
correctly that the market was frequently efficient, they went on
to conclude incorrectly that it was always efficient. The
difference between these propositions is night and day."
Now a new generation of researchers are developing theories
which allow for a combination of both fundamental and
speculative factors to affect commodity futures prices.
Etienne, Irwin and Garcia's paper is a big step forward
because it carefully distinguishes between the influence of the
commodity index traders and the short-term bubbles evident in
commodity futures prices.
It also shows how behavioural factors could be integrated
into a fundamental theory of commodity futures pricing, as has
been accepted in every other major asset class.
Crucially, it shows how herding, momentum-based trading
strategies and other noise trading may cause futures prices
temporarily to depart from fundamentally determined levels, but
suggests such deviations have been relatively brief and reversed
within weeks or months.
Bubbles may always have been part of the operation of
futures markets. For a sample of around 40 annual contracts in
12 different commodities, the authors found bubble-like
behaviour in about a third of the contract months studied.
Bubbles occurred most frequently in sugar (55 percent of
contracts studied) and least frequently in feeder cattle (25
percent) and wheat (24 percent).
BEHAVIOUR AND FUNDAMENTALS
The University of Illinois' Department of Agricultural and
Consumer Economics is one of the most respected institutions in
the field of commodities and derivatives, so the findings cannot
be readily dismissed.
In some ways, commodity research is catching up with
developments elsewhere. The formation and subsequent collapse of
bubbles in other markets has been extensively studied by George
Soros ("The Alchemy of Finance" 1987), Didier Sornette ("Why
Stock Markets Crash" 2003) and Robert Shiller ("Irrational
Exuberance" 2009) for 25 years.
Etienne, Irwin and Garcia have shown how the same approach
could help improve understanding of commodity futures markets.
The authors observe "speculative bubbles are not isolated
phenomena in agricultural markets, but appear in other futures
markets including energy and metals markets as well" citing work
by Phillips and Yu ("Dating the timeline of financial bubbles"
2011) and Gilbert ("Speculative Influences on Commodity Futures
The paper does not investigate energy futures markets. But
the approach could be usefully applied to see if energy and
metals markets exhibit similar bubble phenomena.
A theory of commodity price formation that embraces both
fundamental and behavioural factors would provide a much richer
and more realistic understanding of how futures prices are set.
Accepting that bubbles occur in food (and possibly fuel)
prices does not mean they should be regulated out of existence.
Bubbles may be an integral part of the normal process of
price formation in any financial market, including commodities,
as investors grope towards an equilibrium in the face of
incomplete information and limited liquidity.
Trying to eliminate bubbles through regulation may do more
harm than good. Accepting temporary bubbles may be the price for
allowing the market to perform its long-term function of price
But the paper should finally move the academic and policy
debate beyond its polarised focus on whether speculation impacts
commodity futures prices to ask a more nuanced question: how?
(Editing by William Hardy)