London (Platts)--19Sep2012/750 am EDT/1150 GMT

Financial investment is having a much greater impact on the prices of commodities like oil than underlying supply and demand of the commodity, causing price volatility and allowing prices to become removed from the fundamentals for long periods of time, according to a report by the United Nations Conference on Trade and Development.

This has effectively transformed commodity markets into financial markets and demands a "strong and prompt policy and regulatory response," UNCTAD said in a new policy brief based on its own research released Tuesday.

"While commodity-specific shocks have played a key role in the past, especially on the supply side and in the oil market, this factor lacks persuasive power today," UNCTAD said.

"When political shocks occur, the biggest oil producers undertake remarkable efforts to stabilize prices and to compensate for falling supply by stepping up production in other areas. Rapidly, but steadily growing demand for a range of commodities, especially in emerging economies, does not explain the huge swings recorded in many of these markets from quarter to quarter," it said.

UNCTAD said the amount of money invested in commodities by financial investors had risen to $450 billion by April 2011 from $10 billion around the end of the last century, making the volume of exchange-traded derivatives on commodity markets some 20 to 30 times greater than the physical production.

"These investors... do not trade systematically on the basis of fundamental supply and demand relationships in single markets, even if shocks in those markets may influence their behaviour temporarily.... As they hold by far the largest positions in the commodity markets, it is undeniable that they exert considerable influence on the price movements of those markets," the UNCTAD report said.

The UN agency noted the very close correlation between movements in the the prices of WTI crude, the S&P Goldman Sachs Commodity Index and the Euro Stoxx 600 index of European equities during the first seven months of 2012, despite different underlying fundamentals.

'POLITICAL ACTION' ON GLOBAL SCALE URGED

"While fundamentals cannot explain these price co-movements, the stock market and commodities do share one common, critical feature: the dominant position of financial investors," the report said.

"In a situation of widespread herding in financial markets, the assumption of an atomistic market, in which participants trade individually and independently of each other on the basis of their own interpretation of fundamentals, no longer holds," it said.

"The price discovery market mechanism is seriously distorted. Prices can move far from levels justified by the fundamentals for extended periods. Because of these distortions, commodity prices in financialized markets do not provide correct signals about the relative scarcity of commodities.... To restore the proper functioning of commodity markets, swift political action is required on a global scale."

UNCTAD recommended that policy-makers increase transparency in physical markets, through better fundamental data, and in commodity derivatives markets, by collecting more information on market participants and position-taking.

The regulation of financial investors should be tightened, the agency said, possibly by imposing position limits and a ban on proprietary trading by financial institutions involved in hedging activities on behalf of their clients.

UNCTAD also recommended the introduction of a transaction tax, which it said "could generally slow down financial market activities, in particular high-frequency trading."

Some market-watchers have suggested high-frequency trading was behind the rapid, sharp fall in oil futures prices on Monday, when NYMEX crude fell by $3/barrel in less than one minute.

--Richard Swann, richard_swann@platts.com
--Edited by Robert DiNardo, robert_dinardo@platts.com

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