"In our view, the fundamentals of supply and demand have been disrupted, resulting in a price hike of essential commodities including grains and energy. There is no link that establishes speculation has contributed to the exorbitant rise in commodity prices," according to a Merrill Lynch report.
Since 2001, global financial markets have seen an massive rise in outstandings in derivative financial instruments. According to Bank for International Settlements, outstanding amounts in equity, currency and interest rate derivatives traded on organised exchanges have risen by more than four times of what they were at the start of the decade. Outstandings in over-the-counter (OTC) derivatives have also increased five-fold in the same period.
As part of this general growth in OTC derivatives across asset classes, outstanding amounts in commodity derivatives have increased tremendously.
However, commodities are still only catching up with other asset classes in terms of outstandings. They still constitute only 1.76 per cent of the overall OTC derivatives market, given their importance in the global economy.
In comparison, the value of commodities in the global economy exceeds 10 per cent at current prices, suggesting that outstanding commodity derivatives contracts could well grow at a rate faster than other derivatives in the years ahead.
The rapid growth in commodity derivatives is set to continue if the prevailing free market approach to commodity trading stays. The report considers it as a positive development for the world economy because production capacity in a broad range of commodities needs to expand significantly.
While the flow of funds in index-linked investments may increase the overall long exposure to a commodity, there is little evidence that the increase in index-linked commodity investments have helped increase cash prices.
For commodities such as WTI crude oil, corn or gold, which have experienced strong price appreciation in the last five years, the report finds little evidence of futures prices affecting spot prices.
In fact, futures prices used to lead spot prices earlier in the decade, but as depth in the commodity markets grew, this inefficiency evaporated.
As a result, prices along the forward curve have reacted simultaneously to new information in the last four years. If spot price does not follow futures price, the link between commodity index investment and cash prices would not exist.
