Output Value Risk for Commodity Producers: The Uncertain Benefits of Diversification

Abstract

Significant changes in commodity price dynamics have occurred since 2004, including a strong increase in commodity return correlations. What has been the impact on the uncertainty faced by commodity producers? We answer this question through an empirical analysis of the market value of commodity producers' output, using a sample of 54 countries engaged in the production of 22 commodities. We find that between 1986 and 2012 commodity output value correlated strongly with exports and that its volatility was strongly increasing in the degree of specialization. Between 1986 and 2003, producers specialized in the production of two or fewer commodities experienced an average output value volatility of 25.1%, and producers diversified in three or more commodities faced an average volatility of 14.1%. Average pairwise commodity correlation during this period was 9%. In the 2004-2012 period average commodity correlation was 29%, leading to output volatilities of 25.3% and 18.7% for specialized and diversified producers respectively. We explain this reduction in the benefits of diversification through an approximate decomposition of national output variance in terms of the Herfindahl index associated to diversification in production, average commodity volatility and average commodity correlations.