For more on this topic, see “The Development of Oil Investment Vehicles.”
This is an issue that will not go away – the idea that investment in commodities can have an important impact on both the levels and the volatility of those commodities, despite a lack of observed connection between commodity prices and commodity investment funds. Recently, the Commodity Futures Trading Commission (CFTC) proposed limits on futures trading by ETFs (Exchange-Traded Funds).
In the spring and summer of 2008 oil prices rose to over $145 barrel, increasing the popularity of commodity investment funds. Regulators and policymakers, sensing a correlation between the growth in commodity investment funds and oil and other commodity prices, argued that the investment community was driving up commodity prices (and adding to their volatility) and was seriously hampering the development of our commodity markets.
To understand this issue one must first understand that commodity investment funds do not actually buy physical commodities – they buy derivatives like forwards, futures, and options, which have payoffs that are linked to the prices of the commodities. In other words, they are making bets on the prices of the physical commodities, but they are not actually buying the commodities.
It is certainly the case that flows in and out of commodity funds influence the prices of commodity derivatives. For example, when investors buy more oil futures, the price of oil in the futures market is likely to increase. The relevant question, however, is whether prices in the derivatives markets influence the prices that producers and consumers pay when they purchase the physical commodities. In other words, do bets in the derivatives markets affect the price that we pay for gasoline at the pump?
As a useful analogy, let’s think in terms of a football game and the question of whether or not football betting influences the outcome of the game. We all understand that betting on football cannot influence the outcome of the game unless, of course, the betting market directly or indirectly influences the players. If the players are influenced by the betting market, then yes, of course, the betting can influence the outcome of the game. This is why we don’t like to see football players gambling on football games or even hanging out with known gamblers.
To complete the analogy, let’s first think about the industrial producers and users of the commodities that are also involved in the derivatives markets. The derivatives markets clearly benefit these participants. However, since these players are essentially betting on their own games, there are reasons to be concerned about their potential to manipulate prices in the derivatives as well as the spot markets. However, the individuals and institutions who invest in commodity funds are more akin to the casual sports bettor rather than the actual players. The question is whether these individuals can influence commodity prices?
Again, the football analogy is useful, and the relevant question is whether the betting odds on a game can influence the players. If a player sees that his team is a 30 point favorite, then the motivation to practice hard and play hard is bound to be affected. For similar reasons, the futures price of oil influences decisions to produce and store oil. Specifically, when the futures price is high, there will be more drilling, increasing supply in the future, which in turn lowers the actual prices people pay in the future. However, when the futures price is high relative to the current spot price, there will also be a greater incentive to store the oil, which will increase the current spot price.
So investment flows into and out of derivatives contracts can in fact influence the prices that people actually pay for the physical commodity. The question is then, whether the magnitudes of these affects are large – can these flows explain the recent volatility of prices? – and is this good or bad?
The effect of commodity fund flows on drilling choices is difficult to determine. It’s a bit like asking whether football players are influenced by the point spread – they probably are influenced, but it’s difficult to gauge by how much. In any event, the affect on drilling choices today will have very little effect on current prices. The potential effect of futures prices on storage is somewhat more straightforward to understand and recent evidence suggests that the combination of derivative prices and storage stabilized rather than destabilized the oil markets.
Indeed, during the run up in oil prices at the beginning of 2008 the spot price for oil was considerably higher than the futures price for delivery in 12 months, providing an incentive to reduce storage. By taking oil out of storage and putting more supply on the market, the spot price increase was dampened. Then at the end of 2008 as spot prices for oil were crashing, futures prices stayed above spot prices, creating an incentive to store oil, softening the collapse.
If anything, the volatility in the oil markets over this period of time was caused by a lack of storage capacity that has not grown nearly as fast as the overall oil market. So if policymakers are serious about dampening volatility, they should encourage the growth in storage capacity. What does this have to do with derivatives markets? An active derivatives market makes investments in storage facilities more attractive, because it reduces the risks associated with storing commodities. Hence, policy initiatives to dampen speculation and hedging in derivatives markets are likely to make storage less attractive, which will in turn, increase rather than decrease the volatility of the actual physical commodity prices.
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