G. Chandrashekhar

Mumbai , Sept. 22

FUNDS or fundamentals - what drives commodity market prices, is a question that often engages the stakeholders, especially during times of high price volatility.

While fundamentals have always had an impact on prices, the role of funds too has come to be seen as an important influencing factor. On occasions, too much money chases limited supplies with concomitant effect on prices.

Whether there is a causal relationship between prices and physical balances in any market and the extent of causality is another interesting aspect.

If prices are mainly driven by fundamentals, that is, demand and supply, the causality should run from the physical balance to prices. Investors in this scenario would account for market fundamentals in their investment decisions.

If, however, prices are driven mostly by speculative demand, the causality should run from prices to the physical balance. One explanation for this is that investors buy into the market and the prices they set on the exchanges then affect physical demand and supply or market fundamentals.

In an interesting enquiry whether there is strong evidence of speculative forces or whether some measure of market fundamentals is a strong driver, Macquarie Research Commodities examined the relationship between prices and stocks of base metals copper, aluminium, lead, nickel and zinc over a 30-year period, in terms of co-movement between market prices and market inventory.

While checking for correlation, (a correlation of 0 means that there is no relationship at all between two variables, while a correlation of 1 stands for perfect co-movement) found the following:Running a Granger causality test for various base metals over the period, Macquarie Research found a very high level of probability (99.7 per cent for copper and lead; and slightly lower for other base metals) favouring the hypothesis that stocks lead prices; and considerably lower for the hypothesis that prices lead stocks.

Without exception, the causality runs from the physical market to copper prices, that is, prices are above all determined by market fundamentals, according to Mr Jim Lennon, analyst.

It is nevertheless noteworthy that for some metals, such as aluminium, the difference between the probabilities of two hypotheses is not big. This suggests that, at times, prices have moved away from fundamentals, he added.

In a similar test covering the period from January 2004 to August 2005, the analyst found that the correlation between stocks prices has either remained at high levels or even increased.

The Granger causality tests for various base metals over the last 18 months suggested that for copper, aluminium, lead and zinc, stocks/market fundamentals (as measured by reported stock levels) are still the driving factor of price levels; however, investor activity seems to have become more important as reflected in the changes of probabilities.

In the case of nickel, indications are that investors have taken a bigger influence on price levels.

Interestingly, in the gold market the relationship between prices and market fundamentals works unambiguously from financial to physical markets, that is, prices are determined on financial markets and physical markets then follow.

This is not surprising as the gold market has specific characteristics, such as vast over-the-ground stocks (which amounts to an estimated 40 years of consumption). This renders the actual market balance less important than other variables such as exchange rates, in pricing gold, the analyst observed.

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