Financialization of Commodities: Boon Or Bane?

A Wall Street report recently highlighted on the "financialization of commodities" or the increasing role of commodities being used as investment assets.

They cite a study from Ke Tang at Renmin University in China and Wei Xiong at Princeton University which showed of the growing correlation between prices of commodities with stocks and the US dollar. Mr. Tang and Mr. Xiong writes,

``We find that concurrent with the growth of index investment, commodity prices have become increasingly correlated with the world equity index and US dollar exchange rate, and with oil. In particular, this trend is more pronounced for commodities in the two popular commodity indices, the GSCI 25 and DJ-UBS indices. As a result of the financialization process, the spillover effects of the recent financial crisis contributed to a substantial part of the large increase of commodity price volatility in 2008."

In addition, this has been used by some to cast a bearish light on commodities price trends.

Analyst Simon Hunt is bearish on copper, ``This economic scenario is not conducive to a strong trend growth in world copper consumption let alone to its declining intensity of use, a result of high and volatile copper prices. Moreover, copper’s end users, together with their fabricators, are fully aware that prices have not been driven by real fundamentals, but by the growing intrusion of the financial sector into treating copper, as for other base metals, as an alternative investment." (bold highlight mine)

Well in my view, financialization of commodities isn't a reason to be bearish.

This reflects on the deepening of capital markets in search of higher yield from relative returns, it also signifies the market process of discovering alternative havens or 'store of value' from inflationism and even possibly 'commodity as assets' could also function as sanctuary from numerous regulations.


Besides, commodities plays a minor role (.47%) in the $615 trillion derivatives [from the Bank of International Settlements] market largely dominated by interest rates (73.17%) and followed by foreign exchange (8%) and credit default swaps (5.32%). To consider that even weather plays a role in the derivatives market today as part of the growing sophistication of financial risk management.

Importantly, one mustn't forget that commodities once played the role of money, as Murray Rothbard wrote in Man, Economy and the State,

``Money is a commodity that serves as a general medium of exchange; its exchanges therefore permeate the economic system. Like all commodities, it has a market demand and a market sup­ply, although its special situation lends it many unique features. We saw in chapter 4 that its “price” has no unique expression on the market. Other commodities are all expressible in terms of units of money and therefore have uniquely identifiable prices. The money commodity, however, can be expressed only by an array of all the other commodities, i.e., all the goods and services that money can buy on the market. This array has no uniquely expressible unit, and, as we shall see, changes in the array cannot be measured."

Therefore, in today's environment where inflationism is the dominant path of policymaking, commodities can partly play the role of alternative store of value.

This means that the demand for money which consist of exchange demand (by sellers of all other goods that wish to purchase money) and reservation demand (the demand for money to hold by those who already hold it), would translate to what the mainstream sees as "speculation" or "hoarding".

In short, commodities are not just meant to be consumed (real fundamentals) but also meant to be stored (reservation demand) if the public sees the need for a monetary safehaven.

Moreover, when developments reveal heightened concerns over the accelerating loss of purchasing power in a currency, the role of commodities as money could be reinforced.

As Mr. Ludwig von Mises wrote,

``He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief: accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding. As long as such speculative anticipations are limited to some commodities, they do not bring about a general tendency toward changes in cash holding. But it is different if people [p. 427] believe that they are on the eve of big cash-induced changes in purchasing power. When they expect that the money prices of all goods will rise or fall, they expand or restrict their purchases. These attitudes strengthen and accelerate the expected tendencies considerably. This goes on until the point is reached beyond which no further changes in the purchasing power of money are expected. Only then does this inclination to buy or to sell stop and do people begin again to increase or to decrease their cash holdings.

``But if once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by the progressive fall in purchasing power. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome. This phenomenon was, in the great European inflations of the 'twenties, called flight into real goods (Flucht in die Sachwerte) or crack-up boom (Katastrophenhausse). The mathematical economists are at a loss to comprehend the causal relation between the increase in the quantity of money and what they call "velocity of circulation."

So in my opinion, where commodities serve as insurance against a crack-up boom, financialization of commodities is just one additional way to obtain access to such insurance. Not bad for as long as the counterparty in these contracts produces the 'real goods', when claims are presented.

Lastly, in competition with other asset classes, the financialization of commodities should likewise add to the pricing efficiency of the marketplace.