Financialization of Commodity Markets: When Wall Street Discovered Raw Materials

Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010

A Flood of New Money

Chapter 25, written by Kyle Putnam and Ramesh Adhikari, covers one of the most debated topics in commodity markets: financialization. This is Part 1, covering the first half of the chapter. It focuses on what happened, who the new players are, and the theoretical mechanisms through which financial investors might affect commodity markets.

Here is the short version. After the U.S. equity market collapsed in 2001, a whole new class of investors discovered commodity futures. Pension funds, insurance companies, endowments, and hedge funds started pouring money into commodity indexes. Between 1998 and 2008, exchange-traded futures and options volume grew from about 630 million contracts to 3.8 billion contracts. That is a sixfold increase in a decade. Worldwide commodity index investment went from about $50 billion in 2004 to $300 billion by 2010.

Why did they come? Two big reasons. First, research by Erb and Harvey (2006) and Gorton and Rouwenhorst (2006) showed that commodity futures could provide equity-like returns. Second, commodities had low or even negative correlations with stocks, making them excellent diversification tools.

The New Players: Commodity Index Traders

The investors leading this surge were commodity index traders (CITs). These are institutions that use strategic asset allocation and long-only investment policies. Between 2000 and 2009, the number of CITs quintupled. Hedge funds trading commodity futures more than tripled. Meanwhile, the number of traditional hedgers only increased by 1.5 times.

The CFTC tracks large traders and divides them into commercial (hedgers) and noncommercial (everyone else) categories. After 2000, noncommercial long positions as a percentage of total open interest roughly tripled, going from about 11 percent in 2001 to 31 percent by 2016.

Using the CFTC’s proprietary Large Trader Reporting System, Cheng, Kirilenko, and Xiong (2015) found that by 2010, the median notional net long CIT investment had jumped to $2.33 billion, up from $353 million after 2004. And there were only 18 CITs in 2010. They were few in number but enormous in size.

How They Invest

Most financial investors do not buy physical commodities. They invest through the derivatives market, typically in one of two ways.

Option one: invest in a commodity fund that tracks a popular commodity index. The fund manager buys futures directly or enters into OTC swap contracts. The swap dealer on the other side offsets the risk by taking positions in the futures market.

Option two: deal directly with a swap dealer, skipping the fund. Again, the dealer takes offsetting positions in futures.

The growth in OTC commodity derivatives was staggering. Between mid-1998 and 2008, the notional value of all open commodity OTC derivative positions increased 15 times. After the global financial crisis (GFC), volume contracted dramatically, falling back to 2005 levels by the end of 2015.

On the exchange side, commodity futures trading volume kept growing even after the GFC. The energy sector dwarfed all other groups, with trading volume reaching 45 times its 1986 level by 2016. Grains, oilseeds, foods, and fibers also grew substantially, though not nearly as much as energy.

The CIT Controversy

Index traders held almost half of open interest in some agricultural commodity futures. In the live cattle, lean hogs, and CBOT wheat markets, they held more than 20 percent. Because they generally hold long-only positions, they created a persistent one-sided pressure on the market.

This made a lot of people nervous. In 2009, a U.S. Senate subcommittee investigated “excessive speculation” in the wheat market. Michael Masters, a hedge fund manager, testified in 2008 that financial investors were “unequivocally” contributing to energy and food price inflation. He blamed the 2007-2008 commodity price spike on index speculation.

In response, the Dodd-Frank Act was passed to promote market transparency and limit the activity of financial traders in OTC swaps markets. The CFTC also began publishing separate reports on index trader positions starting in 2006.

How Financial Investors Might Affect Markets

The chapter identifies two main economic channels through which financialization could affect commodity markets: risk sharing and information discovery.

Risk Sharing

The traditional hedging pressure theory from Keynes (1923) and Hicks (1939) says that hedgers are typically short and offer a positive risk premium to attract speculators to the long side. Financial investors can improve this risk-sharing process by being natural longs.

But there is a catch. These investors have time-varying risk appetites. During a stock market crash, they might need to dump their commodity positions to reduce overall portfolio risk. When that happens, they flip from being liquidity providers to liquidity consumers, and they transmit price shocks from equities into commodity markets.

Cheng et al. (2015) found exactly this. CITs and hedge funds react negatively during financial distress, pushing risk back toward commercial hedgers. This behavior motivated an extension of the traditional hedging pressure theory that incorporates the time-varying risk capacities of financial investors.

Information Discovery

Financial investors can also mess up the price discovery process. Singleton (2013) argued that informational frictions from speculative activity can push prices away from fundamental values, creating booms and busts. The problem is that when speculation drives prices up, commodity producers cannot easily tell whether the price increase reflects genuine demand or just financial flows. This can distort inventory decisions and create transitory price booms without the typical inventory buildup you would expect from fundamental demand.

Theoretical Models

Three theoretical models capture different aspects of financialization:

Sockin and Xiong (2015) showed that noise from financial trading in futures markets can feed back into the decisions of goods producers. Producers cannot distinguish between price moves caused by investor trading and those caused by real supply-demand changes.

Baker (2016) built a model showing that financialization significantly reduces expected excess returns and the frequency of backwardation in the futures curve. It also implies increased correlation between open interest and spot prices, and higher volatility of futures prices.

Basak and Pavlova (2016) modeled how institutional investors who benchmark themselves to commodity indexes create a new common factor in returns. Their model predicts three things: all commodity futures prices increase with financialization (especially indexed ones), volatilities increase (especially for indexed futures), and correlations rise both among commodities and between commodities and equities.

My Take

This first half of the chapter does a good job laying out the facts and the theory. The numbers are striking. The speed and scale at which financial money entered commodity markets between 2001 and 2008 was genuinely unprecedented. And the theoretical models are compelling, especially Basak and Pavlova’s insight about index benchmarking creating a new common factor.

The big question, of course, is whether all this money actually distorted prices. That is what Part 2 will cover.

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