Commodity Watch – Prices versus volatility

by: Georgette Boele

Commodity-Watch - 2 April 2015 - Prices versus volatility.pdf ()
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Over the last decade commodity prices have rallied exponentially but also crashed sharply. What have been the drivers behind these sharp swings and how did commodity price volatility behave? Although there are some exceptions, volatility tends to behave asymmetrically depending on the direction of the price move. In general, volatility tends to rise sharply during substantial commodity price sell-offs. However, occasionally, individual commodity price volatility increases also happen when commodity prices rally sharply. Often this is when price peaks are in the making as was the case for gold prices in 2011 and sugar prices in 2010.

Substantial price swings over the past decade…

Over the last decade, financial markets have experienced exponential rallies in commodity prices, but also violent crashes in individual prices. The commodity price rally that started in 2002 and ended in June 2008 was mainly the result of Chinese economic growth, optimism about demand, the search for returns and expectations of further US dollar weakening ahead and introduction of commodity related investment products. This had a particularly significant impact on commodity prices, because investors put on long commodity positions as an anti-US dollar trade.

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The global financial market and liquidity crisis pushed commodity prices sharply lower. This reflected a sharp slowdown in global growth. In addition, the US dollar rallied dramatically and US short-term interest rates rose sharply because of US dollar liquidity shortage in the money market. So there was a run for liquidity. In the two years following the crisis, commodity prices recovered driven by the global economic recovery, enormous macro policy stimulus in major economies, stronger supply/demand fundamentals and a weak US dollar. However, the recovery in commodity prices did not have the same momentum as in the previous rally. This is because individual commodity prices did not rally at the same time. There was a lot of divergence, which was mainly a reflection of different fundamentals. In short, there was no longer an overriding theme such as very strong global growth and/or sharp US dollar weakness. For example, gold prices peaked in 2011 and have moved lower since then. Since 2011, the CRB index has lost momentum and weakness has followed, especially in the second half of 2014. Oil prices rallied to around 125 US dollars per barrel several times in the period 2011-14, but crashed in the second half of 2014. Agricultural commodity prices also experienced notable swings mainly because of weather conditions and crop prospects, while copper prices have been very sensitive to developments in China.

How did price volatility behave over these periods?

For our analysis, we worked with 30-day price volatility of individual commodity prices, including energy, base metal, precious metals and our coverage of agricultural and soft commodity prices. This leads to some interesting conclusions.

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Commodity price volatility tends to behave asymmetrically…

Commodity price volatility tends to behave symmetrically. There is a strong tendency of commodity price volatility to spike higher when commodity prices are aggressively sold off. This behaviour has manifested itself in most of the commodities we cover. A recent example is the sell-off in oil prices in the second half of 2014: prices dropped and volatility spiked higher (see second graph). Another example is that during the sharp drop in base metal prices in 2008, volatility moved substantially higher. In general investors and producers are very comfortable when prices increase. Therefore, there is no real panic when prices rise. However, sharp price falls do trigger action. Producers need to adjust their supply and cancel projects. Meanwhile, investors are forced to liquidate their long positions. So, substantial price drops often go hand in hand with sharply higher volatility.

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…but a rise in volatility at the time of sharp price increase could signal a peak

If 30-day price volatility rises sharply during a significant rally in commodity prices, this could signal that a price peak is in the making. For example, during the 2011 peak in gold prices, volatility also rose sharply (see below). Why is this? In 2011, the market was very bullish on gold prices and investors were afraid to miss a significant rally. As a result, the price rally made them nervous and volatility moved higher.

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Similar behaviour was seen in wheat prices in 2008, wheat, corn and soybean prices in 2012, nickel, coffee and natural gas prices in 2014. In all these periods, both individual commodity prices and 30-day volatility rose.

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Often unexpected events such as government action or extreme weather conditions are the main reasons for the sharp prices increases. For example the extreme drought in the US pushed wheat, corn and soybean prices sharply higher.

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In 2014, extreme cold weather in the US resulted in a considerable rally in natural gas prices, the government of Indonesia banned nickel exports which resulted in a dramatic prices increase, while the drought in Brazil gave strong support to coffee and sugar prices.

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Our outlook

We expect the CRB index to rise this year. This reflects higher base metal prices – driven by strong economic growth – and a recovery in oil prices. It is unlikely that commodity price volatility of these commodities will rise sharply in an environment of strong global growth and positive investor sentiment, barring unexpected events such as the examples mentioned above.

Meanwhile, we expect precious metal prices to fall substantially in the near-term (gold also in 2016) because of further US dollar strength and higher US interest rates/yields. It is likely that sell-offs in precious metal prices will go hand in hand with sharp increases in price volatility of these commodities.