Correlation problems in commodity land

One of the significant advantages of holding a commodity portfolio is not just that the portfolio is uncorrelated with traditional assets but that there is a lack of correlation across commodities. The lack of correlation between different commodities is important because it significantly dampens the overall volatility of the commodity portfolio. There is very little correlation between soft commodities, grains, metals, and energy. In fact, there is often very little correlation between commodities within these sectors. Of course, there are exceptions say between oil and refined products, but there is little relationship between grains and say coffee, sugar or cocoa.

A problem arises if there is a common spike or shock in commodity markets because then there is a marked increase in correlation. The combination of higher volatility within the market and rising correlation across markets has a high impact on risk. This is what has happened this summer between June and September. This is not fully revealed in the correlation numbers given their construction but is very evident in the price movement.

The combination of a price decline with rising volatility has caused many in the long only index commodity space to pull out of the market which has only exacerbated the problem. One more place of delevering driving price behavior after a real shock.