Issue 2: What is financialization…and how is it affecting commodities markets?

Perceptions about the financialization of physical commodity markets are raising concerns about the impact of investments on commodity price changes and volatility. While financialization is a trendy concept, there is little evidence that supports the idea that it is unduly affecting commodity markets, as a number of research articles and papers have highlighted.

University of Muenster Working Paper Series

  • “…whether the speculative impact on conditional volatility has increased…with respect to six heavily traded agricultural and energy commodities, we do not find robust evidence that this is the case. We thus conclude that the increasing finanancialization of raw material markets has not made them more volatile.”

G-20 Study Group on Commodities Report

  • “…Greater investor participation can be expected to enhance the functioning of markets by adding depth and liquidity. This should help producers and consumers to hedge price fluctuation risks. Greater participation of financial investors can also aid the development of long-term commodity futures, which would facilitate risk management and planning over longer time horizons. More generally, participation of well-informed financial investors may enhance the quality of price signals.”
  • “…Greater participation by financial investors in commodity futures markets can bring important economic benefits by improving market functioning. More specifically, markets become deeper to the extent that financial investors take offsetting positions to other market participants or engage in market making. Enhanced market liquidity can also help to accommodate the hedging needs of producers and reduce their hedging costs. Moreover, growing financial activity can promote the development of markets for longer-term futures, facilitating risk management and planning of commodity producers and consumers over longer time horizons.”

IMF Report

  • “Despite recent financial innovation in commodity markets, such as indexing, which has allowed investors to benefit from rising commodity prices without having to maintain physical inventory holdings, there is little discernable evidence that the buildup of related financial positions [in commodity markets] has systematically driven either prices for individual commodities or price formation more broadly.”
  • “Indeed, many commodities without significant futures markets – such as iron ore and rice – have experienced more price appreciation than those with sizeable future markets, such as gold and crude oil.”
  • “…The results [of research] indicate a positive but weak relationship between return volatilities and the extent of financialization, suggesting that price volatility may be better linked to other variables, such as market tightness, stock levels, or geopolitical risks.”
  • “…although financialization may have led to increases in comovement between some commodities, particularly with respect to gold, no apparent systematic connection is found to either price volatility or price changes. These findings are consistent with recent studies in the area by the CFTC and others. Thus, there is little evidence to suggest that trading in futures markets has driven the price run-up or has destabilized the commodity markets during the first half of 2008.”

Paper Presented at the Southern Agricultural Economics Association Meetings

  • “…limiting the participation of index fund investors would rob the markets of an important source of liquidity and risk-bearing capacity at a time when both are in high demand. The net result is that commodity futures markets will become less efficient mechanisms for transferring risk from parties who don’t want to bear it to those that do, creating added costs that ultimately get passed back to producers in the form of lower prices and back to consumers as higher prices.”

Deputy Governor of the Bank of Canada, Remarks to the CFA Society of Calgary

  • “…the financial system is linked with the commodities markets. Here, I mean the intricate web of global markets in which commodities are bought and sold, prices determined and the producers and end-users of commodities hedge against unexpected movements in those prices. These markets are very important in determining the returns that producers earn for their output, as well as the risks they face.”
  • “…I’ve stressed that arbitrage and market-making are critical to tying global commodities markets together. These activities provide significant liquidity to commodities markets and, when they work properly, they also help bring commodity prices into line with the fundamentals of supply and demand – by which I mean, not just current supply and demand but expectations of how supply and demand will evolve in the future. There is strong evidence that broad movements in commodity prices over the longer term indeed reflect these fundamentals at a global level.”
  • “…There is no clear evidence that this trend toward greater financialization has been significant determinant of the overall level of commodity prices. As I have already discussed, the preponderance of evidence indicates instead that commodity prices have been driven by fundamentals – primarily by rising demand from EMEs (emerging market economies)…”

US Foreign Affairs Report

  • “In order to help consumers and companies deal with unpredictable oil prices, the United States should encourage more hedging through the financial markets. This idea may trouble those who blame speculators for price swings, but careful studies by the U.S. Energy Information Administration and the U.S. Commodity Futures Trading Commission have found that medium-term and long-term price shifts are primarily a function of changes in global supply and demand. Policymakers should help facilitate more hedging by encouraging the development of well-regulated financial markets: the point is to relieve those who are exposed to price risks today—from motorists to airlines and other oil-intensive industries—and transfer those risks to speculators, who are more willing and better able to bear them.”

Marketing and Outlook Research Report, University of Illinois at Urbana-Champaign

  • “First, if there is a market impact from index fund activity, it seems likely that it would have occurred during the period of most rapid growth: 2004-2005. Second, the stabilization of the index funds’ percent of total open interest may suggest that other traders have adjusted their strategies to better cope with this relatively new market participant. Third, Working’s speculative index suggests that long-only index funds may in fact be beneficial in markets dominated by short hedging pressure. That is, they improve the adequacy of speculation by helping the market to “carry” unbalanced short hedging. However, the traditional notion that hedging begets speculating may need to be re-visited. The relatively normal level of speculation over the sample period raises some doubt as to whether index funds are behind recent commodity price increases.”

Pauline Skypala, Financial Times

  • “Trade associations representing commodity traders and other financial groups deny there is any link between the weight of money going into commodity markets and higher price levels or volatility. They say fundamentals drive markets in the medium and long term, and while investors may intensify short term trends, they do not create them.”
  • “Kevin Norrish, commodities strategist at Barclays, says the idea that investor flows affect prices is ‘an attractive argument for interest groups and regulators to promote’, but that there is ‘a mountain of evidence’ to show it is not the case.”

IOSCO Report (March 2009)

  • “The empirical regularity disclosed by these studies is that financial participants do not trade in advance of price changes, but rather trade in response to past price changes.”

EDHEC-Risk Institute Paper

  • “We conclude by noting that modern commodity futures markets are the result of 160 years of trial-and-error efforts. Before performing surgery on these institutions, we suggest that Finance Watch’s supporters tread carefully and not adopt “speculative” regulatory proposals whose ultimate effects are unknown. We further recommend that European Union policymakers instead consider studying market practices globally and then adopt what is demonstrably best practice, rather than invent new untested regulations.”

The Oxford Institute for Energy Studies Analysis

  • “…there are also ways in which the presence of financial investors could stabilise markets, off-setting to a degree the previously discussed inherent features of oil price volatility that are present even if financial speculators are absent.
  • “If there are thoughtful active investors who truly do analyse the fundamentals of supply and demand carefully, and do so more effectively than the commercial participants (producers and consumers), then their activity can help make the market more efficient by reflecting changes in fundamental factors in the oil futures price. For example, it could be envisaged that collectively such participants drive the price higher in anticipation of a future tightness of supply and demand, potentially reducing the extreme volatility that could result from the more sudden realisation of emerging supply and demand imbalances.”
  • The existence of active traders – taking both long and short positions – can also help increase the day-by-day liquidity of markets, increasing the ability of producers and consumers to match future commercial needs in large quantity and at finer bid-offer spreads. However, this day-by-day liquidity may well be neutral in its effect on the medium-term (e.g. quarter-by-quarter) price trends which are most concerning, i.e. providing greater liquidity day-by-day may neither help to moderate medium-term price swings nor accentuate them.”