A DROP IN the ocean passes unnoticed but a drop in a puddle makes a big old splash.
Given that most commodity markets are decidedly more puddle-like in terms of size and liquidity than oceanic, it is hardly surprising that the buckets of cash that investors have been throwing at them have caused waves.
What is surprising, however, is how rapidly and profoundly investors have changed some of these markets, by displacing the producers and consumers of these goods as the most important players and either causing outright shifts in demand or amplifiying trends, with ripple effects.
Although commodity markets have always been volatile, investors have in some cases intensified volatility, increasing the cost of trading and the risk of market failure. In many ways, however, investment money has been a blessing. With more and more of people’s pensions at stake, regulators are starting to keep a closer watch.
Although some investors, particularly short-term technical hedge funds, have been active in commodities since the early 1990s, investment in commodities began to take on new proportions after the dotcom crash, starting its current meteoric rise only around 2004. In 2001 there was just $4 billion to $5 billion tracking the Goldman Sachs Commodity Index, now the S&P GSCI. At the end of 2006 that figure was closer to $60 billion.
The best estimate for the total amount invested in commodities is $200 billion. Although that sounds small in comparison with the $6,304 billion of notional outstanding in commodity derivatives contracts (as estimated by the Bank for International Settlements), that ocean is made up of a huge variety of contracts, a few of which are lakes, some of which are pools, and many of which are puddles.
In many commodity markets, producers and consumers are now dwarfed by financial investors with no use for the commodities whose prices they are betting on and influencing.
Anecdotally, bankers say that in less than three years they have seen the balance of trading participation in some commodity markets, particularly metals, change from 75% commercial and 25% investors to 75% investors and 25% commercial.
On the London Metal Exchange, index funds and hedge funds now account for 85% of trading volumes.
Today, there are individual commodity funds looking to invest more than $1 billion in metals markets whereas just a couple of years ago investment from such funds was close to zero.
 |
"The introduction of a silver ETF last year has had a huge impact on the market, lifting its price into a new range. Silver has gone from $6 to $7 an ounce to $13. If it were not for investors there is no way silver would be trading anywhere near $13"
Philip Klapwijk, GFMS |
"The influx of investor money, particularly through index and basket products, has changed the nature of some markets and effectively pushed up their demand curves," says Philip Klapwijk, executive chairman of GFMS, a metals industry consultancy. "The extent to which investor demand is driving things is very hotly debated but because a lot of these markets are rather small their presence has clearly been a factor behind increased price levels and volatility."
Klapwijk adds: "Their impact on gold has been very significant and on silver even more so. The introduction of a silver ETF [exchange traded fund] last year has had a huge impact on the market, lifting its price into a new range. Silver has gone from $6 to $7 an ounce to $13. If it were not for investors there is no way silver would be trading anywhere near $13."
GFMS estimates that approximately 640 tonnes of gold in 2006 was held as investments, out of which ETFs held 260 tonnes. The industrial consumption of gold, including the demand from dentistry, by contrast, was 451 tonnes and total consumption in 2006 was 3,371 tonnes.
Exchange traded funds provide a great way for retail investors to get access to commodities such as metals, which they often hold physical stocks of, but many investors are probably unaware of how small these markets are and how easily their demand can have an impact. The total value of silver held in ETFs at the end of 2006 was just $1.55 billion, the size of a single IPO or bond issue, yet it was a significant factor in nearly doubling the price of the metal.
Substitution effects
The potential for investor demand to push up prices so significantly and quickly has both commercial producers and consumers concerned.
The announcement this May that Zurich Kantonal Bank was launching a platinum ETF on the Swiss Exchange prompted heavy criticism from platinum producers.
They fear that strong investor demand for the metal could cause its price to shoot up in the near term, leading commercial consumers to turn to substitutes such as palladium for catalytic converters and gold for jewellery, a trend that could be hard to reverse, thus damaging demand for the metal in the long term.
|
The make up of Metals |
|
London Metals Exchange Volumes: 1994 - 2006 |
 |
|
Source: LME |
The fear is not unrealistic given platinum’s already high price and the paucity of available stocks. There is only $1 billion to $3 billion-worth of platinum available in stock form around the world, so the market is already very tight.
Platinum producers are well aware of their industrial customers’ price sensitivity, having been beneficiaries of it in the past.
In late 2000 and early 2001, smart investors spotted a shortage of supply in the palladium market and bet that the price would soar if the automobile industry started to run short. Investors helped push the price up, creating a panic among car makers, who needed the metal in their production lines. Investors sold out at the top while car makers such as Ford, which accumulated massive long positions at the top of the market, were left nursing losses after the price fell back when bread-and-butter demand took over again.
Car makers subsequently switched to platinum, and the use of palladium was scaled back in the electronics industry.