Feature – Commodities


By April, inflation reached a 30-year high of 7% and rising commodity prices have been named as a key culprit by Jon Cunliffe, the Bank of England’s deputy governor for financial stability. “We have already started to see some of the effects on commodity prices, including for energy and food,” he said in a speech in April. “Global oil prices have increased by 11% and UK wholesale gas prices have increased by 40% since the inva- sion,” he told the audience at the European Economics & Financial Centre.


This is also a concern for Evan Guppy, head of liability-driven investment (LDI) at the Pension Protection Fund (PPF). “The outlook for inflation has materially deteriorated since the start of the year as a result of further sharp increases in the cost of basic commodities, in particular energy commodities. “These increases have started to feed into consumer prices and will continue to do so in the coming months as businesses pass those higher costs on to consumers.


“The war in Ukraine is a big part of the reason for these increases, with Russia and Ukraine important commodity exporters of, for example, oil, gas and wheat,” Guppy adds. “Headline inflation in the UK will move sharply higher in the next couple of months with the large increase in the energy price cap in April the main driver.”


Not about the money But a closer look at the market reveals a more nuanced outlook. First, it is not so much a shortage of commodities that is driv- ing such turbulence. Globally, the net production of wheat,


grain and cereal is expected to be in line with last year’s figures as other countries have increased their harvests, says UN agency the Food & Agriculture Organisation. While the regulation of metal and energy output is more diffi- cult to adjust, the defining challenge of the crisis seems to be price volatility and distribution rather than price rises. This was picked up by Cunliffe in his speech. “Prices have been extremely volatile, reflecting uncertainty about the course of the war and imposition of sanctions. Had I given this speech at the start of the last Monetary Policy Committee round, the increases would have been 22% and 116%, respectively. Had I given it two weeks later, when the decision was announced, they would have been 10% and 17%.


Short squeeze


Headline inflation in the UK will move sharply higher in the next couple of months with the large increase in the energy price cap in April the main driver.


Evan Guppy, Pension Protection Fund


This is largely due to the impact of derivative markets on day- to-day pricing. The prices of commodities have been influ- enced by speculation about future prices, in a way no other asset class has. The first futures contracts for commodities were found in ancient Mesopotamia in around 4500 BC in the form of clay tokens while modern commodity trading in the US and Europe goes back at least 150 years. As such, commod- ity prices have always been influenced by traders’ perception of supply, rather than the actual availability of those commodities. Commodity markets were already heated prior to the first bul- let being fired in Ukraine, with a surge in demand for timber, for instance, causing exchanges such as the Intercontinental Exchange to lift their margin rates for trading gas futures. For example, margin costs for trading brent crude oil have more than doubled during the past year, which in turn has dried up market liquidity and led to an increase in short squeezes. This decline in futures trades affects the physical commodity markets. Firms that trade physical commodities use futures to manage risk. This has created a paradoxical situation where farmers banking on increased demand for wheat are unable to sell their goods because commodity trading firms have reduced shipments due to the lack of liquidity in the futures market.


Inflation impact


Does all this mean that commodities will continue to drive up inflation? Not necessarily, argues George Calhoun, professor at Stevens Institute of Technology. “The relationship between the prices of raw commodities and those of finished goods is weak and is getting weaker. In the 1960s up until the 1980s, the cor- relation of steel to car prices was 53% and it’s been a negative 11% since the 1990s. The percentage of the cost of a box of Kel- logg’s cornflakes that actually is contributed by corn is between 2% and 4%,” he says.


“The value in consumer goods today is not coming from com- 36 | portfolio institutional | May 2022 | issue 113


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