Once purchased as a way to diversify out of equities, commodities appear to have become an extension of other risk assets. However, this state of affairs may not be permanent.

The reputation of commodities as a diversification tool has taken a battering of late, as prices have seemingly moved up and down in intractable harmony. However, there is a little agreement over whether high levels of correlation are the new normal, or a symptom of the financial crisis that will fade with time.

Correlation in commodities is manifested in one of two ways – either as price co-movements between individual commodities, or against other asset classes, such as bonds and equities. The recent bout of correlation presented initially within commodities but ultimately mushroomed into high levels of synchronisation across all asset classes.

A key year in the rise of correlations was 2005, when the price of food began to rise rapidly, reversing decades of decline. The price of wheat in January 2006 was $167 a ton, according to the International Monetary Fund. By early 2008, it had spiralled to $481 a ton, sparking riots on the streets of 30 countries.

Alongside the rise in prices came increased co-movements on numerous commodity pairs. From 2006, soybean and oil correlations rose from their long-term average of between -0.2 and 0.2, to as high 0.4 to 0.6, where -1 is uncorrelated and 1 is correlated, according to a 2009 paper by Wei Xiong, a professor of economics at Princeton University, and Ke Tang of Renmin University of China.

Periods of high correlation between commodities are not unprecedented, with the 1930s and 1970s seeing broad correlations across prices of oil and raw materials, probably caused by the Great Depression and later the Organisation of the Petroleum Exporting Countries oil embargo and Yom Kippur war. 

However, in seeking to find a reason for the recent spike in correlations, experts have scratched their heads. Whereas the bubbles in earlier decades were tied to global shocks, the rise after 2005 seems to have no obvious catalyst.

The index effect

Academic studies have suggested a key driver is whether commodities are included in one of the main commodity indices, such as the S&P GSCI or the Dow Jones-UBS. They found that the average correlation of commodities contained in indices was much higher, and it made sense to draw a connection between correlations and the wave of money flowing into index products. Those inflows reached $376bn by the end of 2010, according to Barclays, three times the amount in 2005.

There is little doubt that the profusion of fund flows into commodities indices means that fundamentals play a reduced role in price movements compared with 10 years ago

Michael Haigh

The flow of money into indices became known as the financialisation of commodities, and by the end of the last decade, financial players had become dominant traders of commodity futures and options, outnumbering traditional market users by a ratio of three to one, according to the US Commodity Futures Trading Commission.

“There is little doubt that the profusion of fund flows into commodities indices means that fundamentals play a reduced role in price movements compared with 10 years ago,” says Michael Haigh, head of commodity research at Société Générale. “However, the picture is complex because the role of fundamentals cannot be discounted.”

One impact of the financialisation dynamic is that commodity prices have become less correlated to supply and demand, and that is borne out by a reduced correlation of the oil price with oil inventory levels. Before 2005, there was a close relationship between inventory levels and the oil price, but after that year the relationship breaks down, according to an analysis by Commerzbank, with prices seemingly random against inventories.

GRAPH-Commodity correlation causes headache for investors

The China factor

While financialisation is undoubtedly associated with a rise in correlations, few doubt that another important factor is increased levels of demand associated with fast-growing economies, and in particular China. In Asia it is estimated that 75% of land that could be used for crops is already under cultivation. In India that rises to 95%. China has lost 9% of its arable land in the past 10 years, at the same time as demand for food has increased.

“Intra-commodity correlation has been rising between some commodities since early 2000. This is particularly evident between crude oil and copper, as well as the base metals” says Ric Deverell, global head of commodity research at Credit Suisse. “While it is possible that this is being driven by increased financialisation, to us a more likely cause is the surge in Chinese demand for commodities.”

A complication in the correlation dynamic is that it is not uniform across the commodity universe, and there remains sufficient diversity within commodity sectors to suggest that unquestioning acceptance of the correlation doctrine may be mistaken. An example is the energy markets, where evolving supply dynamics in the US have led to a decoupling of gas and oil price movements. Oil prices remain relatively high, while gas prices have halved since 2008. The catalyst for change has been the expansion of shale gas production.

The diverging fortunes of the oil and gas markets show how difficult it is to generalise over rising correlation in commodities. However, in simple terms, there is a consensus that less liquid commodities such as agricultural, soft commodities, livestock and rare metals offer better diversification than energy and industrial metals, which are more pro-cyclical.

Volatility is key

While correlations between commodities may be the result of financialisation or rising demand, an altogether different dynamic appears to be driving correlations between commodities and other asset classes, though again there is disagreement over what exactly that is. In this case, there is less evidence of a spike in correlations after 2005, with the biggest rises coming following the financial crisis in 2008.

One argument suggests that a key driver in the case of commodity correlation with equities and inverse correlation with bonds is levels of asset price volatility, and a study by Credit Suisse shows a long run connection between the two. Under this view, correlation is likely to decline as volatility abates, and will eventually return to zero.

Intra-commodity correlation has been rising between some commodities since early 2000. This is particularly evident between crude oil and copper, as well as the base metals

Ric Deverell

“While history does not provide a foolproof guide to the future, to us this suggests that as the global economy continues to gradually normalise, the correlation between commodities and other asset classes will also fall back to more 'normal' levels,” says Credit Suisse’s Mr Deverell.

An alternative perspective draws a connection between asset class correlation and monetary policy. Low interest rates and central bank policies of quantitative easing have flooded the financial system with money, advocates argue, that has found its way into commodities.

“With policy rates near zero, expectations for real rates of return in fixed income are negative, which disinclines investors to buy fixed income and incentivises them to buy riskier assets,” says Harry Tchilinguirian, head of commodity derivatives research at BNP Paribas in London.

Here today, gone tomorrow?

Whether increased correlation is caused by financialisation, asset price volatility or monetary stimulus, it appears to have become entrenched for now. However, even that view has its detractors.

“Importantly, we find no evidence of a secular increase in correlations in the past few years,” said Bahattin Buyuksahin, Michael Haigh and Michel Robe in a 2010 paper entitled 'Commodities and Equities: A Market of One'. In fact, equity commodity correlation fell in the period between 2003 and early 2008, the authors claim, compared with equivalent earlier periods.

“Our finding that the co-movements between equities and commodities have in general not increased in the past five years suggests that commodities retain their role as a diversification tool,” the report stated.

Certainly, asset class returns during 2011 suggest the case for correlation is not entirely clear cut. While bonds returned 5.9%, commodities lost 0.7% and equities fell 6.9%, according to Deutsche Bank data. Intra-commodity returns were no more coherent, with base metals losing 22.1%, agriculture falling 9.9% and energy gaining 3.4%.

Meanwhile, a study by Société Générale suggests the impact of fundamentals has risen over the recent period, with 35% of the current Brent crude oil price explained by fundamentals, compared with a low of 13% in 2009.

“We are now back to early 2008 in terms of the impact of fundamentals on the oil price,” says Mr Haigh. “I don’t think we will ever get back to fundamentals having the impact they did before financialisation, but what this shows is that the level of correlation in commodities is a two-way street.”

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