Do ETFs Push Up the Price of Commodities?

by on January 29, 2014 | ETFs Mentioned:

With ETFs linked to nearly every commodity imaginable, previously hard-to-invest-in commodities now have the potential to be house-hold investments. While you used to need a futures trading account to trade oil, now anyone with an equity trading account can buy an oil ETF; same goes for gold as well as a host of other commodities [Download Everything You Need To Know About Commodities].

But does the added interest and easy access to commodities through ETFs push up the price of that commodity?

Not all “ETFs” Are the Same

While blanketed as ETFs, there are also commodity Exchange Traded Notes, known as ETNs. ETNs do not buy the physical commodity directly, but rather track a commodity index. For example, the iPath S&P GSCI Crude Oil Total Return ETN (OIL, A-) tracks the Goldman Sachs Crude Oil Return Index. While ETNs may draw investors’ interest to a commodity, thus having an impact in a non-direct way, it is very unlikely these sorts of investments are having an impact on the commodity price directly.

Next we have equity-based ETFs, which invest in the companies that produce, store and transport commodities. An example is the Market Vectors Total Return Gold Miners (GDX, B+) ETF, which invests in publicly traded companies in the gold mining business. Once again, this type of investment is not likely to directly affect the price of the commodity [see Ultimate Guide To "Third Generation" Commodity ETPs].

Finally we have the physical-commodity ETFs. These ETFs actually buy the physical asset or buy futures contracts on the physical commodity. It is these types of funds that are generally targeted with the accusation that their product, or speculation in it, may drive up commodity prices [see also Futures Free Commodity ETFdb Portfolio ].

How Commodity-ETFs May Impact Price

The United States Oil Fund (USO, B) buys futures contracts in oil. A futures contract provides the right to buy a commodity at a certain price at a future date, from someone willing to sell it to you at that price. If I want to buy oil one month from now, I can buy a futures contract locking in a price, and if I hold that futures contract until it expires then I can buy the physical oil at the price I paid for the futures contract from the person who sold it to me. Yet most futures contracts don’t reach this settlement stage, because a speculator, or even an ETF, does not want to take possession of the physical commodity if they trade futures. Therefore, the futures contracts get bought and sold or rolled over, but rarely result in physical delivery, except in the case of those who use futures contracts for their business – such as oil producers [see The Ultimate Guide To Resource-Specific "Third Generation" Commodity ETPs].

In this report, Goldman Sachs estimates the price rises by 10 cents for every 1 million barrels worth of oil contracts. The United States Oil (USO, B) holds about 8 million barrels worth, which, according to the GS estimate, equates to about an $0.80 increase in oil. That is of course assuming that those contracts would not have been opened had the USO ETF not been available to investors and speculators.

Looking at oil ETFs currently available, and if Goldman’s assertion is correct, this equals a few dollars of price increase in the price of oil. USO is the largest oil ETF and therefore would have the largest impact.

SPDR Gold Trust (GLD, A-) holds about 29.3 million ounces of gold, or 911 tonnes. According to the World Gold Council 2012 global demand, gold ETFs accounted for only about 6% of the total global gold demand. So, while an important piece of the pie, ETFs don’t have the necessary demand to really drive up the price of gold [see Picture Edition: The Complete History of GLD].

The Flip-Side

While the evidence indicates ETFs may have a very small impact on the overall price of commodities, there is always a flip-side to each story.

Since ETFs are easy to use, it is arguable that they likely showcase the true demand, not necessarily for the commodity itself, but for access to the commodity. Take gold for example. Before ETFs you had to buy physical gold with a large spread, or drastically marked up jewelry. Now, you can invest easily in ETFs, so more people do it because it is a smarter choice. Jewelry accounted for 43% of the global gold demand in 2012, showing that jewelry buyers have a much larger impact on the price of gold than speculators and ETFs [see also 10 Questions About ETFs You've Been Too Afraid To Ask].

It was also found in two major statistical studies, the first conducted by a federal taskforce and the second by Bahattin Buyuksahin and Jeffery Harris, that futures prices change ahead of net position changes by traders. This indicates that speculators and ETF traders aren’t gaming anything; they are simply reacting to the price occurrences after a price shift has already occurred. Since price movement is what generally attracts investors, the same capital flow sequence typically occurs in ETFs.

Every single market goes through extreme ups and downs, and history shows this has always happened … well before ETFs ever existed. Therefore, ETFs can’t be blamed for price rises, or falls. Regardless of what or who is being vilified, we will continue to see spikes and crashes in commodities and commodity-related ETFs, just as we always have. This is why investors need a sound strategy for investing in this area, as the rewards are high, but so are the potential risks to those who don’t understand the market [see also The Ten Commandments of Commodity Investing].

The Bottom Line

Commodity-based ETFs provide easy access to commodity markets that were much tougher for the average person to invest in a decade ago. The popularity of these investments has brought some accusations that they may drive up the price of some commodities. There is some evidence that oil ETFs for example may have a small impact on the price, but even that is impossible to estimate because if the oil ETFs didn’t exist, investors and traders would likely find a different oil vehicle to invest in, or trade futures contracts. The overall effect of ETFs is not large enough to significantly push prices up when compared to global supply and demand. Commodities have always had big swings in price over time, and will continue to, which is why investors needs to closely manage their positions tied to natural resources.

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Disclosure: No positions at time of writing.