Explaining the Bubble in Commodity Prices

Commodity prices soared for several years until collapsing over the last couple of years. The puzzle has been why prices soared. Was it manipulation? Cartels? Insiders and speculators? There’s an interesting paper digested in FTAlphaville blog that makes a good case. It says the price signals of the commodity markets were distorted. Investors in other assets (housing and stocks) were looking for other places to put their money and selected commodities for a chunk of it. This appeared to increase the demand for commodities. The demand wasn’t from users of the commodities but from investors and those trying to securitize them. Eventually the market corrected, but the influx of new investment money temporarily distorted prices and confused suppliers.

So while speculative inflows don’t necessarily stop supply and demand balancing in the end, they can delay or obscure the price balancing process in such a way that distorts the market for longer and makes it more volatile.

A similar argument can be made today about prime housing stock. Are prices really rising because of a lack of supply? Or are they rising in response to financial collateral needs, which are disguising the real-world demand destruction that is taking place at those price levels.

If there are lessons to be learned from 2008, it’s that if and when the encumbered stock is unencumbered and/or if additional supply (created to cater to what was construed to be real world demand but is really financial demand) hits the market in a way that shows up a slew of empty property inventory, prices could collapse much in the same way.

For now, just like in 2008 with commodities, we are still being mislead by the idea that emerging market (and especially Chinese) demand will keep prices supported no matter what. We are also failing to grasp the difference between real end-user demand and financial collateral demand, and why it is so important in determining fair value.