Commodity price volatility: the reality behind the notion
Arkady Dvorkovich, aide to the president of the Russian Federation and G8 and G20 sherpa
Wildly fluctuating commodity prices have made it more difficult for governments to produce accurate economic predictions and have harmed the potential for growth. The world cannot afford to allow such volatile markets to go unchecked
From "The G20 Cannes Summit 2011: A New Way Forward," edited by John Kirton and Madeline Koch,
published by Newsdesk Media Group and the G20 Research Group, 2011
To download a low-resolution pdf, click here.
Today, the ongoing volatility in energy and commodity markets is central to the political agenda of the G20, but why does it matter in the first place?
In recent years, a number of commodities have demonstrated price fluctuations measured by double-digit percentage points. At extreme moments the price may even double or triple, as once happened to oil prices around the time of the 2008 financial crisis. Due to the magnitude of the economic and political impact of such fluctuations, the world can neither dismiss nor remain a passive observer of these market phenomena.
What is commonly described as volatility represents occasional and not necessarily anticipated price hikes, which undermine governmental efforts at predictable budgets and put at risk the projected profitability of a broader range of business. It is an unwelcome challenge at any time, and even less desirable under the current circumstances.
Exceeding certain limits, it may jeopardise the barely achieved small growth in the aftermath of the world economic crisis that is being currently enjoyed. Volatility also has a considerable impact on economic output, depending on which side of the trade interaction the country or company sits. Price fluctuations may also play a positive role in economic adjustments, sending a signal that may induce a structural change or amendment in market behaviour. The devil is, as always, in the detail, and there is, therefore, a question of what kind of signal and when it comes.
Lastly, there is the issue of whether there is the time or capacity to adapt. If one only relies on the invisible hand of market forces, then government regulation as such remains obsolete. Left unattended, price fluctuations may easily cross the line to where they might develop into energy or food security challenges.
Volatility matters for Russia, because it is a major player in the international oil and gas markets, as well as in markets for some metals, grains and other commodities. An upward dynamic of certain commodities (primarily hydrocarbons, grains and timber) gives the Russian government extra means to fill its exchequer, yet it also has adverse effects on its policy of maintaining a stable and predictable budget. Clearly, Russia cannot complain when prices go up; but it has a sober understanding of the necessity of long-term stability in both trade relations and internal challenges for its currency and inflation.
Following the work of G20 working groups, there has been a series of consultations with market players and regulators on the issue of energy price volatility. Here are some of the results of these consultations:
The volatility discussion that has been taking place at the G20 is directly linked to a broader debate about the need to streamline the regulation of financial markets that, with certain ups and downs, has remained high on the political agenda since the 2008 economic crisis. Mandated by the G20, the International Energy Agency (IEA), the International Energy Forum (IEF), the International Organization of Securities Commissions (IOSCO) and other international bodies are engaged in a fact-finding mission to explore the perceptions of the financial speculation behind recent price spikes and, if any exist, finding who is responsible for that speculation, and then offering some suggestions on what to do.
Remarkably, yet predictably, all these organisations are careful not to draw decisive conclusions. There are at least two reasons for this. First, although references to excessive volatility and abuses in financial markets have emerged as a cliché, there is still no substantive or, more importantly, legal definition of what is meant by these terms. There are no clearly defined criteria for how to differentiate ‘excessive volatility’ from, say, normal or acceptable price fluctuations or how to distinguish decent operations to buy and sell derivatives and other securities from punishable financial speculation that needs to be constrained by regulatory measures.
Second, there is a solid consensus among business people that observed volatility reflects a tightening of the market and fundamental factors, and that to fight volatility politicians need to introduce measures to improve the supply side. Traders believe that it was good news rather than bad when commodity derivatives turned into financial assets: it increases liquidity and facilitates hedging risks in tight markets. Business leaders also warn that any action to constrain derivatives, if not carefully designed, might have adverse effects on the performance of markets.
This perspective is not without argument, but there is another side of the coin. Institutional investors that demonstrate growing interest in investing in commodities have made the interconnection of physical and financial markets much tighter. The amount of resources invested increased from $13 billion in 2003 to between $180 billion and $200 billion in 2008. These factors contribute to price hikes being deeper, speedier and more dramatic.
Moreover, financial players do not think in terms of high or low prices. They earn their income from price differences – in other words, the more volatile the environment, the more profit they make. Bullish behaviour is the dominant strategy for those who invest in ‘paper’ instruments, as it is an easier strategy to follow.
Finally, a decade ago, financial institutions generated about 15 per cent of the profits of US companies. Today, their share has grown to 45 per cent. Almost a million new fortunes have been created through financial operations. In other words, after becoming an asset in itself, investment in securities, especially derivatives, became more attractive than any investment into the ‘real economy’ – a hedging instrument from a subsidiary function turned into a primary one that overshadows physical trade.
With regard to Russia’s position, it is uneasy about substantial and unpredictable price fluctuations in commodities in world markets. This volatility creates extra risks for operational stability for a number of key sectors of the economy, as well as for monetary policy and budgetary planning. Russia has no intention of being associated publicly with any move to unduly raise the prices for end consumers.
What is Russia’s standpoint? Russia suggests that the G20 consider the following recommendations:
Any discussion of whether commodity prices should be high or low makes little economic sense, since those fluctuations reflect not only the dynamics of the balance between supply and demand, but also major macroeconomic factors and, not least, the financial policies of the United States and European Union (including US dollar exchange rates).
The G20 should call on experts to come up with draft definitions of what constitutes excessive volatility and speculation or abuse of the market. Without a consensus on what these labels mean, no constructive discussion is possible, much less proposals for practical measures.
Russia supports the extension of Joint Organisations Data Initiative (JODI Oil) to other commodities starting with natural gas (coal is tricky from technical point of view), with the caveat that this makes sense only if data on the financial aspects of respective markets are collected concurrently. If the gap between knowledge of ‘physics’ and ‘money’ remains as it is, there will be no basis either for analysis or for practical action.
Russia has already started to apply this approach on the national level, introducing a law on the State Information System on Energy, which passed its first hearing in parliament in September. This experience could be useful if all agree that it is necessary to explore the creation of a global information system on energy data, supplementing existing databases of national and international bodies.
To conclude, the keys to success are a closer dialogue between the consumer and producer countries and the coordination of the energy policies of the major players. When, as happened in the spring, Russia learned about the release of US oil reserves from media reports and not from its counterparts on energy, it does not contribute to price stability. My strong belief is that this was just an exception that proves the rule. The rule is that everyone sits in the same boat, and only synchronised and carefully crafted energy policy will keep that boat afloat in the turbulent waters of today’s economy.
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