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One of the key arguments behind a free market is that market price signals aid producers in making investment decisions, which in turn leads to a "better" allocation of capital throughout an economy. The key trouble with central planning is that the plans are only as good as the planners. History has shown that typical central planners have had a rather tricky time allocating resources better than the market. But what happens when market price signals no longer represent the supply and demand of the commodity, goods, or service in question?

From time to time throughout financial history some individuals who thought they knew better than the market put a lot of money into trying to show the market a thing or two about what prices should be. Some rather large examples are the Hunt brothers in the Silver market or Amaranth in the natural gas markets. Amaranth wasn't necessarily a direct attempt to "corner" the market but nonetheless they represent a pretty clear case where an investors size had a direct impact on market prices.

Over the years, there have been attempts to prevent market players from "cornering" the market. While some may question how effective policies such as contract limits have had in maintaining market stability, the point is that regulators do attempt, at least to some extent, to prevent individual players from manipulating the market. There are also laws against collusion to prevent a team of players from manipulating markets. However, what happens when there is no explicit or implicit collusion, but due to sales pitches by sell-side research departments and consultants, armed with decades of HISTORICAL data, non-traditional market players are persuaded into getting involved in new markets? An unintended consequence may very well turn out to be a less efficient market- which is to say a market that no longer sends price signals to producers and consumers that are relevant to the supply and demand fundamentals of the market in consideration.

An FT article by Edward Hadas discusses the financialization of commodity markets and its impact on "market price signals". He opens the article with what he claims was a popular joke among economists during the fall of the USSR - which like most economist jokes requires a certain sense of humor.

Soviet patriot: “The USSR will invade and conquer every country in the world, except New Zealand.”

Curious observer: “Why leave New Zealand out of the global communist economy?”

Patriot: “So we can find out the market price of goods.”

Hadas asserts that, "commodity markets have been victims of 'financialisation'. Financial markets set prices, which give producers and customers almost meaningless signals." It is important to note that he does not argue that there is a single guilty party, or group of like minded companies, doing something illegal per se - which is a sharp contrast to the often over used campaign slogans that the big bad speculators are conspiring to manipulate prices.
Hadas goes on to argue that, "the commodity market’s information is financial, not industrial or economic. While demand is growing fast and supply is still constrained after decades of underinvestment, the producers’ profitability – Rio’s annualised return on tangible equity in the first half was a stunning 39 per cent – is best read as a sign of the cash available to buyers, both industrial and more speculative. Similarly, the best explanation for the sudden price fall in the past few weeks is that the money flow has become less ample."

Hadas might very well be on to something. However, rather than focusing on any individual player who is attempting to manipulate prices, one must step back and take a macro approach to the problem at hand. For the better part of a decade (probably much longer at this point) consultants have been persuading pension funds to invest in commodity markets. Commodities went from being, well, commodities to suddenly catapulted to the classification of an "asset class". This group alone represents several trillion dollars worth of financial firepower. When they collectively increase their holdings of commodities from zero percent to two, three, five, ten or more percent of their holdings, it represents hundreds of billions of dollars pouring into the commodity markets. Additionally with the advent of commodity ETF's, individual investors have added billions of dollars of fuel to the fire.

There are two significant ways these new market players impact commodity markets. First, and foremost, classical economic forces of supply and demand are marginalized in their ability to send signals through market prices - which should play a paramount role in influencing investment decisions by producers. Secondly, the desirable properties of commodity markets (i.e. enhanced diversification) will vanish overtime, leaving pension funds and other non-traditional commodity investors with substantial losses as they learn the hard way that commodities are becoming more and more correlated with other financial instruments. Of course this is no coincidence. The simple fact is that as the share of interest in commodities declines from producers and consumers to non-traditional financial interests (i.e. passive commodity investors such as pension funds and individual investors through ETF's) the commodity markets become more and more correlated with other financial assets (i.e. a risk on, risk off investment world). In a world of risk on, risk off, individuals and pension funds can no longer blindly count on increasing diversification and reducing risk by passively investing in commodities.

Individuals, and many already have, are going to get burned in commodity ETF's. The mere fact that commodities constantly trade at different prices "on the curve" (different months into the future) create new complexities that I don't really believe most individual investors in ETF's fully appreciate. The fact that you can buy the oil ETF USO, oil prices can go up, AND you can still lose money will just blow people's minds. This is true in agricultural commodities, industrial metals, and energy commodities. Gold, and possibly silver (although arguably to a lesser extent), are probably the only commodities with corresponding ETF's that won't really change in their dynamics, since they have historically been driven by financial interests (i.e. an inflation hedge and/or a safe haven against world instability).

Hadas ends the FT article by saying, "Communism has died, but financialisation is diminishing one of the advantages of free markets. Anyone for a New Zealand moment?" I must conclude by urging any individual investor considering a commodity ETF to strongly consider the dynamics of the fund in question. There are lots of different risks that should be considered before trading on of these instruments and it might turn out that investing in commodity companies with exposure to the target commodity is a better strategy for individuals to invest in commodities.

Thanks for reading and good luck.

Source: Beware Commodity ETFs