As gasoline prices rise, despite stagnant demand, observers want to pin the blame on someone. It can’t be the refineries, since they’re making so little profit that they are going out of business. And there have been more oil assets going into production. So why the change?
Many think the answer lies in futures markets. There are two, very different, explanations. One is the explosion in commodity ETFs. There is a steady drumbeat among U.S. politicians that growing institutional interest as well retail vehicles necessarily push up the prices of commodities. Here’s the 2009 testimony of Michigan Congressman Bart Stupak before the the Commodities and Futures Trading Commission:
“According to CFTC data, from January 2008 through the end of June 2008, index investors poured $55 billion into major commodity indexes, pushing the price of crude oil from $99 per barrel to $140 per barrel. Gasoline prices spiked to a national average of more than $4 a gallon, with prices reaching more than $5 a gallon in some regions of the country.
“That same market collapsed over the course of the next six months, with prices plummeting to $30 per barrel by December 2008 as investors withdrew $73 billion from the market. This was not a coincidence. The dramatic drop in oil prices was occurring at the same time index investors fled the market. From January 2009 through May 2009, you can see the price rise from $35 per barrel to $70 per barrel as index investors come back into the market and pour in $35 billion into major commodity indexes.”
Stupak has, in some sense, ploughed furrows now being walked by UN, in a paper called “Price Formation in Financialized Commodity Markets: The Role of Information,” prepared by the secretariat of the United Nations Conference on Trade and Development.
The “financialization of commodity markets,” the report says, “has increased significantly since about 2004, as reflected in rising volumes of financial investments in commodity derivatives markets – both at exchanges and over the counter (OTC). This phenomenon is a serious concern, because the activities of financial participants tend to drive commodity prices away from levels justified by market fundamentals, with negative effects both on producers and consumers.”
The argument is that, far from the efficient markets hypothesis, where all the relevant information is already baked into the price, “market participants also make trading decisions based on factors that are totally unrelated to the respective commodity, such as portfolio considerations, or they may be following a trend. Therefore, it is difficult for other agents in the market to discern whether or not their transactions are based on information about fundamentals, which in any case is sometimes difficult to obtain and not always reliable. … A wide range of motivations leads traders to engage in this so-called ‘intentional herding’ on a perfectly rational basis, the most important one being imitation in situations where traders believe that they can glean market information by observing the behaviour of other agents.”
So it seems, and this leads to the second explanation, it’s not the mass of investments into commodities markets – since as Stupak points out, that money can run hot and cold, just as it can for stock markets or any other investment vehicle (Canadian real estate, anyone?).
The problem may rather lie in new trading patterns. That’s what David Bicchetti and Nicolas Maystre, also at UNCTAD, argue in a recent paper: “The synchronized and long-lasting structural change on commodity markets: evidence from high frequency data.” Trading seems to reduce the benefit of holding what were formerly considered to be negatively correlated assets. But how did negatively correlated assets become positively correlated?
Bicchetti and Maystre write: “commodity investment specialists, asset managers and investment banks have created new products linked to commodities to satisfy the demand from investors. Consequently, the volumes of exchange-traded derivatives on commodity markets are now twenty to thirty times greater than physical production. By contrast, in the 1990s, financial investors accounted, on average, for less than 25 per cent of all market participants. Today, in some extreme occurrences, financial investors represent more than 85 per cent of all commodity futures market participants.”
But financial investors are not, as might be supposed, long-only institutional style funds, be they pension plans or retail ETFs. Instead, they note, that in the financialization of commodities markets, “the proponents would usually argue that the presence of these new types of agents in commodities markets would ease the price discovery problem and bring the price closer to its underlying fundamentals. In addition, it would provide further liquidity and transfer risks to agents who are better prepared to assume it. On the other hand, a growing number of studies provide evidence of price distortions linked to the financialization of commodity markets. Most of these studies base their analysis on index trading. How, since 2008/2009, investors prefer more active investment strategies on commodity markets than simple index trading.”
Active trading is the fly in the ointment. As high-frequency traders seek to arbitrage in all markets, with algorithms, then “the recent price movements of commodities are hardly justified on the basis of changes of their own supply and demand. In fact, the strong correlations between different commodities and the S&P 500 at very high frequency are really unlikely to reflect economic fundamentals since these indicators do not vary at such speed. …Our analysis suggests that commodity markets are more and more prone to events in global financial markets and likely to deviate from their fundamentals.
“This result is important for at least 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.”
In other words, diversification doesn’t work if everyone is diversifying the same way at the same time. Just ask the guy at the gas pump how long the discount will last if he sets his price a penny lower than his competitors.