1. Why and how are commodity producers using derivatives markets?
  2. Why and how are commodity end-users using derivatives markets?
  3. What is the role of commodity investment funds and how do they behave?
  4. Are middle and long-term fundamentals affected by short-term shocks?
  5. Is commodity price volatility higher since 2000 than in the past?
  6. Why are commodity futures markets many multiples larger than the size of the underlying physical market?
  7. Correlation and causation: does one thing cause another, simply because it came first?

  1. Why and how are commodity producers using derivatives markets?

    The production of commodities (energy as well as food or metals) involves costs and risks at multiple stages of the process. Commodity producers use commodity derivatives to hedge, or insure their production, consumption, or working inventories against the uncertain effects of fluctuating prices.

    Here are some common examples of how different sectors commonly use derivatives:

    Oil companies use energy derivatives to adjust their exposure to price fluctuations of crude oil, refined products, natural gas, power and coal. They use freight rate derivative contracts in their shipping business to adjust their exposure to freight-rate fluctuations. As part of their financing and cash management activities, oil companies also use derivative instruments to manage their exposure to risks of changes in interest rates, foreign exchange rates and commodity prices.

    Steel and aluminum producers use energy derivatives to adjust their exposure to fluctuations of oil, natural gas and coal. To make aluminum out of the Bauxite, a tremendous consumption of power is needed.

    Agriculture producers have an unpredictable factor in their a production-to-distribution chains that are of less importance in the metal or energy spheres: geopolitical risks (unilateral export ban, breach in the chain due to civil wars or destruction of storage or transportation capacities, climate shocks). As a result, commodity price risk arises  from transactions on the world commodity markets for securing the supplies of cereals, coffee, cocoa…all of them being necessary for the manufacture of food products crafted by food commodity end-users (like Nestlé, Unilever or Danone).

    Agriculture producers, therefore, use derivatives to adjust their exposure to price fluctuations and also customized hedges. Derivatives help bakeries manage price volatility of their flour so that their retail prices for baked goods can be as stable as possible for consumers and grocery stores. Derivatives also help restaurant chains maintain stable prices on their chicken so that they can offer consistent prices and value to their customers when selling chicken sandwiches.



  2. Why and how are commodity end-users using derivatives markets?

    The purchase and use of commodities for manufacturing products (food commodities, metals, oil used for plastic materials) or for power and energy (gasoline, jet fuel, coal) involves multiple costs as well.

    Commodity end-users, like producers, use commodity derivatives to hedge or insure their consumption, or working inventories against the uncertain effects of fluctuating prices.

    Here are some common examples:

    Airlines use suitable derivatives to implement effective hedges of price risks for future fuel consumption and future emission certificates.

    Food companies use not only commodity derivatives but also currency forwards, futures, options and interest rate forwards. Like producers, they face commodity price risk arisen from transactions on the world commodity markets for securing the supplies of green coffee, cocoa beans, cereals, milk and other commodities necessary for the manufacture of end-products. They hedge these risks through the use of exchange-traded commodity derivatives. The commodity price risk exposure of anticipated future purchases is managed using a combination of derivatives (futures and options) and executory contracts (differentials and ratios). The vast majority of these contracts are for physical delivery, while cash-settled contracts are treated as undesignated derivatives. As a result of the short product business cycle of their activities, the majority of the anticipated future raw material transactions outstanding at their balance sheet date are expected to occur in the next period.

    Producers and retailers of consumer goods enter into derivative transactions as part of their strategy for hedging foreign exchange and interest rate risk. They may also use equity-based derivatives to create synthetically an economic exposure to certain assets. Luxury watch and jewellery activities are exposed to price fluctuations of precious metals (gold, platinum, rhodium). In order to insure their consumption or inventories against the effects of price swings, they use derivatives consisting of contracting physically settled futures or options.

    IT companies use derivatives to partially offset their business exposure to foreign currency exchange risk. They may enter into foreign currency forward and option contracts to offset some of the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales, on net investments in certain foreign subsidiaries, and on certain existing assets and liabilities. They also use derivatives to hedge their risks related to commodities that are necessary for manufacturing IT devices and computers (rare earths like palladium and copper).




  3. What is the role of commodity investment funds and how do they behave?

    Over the past 10 years, there has been an inflow of capital into commodity investment funds. This is often used to show how and why financialization is adversely affecting commodity prices and price volatility.

    However, as Professors Irwin, Sanders and Merrin have written: “Simply observing that large investment has flowed into the long side of commodity futures markets at the same time that prices have risen…does not necessarily prove anything. This is more than likely the classical statistical mistake of confusing correlation with causation.” They go on to say that “There is little evidence that the recent boom and bust in commodity prices was driven by a speculative bubble.”

    The fact is, long-term financial investors are helpful not only because they bring capital but also because they can bring balance. In equity markets, long-term investors bring stability in issuers’ shareholdings and governance; equally, in commodities markets long-term investors bring stability, especially when the markets have to face short-term events that have immediate effects (climate shocks, changes in political situation – in particular individual political decisions: Russia’s export ban on wheat, China’s limitation of production of rare earths, Thailand’s export ban on rice).

    Short-term investors (investment horizon within the commodity cycle) can intensify very short-term trends because of herding, but not create them; the empirical evidence, which comes from the US Commodity Futures Trading Commission, confirms that index investors do not amplify prices away from fundamentals beyond the very short-term. Strong market abuse rules enforcement is crucial for the sake of commodity producers, commodity end-users and of course end-customers.

    Regarding the facts and data, the global production value across the 23 biggest commodity markets in 2011 exceeds US$8 trillion. In comparison, managed money (investment portfolios) linked to commodity prices is around US$400 billion, of which more than half (US$260 billion) is in passive indices: passive index investors invest money in commodity markets and hold that investment for long-term gain.

    This means that the total collective positions of all financial investors represent less than 5% of the production value of global physical commodities markets and that only 1.75% pursues an active investment strategy (short-term). The physical value calculation excludes all consumers and middle-men (e.g., transporters of commodities), which would shrink the relative size of commodity paper investments even further. Investors with active investment strategies have to be monitored since their reactions to booms or busts within the cycle can affect short-term prices and then accelerate some trends but long-term investors provide patient and ever-reliable capital and only expect a fair and reasonable rate of return over the long run.

    But let’s have a look at the functioning of commodity futures market, such as ICE Brent or CBOT wheat. They are not trading the underlying commodity. These futures markets are trading the probabilities of where crude oil and wheat prices will be at certain points in the future, as derived from the real and ever-changing fundamental risks in the underlying and other physical markets. As these risks change constantly due to unpredictable weather and numerous other fundamental factors (for instance export bans), greater futures paper volumes will produce better transparency and more precise price discovery. Moreover, arbitrage keeps physical and paper markets in constant communication with each other, while contract expiries regularly force a clearing (once per month in oil) of forward-looking assessments back to the current condition of the underlying physical markets.

    In this context, investors in index products are regular sellers of futures, as they must routinely roll their positions as expiries near. Moreover, because they target certain dollar exposures as a share of their total portfolio, as prices rise the index investors’ demand for futures falls and they buy less during rolls. Conversely, when prices fall, the portfolio weights also fall below target and the index investor will buy more to offset the shortfall. In this way, the index investor adds to the overall stability of the market because he is a net seller when the market calls for supply and a net buyer when the market calls for demand.

    One example from the CBOT wheat market:

    In 2007-08, the net position of index investors steadily dropped from 201 thousand contracts (January 2007) to a low of 127 thousand contracts (December 2008) while prices were high. As prices bottomed in 2009 and 2010, index investors started increasing their net exposure, from the 127 thousand contract low in December 2008 to nearly 230 thousand contracts by mid-May 2010.

    When foodstuff prices were at recession lows in 2009, many developing countries have benefited from long term investment funds which bought the paper food markets and gave farmers liquidity for hedging their forward price risk, rather than carrying that risk entirely in a cash market depressed by economic recession.

    In parallel, after a poor wheat harvest in 2010, Russia banned physical wheat exports, exacerbating food shortages in poorer countries and creating higher price volatility for consumers least able to weather it.

    Contrary to assertions that index investors were (a) buying increasingly larger quantities of wheat during 2007 and 2008, and (b) doing so without regard to fundamentals, CFTC data show that index investors were steadily selling down their quantity exposures as the unit value of wheat increased.



  4. Are middle and long-term fundamentals affected by short-term shocks?

    No. The principal driver of rising price levels is the rapid escalation of marginal production costs in the middle and long-term. Short-term shocks are affecting prices only in the very short-term.

    The rising costs are the direct consequence of strong and sustained emerging market demand growth, exhausting spare capacity and forcing investment in costlier and ever-more-difficult-to-access sources of supply.

    As Nobel Prize winning economist Paul Krugman pointed out in a recent editorial, “Price volatility exists in our markets because we live in a ‘finite world’ where there is not…an inexhaustible supply of oil, wheat, milk or other physical commodities to meet the global demand for such products. Simply put, sometimes prices are higher because the demand for a product around the globe is greater than the supply.”

    Numerous studies – from the FAO, IFAD, IMF, OECD, UNCTAD, WFP, World Bank, WTO, IFPRI and UN HLTF support this view. The study, “Price Volatility in Food and Agricultural Markets: Policy Responses” May 3, 2011, highlights the key fundamental drivers that are driving current and coming food prices and price volatility.

    According to the study:

    • “Growing population and income in emerging and developing countries will add significantly to the demand for food in the coming decades. By 2050 the world’s population is expected to have reached about 9bn people and the demand for food to have increased by 70% to 100%. This alone is sufficient to exert pressure on food commodity prices.”
    • “Agricultural commodity prices are becoming increasingly correlated with oil prices. Oil prices affect agricultural input prices directly and indirectly (through the price of fuel and fertiliser, for example). In addition, depending on the relative prices of agricultural crops and oil, biofuel production may become profitable (without government support) in some OECD countries.”
    • “Climatic factors have indisputably contributed to the price rises in 2007-2008 and again in 2010. In 2008, an already tight market situation for wheat was aggravated by drought in Australia, which is an important supplier of wheat to world markets. Canada, another important supplier, also experienced weather related low yields for several crops. More recently, drought followed by fire in the Russian Federation, fears about the Australian and Argentinian crops, and several downward revisions of US crop forecasts in late 2010 and early 2011 have brought strong market reactions and soaring prices.”




  5. Is commodity price volatility higher since 2000 than in the past?

    Actually, and conversely to the impression that comes from the daily price changes data, the answer is NO.

    The existing impression of high volatility is belied by the facts. For instance, in oil markets, the impression of high (and possibly abnormal) volatility is an artifact of daily changes around a higher price level, which is itself the result of rising marginal production cost (a fundamental).

    Defining volatility as the daily price change in currency per quantity terms ignores the fundamentally-driven increase in production cost. The effect disappears when the higher price level is compensated for by examining volatility as daily percent change. The following graphs illustrate this effect.


    The first chart plots ICE Brent crude oil daily price changes in USD per bbl, while the second chart takes the same data and plots daily percentage change.

    Behind the fact, defining volatility as the daily price change in currency per quantity terms introduces systemic distortion in two main ways. First, it is the natural tendency for nominal prices to appreciate through time, all the more that marginal production costs increase at a rate often beyond the rate of inflation. Marginal production costs are among the most powerful drivers of commodity prices. Second, the dollar per unit portrait of volatility cannot detect whether volatility is high or low on a proportional basis. Yet, as cost-driven price levels increase, it is axiomatic that normal variation (due to weather, economic cycles, and so on) on the higher base will result in larger absolute price movements. Similarly, price movements will appear smaller in unit terms, when excess production capacity causes market-clearing prices to fall, even if those moves are quite large in percentage terms, demonstrating higher proportional volatility.

    In short: From $30 to $36, the price increases by 20%…From $100 to $106, the price increases by 6%…In each case the price change is $6!

    Other evidence?

    Look at the following chart about NYM heating oil (the primary vehicle for all jet fuel hedging in the world):


    This chart shows that daily price changes have only once violated a +/- 9.5% band since 2005, though this band was violated more than twenty times between 1988 and 2005.

    Oil reflects a lot on volatility for agriculture commodities for two reasons. First, in any given year, it represents between one fourth and one third of the worldwide production value of commodity markets. Second, oil plays an important role in setting costs and guiding the price evolution of most industrial commodities and agricultural commodities. Biofuel production is an important demand factor. According to the UNCTAD report “Price Information in Financialized Commodity Markets,” “The decision by some governments to introduce blending requirements and subsidies for biofuel production is considered to play a significant role in the recent price hikes of grains; they also strengthen the correlation between oil markets and agricultural markets” In addition, agricultural production would not get far without the diesel that runs the tractors (production) and the lorries and boats (transportation).



  6. Why are commodity futures markets many multiples larger than the size of the underlying physical market?

    Some studies do note that the annual volume of CME wheat trades is 46 times the size of US production (2008 data). This seems to suggest that the futures markets are trading phantom bushels of wheat.

    But that’s kind of like saying: if the total value of shares traded in a company is greater than the company’s total market value, then investors are trading phantom shares.

    The fact is, multiple investors can and do buy and sell the same contracts (or shares). They also can and do exchange the same currency bills and notes for goods in the course of daily economic activity. The frequency with which this happens is about the velocity of transactions, not about the size of the markets.

    More importantly, physical markets also have volume multiples larger than the underlying physical production: there are multiple physical transactions that bring a single bushel of wheat from the seed vendor to the farmer to the trucker to the elevator to the marketer to the barge captain to the miller to the baker. In this simple illustration, there are already 8 physical agents making transactions on a single bushel (8X production) and the wheat has not yet reached a single food packager, wholesaler, retailer or restaurant. This supply chain is an example of velocity in commodity physical markets.

    A better like-for-like comparison would in fact be between the total volumes of transactions in the paper market against the total volume of transactions in the physical market.

    But even though, for instance, the paper volume was to be some large multiple of the physical volume, would this result in non-fundamental prices? No, because the large volumes (each of which represents a purchase and a sale) would constantly stress-test assumptions and opinions against a regular touch to the physical markets at expiry. The futures price would be closer to the fundamentals of the underlying, not further away. Indeed, the cash market can only tell us information about the state of the world here and now: the paper market tells us today about fundamental risks associated with the future. This is extraordinarily valuable information… and it is publicly available.



  7. Correlation and causation: does one thing cause another, simply because it came first?

    The warning that “correlation is not causation” needs to be kept in mind when interpreting commodity market data. This is especially true when it comes to the causation between financial investments in commodity derivatives and commodity price swings.

    Numerous studies have looked into the issue of whether commodity investing is influencing prices. No credible research has found a link.

    Financial investors respond to current and probable future fundamentals; and help communicate this information into markets in real time. This is a valuable economic activity, as this information then becomes available to everybody.

    If they are long-term and passive investors who just have to routinely roll their positions as expiries near, they bring balance.

    If they are short-term (within the commodity cycle) and active investors, herding is possible in case of a shock (weather event, economic crisis, export ban …) and then they can affect prices in the short term. But rapidly the fundamentals are re-taking the lead.

    Other fact-based analyses also conclude against causality from speculators, noting even the financial shock of 2008, the worst since the Great Depression, pales in comparison to fundamental factors. The European Central Bank, for example, has stated: “the destabilizing financial shock only explains about 10 percent of the total variability in oil prices, and shocks to fundamentals are clearly more important.”