Commodities have seen a roller coaster ride in 2022. Right from Saudi Aramco to Exxon, oil companies are reporting bumper earnings and in the current calendar year, most of these companies have recorded the highest earnings in their history. From next month, sanctions on Russian Oil will kick in that may spell another round of volatile moves in crude. Meanwhile, Russia is imposing its own set of restrictions on Ukrainian wheat and food security in the Middle East and African countries are under threat as Ukraine supplies 10% of global wheat. The Russian embargo has pushed wheat prices ($8.73 bushel) 50% higher than the 2019-21 average. Against the backdrop of topsy-turvy events in the commodities world, Fortune India’s Rajiv Ranjan Singh spoke with Ivo Sarjanovic, Professor, Agriculture Commodities at the University of Geneva in Switzerland. Ivo is also a co-founder of HEDGIT, a Geneva-based commodities fund. Here is the excerpt from the interview:

1) Why have commodities swiftly moved up after the pandemic and then in the second half of 2022, fell despite the Russia-Ukraine war? Do you think, war is good for global commodities?

Sarjanovic: Commodities bounced since April-May 2020 due to supply chain bottlenecks, serious weather problems leading to smaller crops, energy transition bumps in Europe, and inflation as a consequence of loose monetary policy dominated by fiscal expansion as a response to Covid economic contraction.

War is a shock to normal commodity flows. War could be bullish if any of the participants is a big supplier like Russia in energy or Ukraine in agriculture or it could be bearish if any of the participants is a big buyer like China. For example, if China would decide to invade Taiwan, we may see first a round of security reserve purchases by China leading to higher prices, followed by a collapse of import demand during the war leading to lower prices.

Commodity prices have been falling since April 2022, not due to the war but due to the end of QE by the Fed leading to higher interest rates, a stronger USD and the prospects of slower GDP growth or potentially a recession, which are negative for commodity prices in general. The slowdown of the Chinese economy due to Covid and other economic motives is negative too. The driver of lower prices has been mostly macro, not the war. If the war would stop now, commodity prices would go further down.

2) Do you believe the price spike in commodities after the pandemic was more related to speculation and supply constraint rather than demand?

Sarjanovic: I don't think commodities hedge funds or speculation can drive and hold prices above fundamental levels structurally. Funds are the catalyst of price changes because they react faster than commercial players but they are not ultimately responsible for the price level. Eventually, funds can disconnect prices from fundamental equilibrium in the very short run but if the delivery mechanism of an organised futures market works well, you have a convergence between derivatives and physical whenever the next open position becomes spot. And this happens several times per year.

3) Can you give a ballpark figure for institutional money chasing commodities like agriculture commodities, precious metals, crude, etc., and how much upmove in prices in the past two years or the last decade can be attributed to institutional investment or speculation?

Sarjanovic: Big picture, by October 20th, index funds have something like $110 billion in both the Goldman Sach Commodity Index (GSCI) and Bloomberg Commodity (BCOM) indices. So that’s $220 billion total in the hands of index funds. Then hedge funds have another $10 billion in agriculture and $40 billion in energy while they are flat in metals.

So approx. $270 billion in total from institutional money is chasing commodities. Obviously, this is only derivatives and does not include physical ownership, if any. You will note that these numbers are pretty small compared with the size of equities and bond markets.

4) Where do you see demand destruction will creep into industrial metal, crude or agriculture commodities? How much price rise from current levels can be absorbed before demand destruction comes into play?

Sarjanovic: I believe we are already seeing demand destruction in some markets. For example, the wheat world flows may shrink by 5% and 3% in maize and soybean meal, respectively. Prices are high in US Dollar terms but they are even higher in local currencies due to the devaluation of several currencies against the US dollar. The Brazilian Real is the only exception. If the Brazilian Real would have devalued like other currencies, the prices of some agricultural raw materials would be lower. People used to say that the demand for agricultural goods is inelastic to high prices but this is valid only if one or a few prices move up while the rest is unchanged when you have most of the agriculture prices sharply up together with higher energy bills, higher rent, higher interest rates and the prospects of higher unemployment, demand suffers.

5) Do you believe the boom in commodities, especially industrial metals, is coming to an end on the back of central bank tightening?

Sarjanovic: I believe that central bank tightening leads to higher interest rates, if the Fed tightens faster or more aggressively than other central banks, the dollar gets stronger and this is a headwind for commodities in general. It’s quite difficult to imagine commodity prices moving up if the world economy is not growing unless you have some severe supply shocks. Industrial metals are very dependent on China’s purchases and the energy transition path.

6) Can you provide numbers that illustrate how commodities behave in a rising interest rate regime? Especially agri-commodities, and industrial and precious metals?

Sarjanovic: Commodity prices don’t react just to interest rates but also to supply and demand changes. Higher interest rates mean slower growth prospects. And commodity demand is very dependent on GDP growth. You can compare the evolution of any commodity price index since April 2022 and you will see that in spite of the bullish impact of the war, commodity prices are lower as interest rates went up.

Ivo Sarjanovic

End of QE triggers demand destruction in commodities, says agri expert Prof Sarjanovic