High-frequency traders have caused U.S. commodity futures prices to disconnect from market fundamentals of supply and demand since the 2008 financial crisis, according to one of the authors of a forthcoming U.N. report.
Also known as black-box players, they plug algorithms into computers to generate numerous, lightning-speed automatic trades that are designed to make money from arbitrage on razor-thin price differences and movements.
An increasingly high correlation between commodities and equities, caused largely by high-frequency traders, means that prices for oil and other U.S.-traded contracts are more exposed to "sudden and sharp corrections", said a draft report seen by Reuters.
High-frequency trading is estimated to account for over half of all U.S. equity trade volumes and a smaller but rising share of commodity futures trades.
The study suggests that these players have penetrated deeply into energy and agricultural markets with the growth of electronic trading.
"The strategy of those involved in high-frequency trading tends to reinforce the correlation between equities and commodities," said one of the report's authors, Nicolas Maystre, an economic affairs officer at the United Nations Conference on Trade and Development (UNCTAD).
"We are not saying that it's all about speculators and (that) fundamentals don't matter. But we are saying that they tend to matter less, except in extreme cases," he added.
The report examines the front-month contracts for NYMEX-traded WTI oil as well as sugar, wheat, corn, soybeans and live cattle between 1996-2011.
It concludes that there is growing evidence that "the financialization of commodity markets has an impact on the price determination process", which is important for two reasons.
"First, it questions the diversification strategy and portfolio allocation in commodities pursued by financial investors.
"Second, it shows that as commodity markets become financialized, they are more prone to external destabilizing effects," the report said.
Unlike other studies on commodity prices, based mostly on daily prices, the UNCTAD study uses 'ticks', a measure of trading activity that can be recorded every millisecond, to gain better access to intra-day trading patterns.
The report shows that the number of trades recorded by vendor Thomson Reuters' tick history has nearly doubled on benchmark U.S. crude since 2008 to over 41 million, indicating that a new breed of financial investors has joined traditional parties such as big producers and consumers.
Correlation between commodities and other markets strengthened after the collapse of Lehman Brothers in 2008 as investors collectively shifted their focus from supply and demand fundamentals to clues about economic recovery.
One of the ongoing dangers of the disconnect with fundamentals is higher volatility and the risk of a sudden sharp correction, the report said.
"These investors (high-frequency traders) don't have a real physical interest in markets, so if markets are now just responding to equity, it creates a destabilising effect on commodities ... It can create bubbles," said Maystre.
In equity markets, U.S. regulators found that these traders were a factor behind the "flash crash" of May 2010 when stocks plunged suddenly and for no fundamental reason.
Another consequence is that investors seeking to diversify or hedge against other investments in their portfolio are often disappointed, the report said.
For most of the second half of last year, a fresh scare in the euro debt crisis or a weak economic number could lead to a rise in the dollar, and risky assets such as equities and many commodities would sell off in lockstep.
This year, fund managers say, the trading patterns of commodities and other risky assets such as stocks are likely to increasingly diverge and fundamentals play a stronger role as economies start to recover. (Additional reporting by Tom Miles, editing by Jane Baird)