Futures Contracts

A futures contract is an agreement to buy or to sell a specified quantity of a commodity for the agreed price, with delivery at a particular future time. The quantities covered by a contract, and the periods when futures contracts fall due, are determined by the trade practices of the exchange, and vary across commodities and exchanges. A few examples will illuminate the contract volumes and number of contracts on leading commodity exchanges in 2014: White sugar on ZCE, 10 tons, 98 million contracts; Wheat on CBOT, 5,000 bushels, 32 million contracts; Crude oil on NYMEX, 1,000 barrels, 145 million contracts; Steel on SHFE, 10 tons, 408 million contracts; Copper on LME, 25 tons, 39 million contracts. The standard features of futures contracts make them highly liquid. The owner of a contract can sell it at any time at the going price for that commodity and delivery month.

It is important to distinguish futures contracts from forward contracts. The latter involve a wider concept that comprises futures contracts. Any contract that stipulates delivery in the future is a forward contract. Forward contracts need not have standardized provisions regarding quantities, grades, and dates when they fall due. Since each forward contract is unique, it is much less easy to trade. A transfer of a forward contract is dependent on finding a party interested in its particular specifications.Footnote ²

A member of the exchange entering into a futures contract to buy does not need to pay for the purchase at the time, but is required to provide a margin, usually representing 10–20% of the purchase value, as their commitment to the deal. This margin is held by the clearing house of the exchange, formally the opposite party to the contract. If the price declines after the buyer has signed the contract, a need may arise to top up the buyer's payments, so that the margin always stays at some 10–20% of the current contract value. Suppose that the buyer has committed to purchase a commodity for $10,000, and has paid a margin of $1,500. If the price falls by 20% before the stipulated delivery time, the buyer will have no incentive to fulfill the contract. It will be financially preferable to lose the margin and buy the commodity at the lower price, for $8,000. Hence, to ensure contract execution, the buyer will be asked to make additional margin payments before the margin has been depleted by the price fall. Failing such additional payments, the contract will be liquidated. This will take the form of issuing a futures sales contract to the buyer with the same delivery date but at the going, lower price. The two contracts will cancel out each other, and the loss, amounting to the difference between their values, will be recovered from the original margin payment. If, on the other hand, the price rises, payments can be made to the futures buyer, since the buyer is not required to hold margins above the 10–20% level. Analogous conditions apply when members of the exchange enter into futures contracts to sell.

In any normal circumstances, the margins will provide a complete financial guarantee for the commitments entered into by the clearing house. In principle, therefore, commodity futures trade involves no risk that the opposite party defaults. This adds considerably to the fungibility of futures contracts.

The tin debacle on the LME in 1985 is a spectacular, though rare, instance of futures contract holders defaulting on their obligations, but it should be added that the LME did not have any clearing house at the time. The defaulter was no less than the International Tin Agreement, dominated by its producing country members and operating through a combined use of buffer stocks and export restrictions. Through a series of events in the early 1980s, the Agreement came to defend a price substantially above long-run equilibrium, applying export restrictions and yet forcing the buffer stock manager to buy increasing quantities of the metal. To stretch the financial resources available for the purpose, the manager employed the stock, which had grown to an enormous size, as collateral for loans which were then used for margin payments in futures transactions. By October 1985, the manager's resources had been completely exhausted, so he ceased operations, defaulting on his futures purchase commitments and leaving behind a total debt in excess of $1 billion, a huge sum at that time. Tin trade on the LME was suspended, and when it reopened in June 1989 the price settled very substantially below the level before the default. The debacle led to a fundamental reorganization of the LME, including the establishment of a clearing house.

In practice, the existence of a clearing house does not offer an iron-clad guarantee against default. When price movements are very fast, the call for additional margin payments may not be speedy enough to assure that margins are positive on all contracts at all times. The possibility of default will be there as soon as margins reach a zero level.

Today's quote for future delivery is usually not the same as today's spot price. Depending on current market conditions and expectations about the future, there will ordinarily be a difference between the two. The term contango refers to a situation where the futures price exceeds the spot price, while backwardation involves a futures price below the spot level. We return to a further discussion of this distinction later in this section.

The majority of futures contracts are entered into for the purpose of hedging, speculation, or investments, with no intention to provide or take physical delivery at the contract's expiry. In fact, some exchanges do not offer any facilities at all for physical trade. A major proportion of the futures contracts are voluntarily liquidated through the procedure described above, before delivery falls due. The liquidated futures purchase transaction will yield a loss if the price for the contracted delivery date has fallen between the issuance of the original contract and liquidation. The transaction will yield a profit if the price has risen. The reverse will be true for futures sales transactions.

Options

The options traded on commodity exchanges are directly related to the futures contracts. One must distinguish between the issuers and holders of options, since their involvements are highly asymmetrical. There are call and put options. A call option gives the holder the right (but not the obligation) to buy a futures contract at a predetermined price, the strike price, at any time until the option's expiry. Analogously, a put option gives the holder the right to sell a futures contract at a predetermined price. The issuer of the option is obliged to comply with the holder's rights.

Options are freely transferable. The price of the option is called the premium. This is what the issuer charges when the option is first issued and what the holder is paid when the option is transferred to another holder.

Options have a limited life and lapse on their expiry. The life can extend over several years. The premium will fluctuate through the life of the option in a pattern determined by two factors, i.e., the “time value,” which depends on the remaining time until expiry (the shorter the remaining time, the lesser the value), and the “intrinsic value,” which depends on the relationship between the strike price and the underlying futures contract price. The intrinsic value will fluctuate in parallel with the futures price development. At the time of expiry the time value will be zero, and the intrinsic value will represent the entire premium.

The option holders’ only obligation is to pay the premium. To them, options are distinctly different from futures contracts, in that they do not carry any responsibility for taking or making deliveries. From the issuers’ point of view, the option carries a strong resemblance to a futures contract in that their obligation is precisely to issue such a contract whenever the option holders choose to exercise their right.

The holder will reap a profit if the option premium rises from the time it was acquired and until the right is exercised. The holder will lose if there is a decline in the premium. The holder's loss cannot exceed the premium paid, for the holder can always choose to do nothing and to let the option lapse. The issuer's gains and losses are opposite to those of the holder. The gains are limited to the initial premium received, but the potential losses are infinite.

As in the case of futures contracts, the issue of options is guaranteed by the clearing house of the commodity exchange. Also, in a majority of cases, the option rights to acquire futures contracts are not exercised. Instead, the options are sold at the going premium when it is positive, or not exercised at all when the premium is zero.

A Physical Trade Outlet

Most exchanges do offer a convenient facility for physical trade to the buyer or seller who needs it, for instance because no trading connections have been developed. The exchanges always stand ready, in principle, to absorb and release the commodity on a spot basis, at the going price. The importance of this function, though quite limited compared to futures and options trading, should nevertheless not be underrated. In 2014, physical deals on the LME involved about 2 million tons of aluminum (about 4.5% of total global aluminum production), 365,000 tons of copper (about 1.7% of global copper production), and some 115,000 tons of nickel (about 5.9% of global nickel production). Physical trade as defined here is the material that flows out of inventories (private communication with Phillip Crowson). However, one should keep in mind that all materials going out of the warehouses held by an exchange are not necessarily used directly by consumers.

Socialist countries used to be particularly important users of the exchanges for their physical trade. Much of the somewhat irregular supply of USSR aluminum and nickel was disposed in the 1970s and 1980s through the LME. Similarly, Chinese requirements for metal imports were for a long time significantly satisfied through purchases on the LME. Producers who for some reason have been unable to place their entire output directly with clients are known to dispose of their marginal supplies on the exchanges. The inventories held by the exchanges provide a convenient supply of last resort when other supply sources dry up.

After dealing with futures, options, and physical trade facilities, we now proceed by exploring the role of the exchanges as mechanisms for setting commodity prices, arguably their most important function.

Price Formation

The following several paragraphs clarify the dominant role played by exchanges in setting the prices for physical transactions in the commodity industries. Two circumstances must initially be clarified. First, as noted, only a limited part of the trade that takes place on the exchanges is physical trade. Most of the action involves paper transactions in which physical material never changes hands. Second, a predominant proportion of physical trade occurs outside the exchanges, in transactions directly between the producers and users of the commodity. The point to be elucidated is that this predominant physical trade regularly occurs at prices tightly related to those that prevail in spot and futures transactions on the exchanges.

Whenever an international commodity exchange succeeds in establishing a broad-based and continuous trade in a commodity, the price quotation in that trade is usually adopted, with required modifications, throughout the commodity industry. The price-setting mechanisms on the exchange are of course far from perfect in reflecting market fundamentals. For instance, where the market is thin, a few transactions may unduly influence the price developments in an ad hoc manner. With a thin market, there is also the likelihood that gaps will occur in the time series of futures prices, because there are no contracts expiring in some of the months covered by the trading period.

An interesting question then becomes; how much trading is needed for an efficient representative price to be established? According to Holder et al. (Reference Holder, Thomas and Webb1999), a monthly trading volume of more than 10,000 transactions is a criterion to define a futures contract as successful. However, data from the three largest exchanges (CME, ICE, and Eurex) reveal that between 58% and 68% of all traded futures in September 2014 did not reach this threshold. Does this imply that efficient prices are not reached in these markets? In a recent study, Adämmer et al. (Reference Adämmer, Bohl and Gross2015) investigates two thinly traded futures contracts, hog and piglet, at the Eurex in Frankfurt, and comes to the somewhat surprising conclusion that even a few transactions per week can be enough to provide reliable price information for producers and traders of physical commodities.

Different prices may be quoted when a commodity is traded on several exchanges. Ordinarily, the prices will run in parallel. Also, the possibilities for arbitraging will prevent the price difference from widening beyond what is warranted by differences in the specified quality that is traded, and to reflect the transport costs from the point of delivery to the major consuming centers.

Claims are sometimes made that the price quotations on commodity exchanges are distorted through intentional manipulation, including attempts to corner the market, such as occurred in silver in the Hunt brothers episode of 1979, and in copper during the Sumitomo scandal in 1996 (Gilbert, Reference Gilbert1996). These shortcomings of commodity exchange prices notwithstanding, it should be underlined that the alternative price setting mechanisms suffer from other, often more serious, deficiencies, so the influence of commodity exchange quotations on the prices at which trade takes place in a commodity industry is not surprising.

A great attraction is that the prices set by the exchanges are instantaneously available and widely published. This contributes significantly to the influence they carry in trade and industry. Where trade in a commodity has been successfully established on an exchange, its prices tend to replace other price quotations and dilute the price-setting power of producers. Since the late 1950s, Metal Bulletin regularly quoted a price for aluminum in Europe, entitled “Certain Other Transactions,” which at times differed substantially from the dominant Alcan (producer) quotation. After the introduction of aluminum on the LME in 1979, the Metal Bulletin price became superfluous and was discontinued (Crowson, Reference Crowson1998). In the course of the 1980s, the LME quotation was generally accepted as the authoritative reference price. Developments have been similar in the case of nickel. Oil used to be given by Platts or Argus, but is now taken from the price of Brent on ICE or WTI on NYMEX, while quotations for steel futures introduced on the LME in 2006 have replaced the trader prices hitherto published by Metal Bulletin.

The OPEC oil producers ceased posting their sale prices after crude oil trade was introduced, first on NYMEX in 1983, and then on ICE in London in 1988. With the lively oil trade on the exchanges, the cartel's ambitions have been shifted to the defense of a price band, with the desired prices to be attained not through producer dictate but through market forces on the exchanges, with the actions of the cartel limited to adjustments in supply.

Producers find it hard to exceed the widely quoted exchange price levels for long and by more than the narrow margins that buyers are prepared to pay for the increased convenience and security offered by a longstanding trade relationship. Where producers continue to quote their own prices, these quotations tend to change much more frequently and more tightly in line with the market once an exchange starts to provide a pricing rod, and in the end the producer quotes tend to become an irrelevance.

The exchange prices are influenced instantaneously by events both in the commodity market and in the outside world. Their daily fluctuations can therefore be considerable, and sometimes they are claimed to be seriously exaggerated by speculation (discussed in more detail in Section 7.3). Prices in transactions outside the exchange tend to be more stable, either because producers maintain their own quotations for much longer than a day or an hour, or because they employ, e.g., monthly averages of exchange quotes when they sell to their customers. Price stability may of course be desirable, but such stability can gloss over pent-up imbalances which could cause severe disruptions in the market once they become visible. Instantaneous price adjustment to emerging market fundamentals instituted by trade on the exchanges can help avoiding such disruptions.

Contango and Backwardation

Just like the instruments of futures contracts and options, the relationship between the spot and futures prices (contango and backwardation, respectively) provides considerable scope for rewarding commodity engagements by the financial community. It is appropriate, therefore, to discuss this relationship in some detail before venturing in the next section into the involvements of the financial community in commodity markets.

A contango market results from an abundance of immediate supply relative to the expected future supply. The current abundance will depress the price for immediate delivery, as compared to delivery in the future. Notice, however, that the possibility of arbitrage limits the level of the contango to the cost of storing the commodity between now and the time of future delivery. For example, the 12 month futures price cannot exceed the spot price by much more than 7% when the cost of physical storage, including deterioration, is 3% per year, and the rate of interest is 4%. A higher contango will make it profitable to buy spot, take physical delivery, and incur the cost of storage while immediately making a 12-months futures sale. Such action will increase spot demand and raise spot prices until the contango declines to just above the 7% level.

The contango is a blessing to producers in oversupplied markets, for it provides a neat mechanism for financing excess inventories without risk to the investors. This investment opportunity has been regularly employed by banks and other financial agencies. Strictly speaking, the deals represent long hedges. However, the different nature of the agents and of the basic purpose for their action warrants their classification as investors, not as hedgers.

A market in backwardation indicates a shortage of immediate supply and a perception of more ample supplies in the future. In contrast to the contango, there is in theory no maximum in the difference between spot and futures prices when the market is in backwardation, since arbitrage is not possible. A shortage today can cause spot prices to explode, irrespective of what is expected of the future. The futures price could remain at only a fraction of the inflated spot price, despite the knowledge that the current shortage will soon be overcome, e.g., because new production facilities are being opened up. In practice, inventories almost always establish a tie between the high spot price and the low backwardated futures price, and this has to do with the convenience yield of inventory holdings. Inventories typically exist at many levels throughout the production–processing–wholesale–retail chain, and they yield a benefit to the holders through the convenience of being immediately available should a need for their use arise. The inventories will be held so long as this benefit is valued more than the net gain from selling spot at the high price, buying futures at the low price, and accepting the inconvenience of doing without until the futures purchases are delivered. At some level of backwardation, the inconvenience is overwhelmed by the gain from an inventory release. This constitutes a link between the spot and futures price, and a cap to the extent of backwardation.

Hedgers

The general principle of hedging is to open a futures position opposite to that confronting the hedger in the physical market at a future time. The hedger is interested in safeguarding against one of two fundamental price risks.

The first is that the value of unsold products will decline if the commodity price falls.

An owner of a commodity inventory (wholesaler, processor), can assure itself against the risk of price decline by making a short hedge at the time it acquires its inventory, i.e., by futures sales involving quantities and due dates that correspond to the planned disposal of its physical holdings. In this way the owner assures itself of the current commodity price on the futures market for these future disposals. When a physical disposal comes due, the owner will buy a corresponding amount spot on the exchange. The initial futures and later spot transactions on the exchange cancel out each other. If the price has fallen in the period between physical acquisition and disposal, there will be a loss from the physical transactions, but a compensating gain from the futures purchase and spot sale on the exchange. If the price has risen, the exchange transactions loss will be compensated by the gain in the physical trade. The cost of this hedge will be the interest on the margin payment and the brokerage fee, plus any contango or minus any backwardation that prevails in the market at the time the futures contract is signed.

The wholesaler can alternatively acquire a put option with a strike price close to its physical purchase price, and with expiry about the time of its planned physical sale. If the price falls, the wholesaler will compensate its physical loss by the gain on the option premium. If the price rises, there will be a gain from the physical trade, but the premium of the option may fall to zero. The cost of these transactions will be the premium paid for the option and the brokerage fee for its purchase and sale.

The specific circumstances of each case will determine which of the two hedges provides the best and cheapest price insurance. The futures hedge will involve an expanded financial cost of additional margin payments, and an ensuing temporary need for more cash if a loss is incurred in the exchange transaction. The options hedge can yield a speculative gain if rising prices result in a profit from physical transactions that is larger than the premium initially paid for the option.

Commodity producers often make short hedges when they consider the current price quoted in futures transactions to be attractive. The commodity exchanges provide them with a means to lock in that price for their future output. Metal producers are known on occasion to have sold their entire anticipated output over several years into the future, thus securing the price of that output. New gold mines have sometimes used such extensive futures sales as collateral for loans to finance the development of the mine, as did CODELCO, the state-owned Chilean copper corporation, with the anticipated output of Gaby, a new mine (Platts Metals Week, 2006), and more recently, shale oil producers in the USA, to protect themselves against impending oil price falls in 2014.

The second risk is that the cost of future commodity purchases will increase if the commodity price rises.

A direct user of a commodity or a manufacturer of goods with a high content of the commodity might avoid the risk of a forthcoming price rise by locking in the current prices in the futures market through a long hedge. This involves futures purchases on the exchange timed to coincide with the user's physical commodity needs in the future, cancelled through spot sales on the exchange at the time of the physical purchase. Alternatively, a call option can be acquired to make a long hedge. The assurance against price risk, as well as the cost of the transaction and the relative merits of the futures versus options instruments, is analogous to that in the short hedge. Users could alternatively make a long hedge to secure an uncertain physical availability.

The possibility of hedging a specific commodity is not entirely contingent on it having a developed futures market. An imprecise, but often satisfactory, hedge can be attained with the help of a closely related commodity whose price is likely to move in parallel with the one on which the hedger is dependent. An edible oil not traded on any exchange can be approximately hedged through the futures market of another closely related edible oil. Arabica coffee futures can in most cases provide a satisfactory hedge for robusta coffee, while crude oil is a reasonably close hedging substitute for bunker oil. Natural gas futures contracts also provide acceptable hedging facilities for deliveries in geographical markets out of the reach of the exchanges.

Speculators in Commodity Markets

The high level of standardization and the ensuing liquidity of the futures contracts and options makes it very easy to move funds in and out of commodity markets. This characteristic is a precondition for the widespread interest of the financial sector in commodity placements. As noted earlier in this section, there are two different actors, each with distinctly different investment objectives, and the instruments employed on commodity exchanges can be used to provide the satisfaction of either. The next several paragraphs explore the behavior and objectives of the commodity speculator. We subsequently turn to the investors who see the commodity markets primarily as an additional asset class providing prospects both for inherently safe placements with returns only marginally above the “normal,” or for riskier but profitable investments, with the added benefit of offering means for portfolio diversification.

Speculation is a broad and amorphous concept. In the context of commodities and in the broadest sense, it involves all actions that aim at profiting from a move in commodity price. Buying a futures contract on the exchange, or prematurely filling a half-full automobile tank, both in anticipation of an impending price rise can be classified as speculative activity, even though the latter action is undertaken by a commodity consumer (the car driver). A narrower definition, in which the speculators have no intrinsic interest in the commodity as such, is common. According to the Shorter Oxford English Dictionary, speculators buy and sell “in order to profit by the rise or fall in the market value, as distinct from regular trading or investment.”

The speculator's typical objective is to reap very high profits in return for taking very high risks. With the narrower definition, the difference between hedgers’ and speculators’ behavior can be explained either by a difference in risk aversion, or by the greater ability of speculators to diversify their positions. The role of speculation can therefore be seen as a means for the transfer of risk among agents with different preferences.

The commodity exchanges provide the speculators with attractive opportunities for highly geared investments. The limited margin payments on futures contracts stretch the speculators’ money at least by a factor of five, as compared with speculation in physical commodity deals. The potential return – and loss – for a given investment, is multiplied in equal measure. The issue of options involves speculators in a risk of unlimited losses. But although there is an upper limit on the gains from the issue of options, these gains can be massive in relation to the small capital that needs to be committed.

Combinations of futures contracts and options permit speculators to set the degree of risk in accordance with their desires. For example, they can enter a futures contract to sell if they expect prices to decline. If, instead, prices rise, they will lose, and there is no limit to the size of the loss. Such a limit can be established at, say, 50% of the value of the contract, by the speculator acquiring a call option with a strike price 50% above the futures sales price.

Since the clearing house of a commodity exchange must maintain a balanced position in any commodity for any future date, the minimum role that the speculators must play is to establish futures contracts that fill the imbalance between short and long hedges (Ghosh et al., Reference Ghosh, Gilbert and Hughes Hallet1987). Because, by definition, they do not hold any offsetting positions on these minimum investments, the speculators carry the entire risk of loss or potential for gain from price movements.

Speculators are always there to respond to hedgers’ needs regarding volume and timing of futures and options, at a price. Ordinarily, however, their actions go far beyond the satisfactions of hedgers’ requirements. A large part of the positions they assume constitutes bets against other speculators. In these ways, speculation improves the continuity and increases the liquidity in commodity exchange trade.

The expanded speculative activity has raised concerns about a possible upward price push and the creation of price bubbles for commodities by speculators. This issue is further discussed in the chapter's final section.

Financial Investors in Commodity Markets

The past decade has seen a phenomenal growth in commodity investments by institutions, hedge funds, and individuals, who buy and sell futures and options without an ensuing physical transaction. Globally, commodity assets under management by financial investors increased in value from about $13 billion in 2003 to an astounding $450 billion in 2011. Despite a subsequent decline as the boom ended, these volumes still reached some $350 billion in 2013 (FCA, 2014).

The expansion of electronic trading over the period has stimulated the emergence of many new financial tools facilitating investors’ commodity engagements. These were initially developed by investment banks. They comprise commodity index funds, over-the-counter (OTC) swap agreements, and many others. All are related to one or other established commodity price index. Goldman Sachs was one of the first to establish a Commodity Index Fund and to launch its trading on the exchanges (Goldman Sachs, Reference Goldman2005). The Standard and Poor's Goldman Sachs Commodity Index (S&P GSCI) is one of the most widely tracked, and considered an industry benchmark. The GSCI is heavily weighted in energy. The major alternatives comprise the Bloomberg Commodity Index (BCOM) and the Commodity Research Bureau (CRB) Index, the latter in existence since 1957. All the financial instruments provide indirect exposure to a specific commodity, or a group of commodities in futures markets, traded on exchanges. With many variations, investments in these instruments are expended on buying commodity futures, which are rolled over at maturity, i.e., sold just before expiry, with a matching purchase of new futures.

Special mention is warranted of exchange-traded funds (ETFs), the most common among the new financial products. ETFs offer investors the possibility to pool their money into a fund to gain exposure in commodity assets. The launching financial institution invests in futures contracts in the chosen commodities and then sells shares in the fund to individual investors.

The development of these exchange-traded instruments has provided market access to institutions and individuals who might otherwise have been prohibited by law, or reluctant for other reasons, to participate in financial trading in commodity markets. It should be added that the exchange-traded instruments generate considerable brokerage fees; hence they are favorably viewed by the launching investment banks (Irwin and Sanders, Reference Irwin and Sanders2012).

The phenomenal growth of the new instruments was strongly stimulated by the findings in some analyses presented to promote commodity investments. Calculating the performance of hypothetical investments in the futures of these indexes several decades back in time yields remarkable conclusions: Both the total returns and the risks to investors in these instruments would have been on a par with those on equity investments, and much higher than those from investments in bonds. There is little correlation in the annual return from equities and commodities, so the addition of the latter stabilizes the overall diversified portfolio performance. Furthermore, commodity investments are claimed to provide a better protection against inflation than do investments in equities and bonds, and they are far superior in terms of returns to investments in physical commodities or in the equity of commodity-producing firms (Center for International Securities and Derivatives Markets, 2006). Even more remarkably, there are numerous academic papers that reach similar conclusions (Bodie and Rosansky, Reference Bodie and Rosansky1980; Conover et al., Reference Conover, Jensen, Johnson and Mercer2010; Erb and Harvey, Reference Erb and Harvey2006; Gorton and Rouwenhorst, Reference Gorton and Rouwenhorst2006; Greer, Reference Greer1994).

We are somewhat skeptical of these findings. Could the more recent ones of the studies just quoted be unduly dependent on the impact of rising prices during the commodity boom of 2004–11? And how would the results be altered if the price falls between 2011 and 2015 were included in the analysis? Our skepticism is strengthened by the more recent contribution by Bessler and Wolff (Reference Bessler and Wolff2015), who conclude that the benefits of adding commodities to a portfolio are considerably smaller than suggested in earlier work. Furthermore, their results suggest that the investment returns vary with type of commodity. There are more benefits from industrial materials, precious metals, and energy, and hardly any positive portfolio effects at all for food commodities.

An obvious question to ask is how and why so many studies conclude that hypothetical investments in futures commodity indexes would have performed so well even in the face of a period of long-run commodity price decline (for over two decades before the most recent commodity boom), as depicted in Figure 6.1 of the preceding chapter.

Iwarson (Reference Iwarson2006) provides a plausible explanation by revealing a methodological fallacy in the approaches to calculate the yield. It goes beyond mere numbers by subdividing the backdated returns from 1970 to 2005 yielded by hypothetical investments in the Goldman Sachs index into several components. When measured in nominal SEK (Swedish currency), the total annual average return over this 35-year period works out at an impressive 15%, compared with a 17% annual return on the holding of Swedish equities and 10% on the holding of Swedish bonds (however, the commodity futures index investment would have slightly outperformed a portfolio of US equities, measured by the S&P 500 index). The commodity futures index returns consist of the following components:

• An annual average 6% return on rising spot prices of commodities, primarily an effect of the heavy dominance of oil in the Goldman Sachs index, and the strongly appreciating oil prices over the period,Footnote ³ so it cannot be precluded that an equally weighted index would have shown a zero or even negative yield on this count;

• A roll return of 2% per year, implying backwardation most of the time for most of the commodities comprised in the index; and

• A collateral return: since investments in the futures commodity index require no more than a small margin payment, most of the committed capital can be used to purchase treasury bills, with the interest received attributed to the commodity investment. This collateral return has averaged 7%, almost one half of the total return.

In our view, the claim that the total return on investments in commodity index futures is on a par with that of holding stocks is fallacious, and greatly exaggerates the attractiveness of commodities versus stocks as investment classes. This fallacy arises from the comparison of investments in commodity index futures, which benefit from a large collateral return, with investments in holding stocks, which do not. The correct comparison should be with investments in stock index futures (substantially increasing the investors’ risks), where both instruments benefit from collateral returns. We have not seen such a comparison presented by those who have marketed investments in commodity index futures, but given the significance of the collateral return, the investments in commodity futures are unlikely to match investments in stock futures.

Despite the fallacy identified above, investments in commodities are likely to prevail, even if at lower levels than at the top of the commodity boom. The investment banks continue their eager promotion of commodity investments, while the public may like some involvement in an alternative to the dominant equity market.

Impact on Prices

Speculators make their bets on the futures markets. Their purchase of futures pushes up the futures price, and this will impact on spot prices too, through the possibility to arbitrage if the market is in contango and through the convenience yield in backwardated markets. Liquidation of speculators’ long positions will have an analogous depressing impact on futures and spot prices, as will an initial speculator entry through futures sales. Given the huge volumes in the futures markets, the speculators’ positions would have to be very sizable to make a dent on these markets. But it is important to realize that the resources of the financial markets potentially available to speculators are huge too, and that the limited margin payment requirements provide for a considerable stretch of these resources. Also, the speculators’ impact can be greatly augmented by a focus on selected markets, and not necessarily the biggest ones.

The basic theoretical presumption is that, under normal circumstances, speculation will even out price variations (Telser, Reference Telser1981). After harvest, when the price is low, speculators will bid up futures prices until the contango is sufficient to make investments in inventory holdings worthwhile. The demand for inventories will strengthen the spot price level. At the height of an industrial boom, the speculators will bid down futures prices, and so make stockholding unprofitable. The liquidation of stocks will reduce the inflated spot price. In this way, speculator foresight stretching across seasons or phases of a business cycle generates profits to their actions, and at the same time this foresight evens out the inherent commodity price instability.

The theoretical analysis may seem to be contradicted by the observation that commodities traded on the exchanges tend to have less stable prices than commodities which are not. But then, the causality could be the other way round. Exchanges perform especially valuable functions for commodities with inherently volatile prices, and their services are simply not needed for materials whose prices are stable. We noted early in the chapter that the stabilization schemes maintained by the US government in the groundnuts and tobacco markets are the probable reason why these commodities are not traded on the exchanges. Exchange-traded commodities can in fact constitute a kind “adverse selection” insofar as price stability is concerned.

The speculators’ activities would destabilize commodity markets only if their forecasts proved persistently wrong. Say that the industrial boom and the high industrial commodity prices of agricultural or mineral origin were not followed by a recession and low prices, but by a strike and even higher prices. Then the depletion of existing inventories caused by the wrong speculator expectations would amplify the ensuing price rise and the speculators would lose wholesale from their investments.

If, in fact, speculators lose on average, and so destabilize prices, there may nevertheless be a positive consequence of their activity in that the losses would correspond to a lowering of the average price paid by users and/or an increase in the average price received by producers (Friedman, Reference Friedman1969). The net social effect of such destabilizing speculation would depend on whether this benefit is greater or smaller than the discomfort of greater price instability. It may be that producers would feel the need to insure themselves against the higher price volatility, and that the cost of the measures would absorb their price gain.

Even if commodity speculation were normally to yield a gain, and so to stabilize prices most of the time, this does not preclude the existence of speculative bubbles, which on occasion could drive prices to extreme highs or lows. Bubbles have to do with the fact that speculators are often more interested in what others believe and do (herd behavior) than in the fundamentals of the commodity market. Keynes (Reference Keynes1936) distinguished between large, professional, and well-informed speculators on the one hand, and small amateur speculators on the other. It could be that the former profit from speculation while the latter lose. Speculators who are successful become large, and those who are not leave the market and are replaced by other small speculators. This distinction provides an interesting mechanism for the emergence of speculative bubbles.

Commodity markets are occasionally invaded by amateur speculators. Their entry results in a strong price boost, even when the fundamentals for higher prices are not there. The professionals will then tend to follow the amateurs and amplify the price increase in the confident belief that they can profit from the price moves. Once the amateur money inflow has been exhausted and the price ceases to rise the professionals sell out, and the bubble bursts. In such circumstances, profitable speculation by the professionals will have a destabilizing impact on prices (Stein, 1981).

Analyses of the impact of speculation on prices have recently been greatly facilitated by more systematic data collection. The Commodity Futures Trading Commission (CFTC) in the USA makes an ambitious effort to collect detailed data on the composition of open interest across commodity futures and options contracts in the USA in the so-called Commitment of Traders (COT) report. The data cover 22 commodity products (agricultural, energy, and metals), and are made available to the public, in both short and long formats, at an aggregate and disaggregated level. The disaggregated COT data were first introduced in October 20, 2009, but available numbers go back to June 13, 2006. In the short report, open interest is separated both in reportable and non-reportable positions. For reportable numbers, short positions are provided for commercial and noncommercial traders, respectively, regarding holdings, spreading, changes from previous report, number of traders, and percentage of open interest by category. The long report additionally divides the data by crop year (if applicable), and identifies concentration of positions held by the four and eight largest traders. Supplemental reports provide futures and options positions for commercial, noncommercial, and index traders altogether in 12 agricultural commodities.

In an early study on the effects of speculative activity on commodity prices, Cooper and Lawrence (Reference Cooper and Lawrence1975) found that speculation was an important factor behind the sharp increase in commodity prices from 1972 to 1975. However, during this period the amount of financial capital in commodity markets was only a fraction of what it is today. As noted earlier in the chapter, the presence of financial investors not directly related to commodities increased substantially in commodity futures markets from about 2003 and onwards. At about the same time commodity prices started to increase, and it would not be surprising if the new financial investors were attracted to commodities by the possibility of high earnings. However, since the increase in financial involvements coincided with large movements in commodity prices, the view that speculation had a real impact on commodity prices emerged. The hedge fund manager Michael Masters was a strong proponent of this view, which he presented several times to the US Congress and CFTC. In Masters (Reference Masters2008) he argues that the substantial increase in institutional investors in commodity markets, with nearly $30 trillion in assets to manage, created a massive bubble in commodity futures prices.

Recent research on this issue has been extensive, and most of the studies use the publicly available CFTC data. Hamilton (Reference Hamilton2009) developed a formal model of price formation in the crude oil market that identifies a theoretical condition for price bubbles caused by speculative activity. Empirical evidence of the occurrence of price bubbles during the latest commodity boom is found by Gilbert (Reference Gilbert2010a). In his study Gilbert examines price changes for crude oil futures, three metals futures, and three agricultural futures during 2006–08. The results identified price bubbles for seven out of nine markets, but only for a very small percentage of the days investigated (e.g., 21 out of 753 days for crude oil futures). Gilbert and Morgan (Reference Gilbert and Morgan2010) and Gilbert (Reference Gilbert2010b) found similar evidence, i.e., that index futures investments had an impact on food prices during the 2006–08 price spike. Tang and Xiong (Reference Tang and Xiong2012) do not test for price bubbles, but find that the development of commodity index investments has led to an increased correlation between commodity futures prices and prices of other financial assets, pointing to a linkage between commodity futures price movements and investments in commodity indices. Singleton (Reference Singleton2014) too finds that the recent flow of capital into index funds is positively correlated with changes in futures commodity prices.

However, a majority of economists express skepticism about the argument that speculation caused price bubbles during the latest commodity boom (see e.g., Krugman, Reference Krugman2008; Pirrong, Reference Pirrong2008). In fact, most of the empirical studies on this issue do not find that financial speculation has been important in driving commodity prices – see e.g., Alquist and Gervais (Reference Alquist and Gervais2013), Kilian and Murphy (Reference Kilian and Murphy2014), Kilian and Lee (Reference Kilian and Lee2014), Fattouh et al. (Reference Fattouh, Kilian and Mahadeva2013), and Knittel and Pindyck (Reference Knittel and Pindyck2016) who all investigate this issue on the oil market. Similar results, i.e., that speculative activity does not affect prices, are found for energy and agricultural markets by Brunetti et al. (Reference Brunetti, Bükyüksahin and Harris2011), Irwin and Sanders (Reference Irwin and Sanders2012), and Hamilton and Wu (Reference Hamilton and Wu2015). Brunetti et al. (Reference Brunetti, Bükyüksahin and Harris2011) also find that market liquidity reduces the volatility and thus the risk in these markets. This is in line with the results in Deuskar and Johnson (Reference Deuskar and Johnson2011). Irwin and Sanders (Reference Irwin and Sanders2011) present a thorough survey of the literature, and conclude that a majority of the research does not support the view that speculation has had an impact on commodity prices in the course of the present century.

We argue, in line with the majority of the research findings quoted above, that speculators and other financial investors are not to blame for accentuated price volatility and bubbles in commodity prices. Revealingly, several commodities not traded on exchanges, and hence not subject to speculation, have exhibited equally strong upward price movements as those subject to exchange trade and speculation during the most recent boom. Most of the variation in prices appears to be due to fundamentals.

Other Impacts

Other impacts of commodity exchanges on commodity markets and commodity-producing industries have been suggested, although here too firm empirical evidence remains to be provided. For instance, it is plausible that producers will tend to adjust the quality of their output toward the standards adopted by the exchanges for the purpose of futures trading, even when the commodity is sold through other channels. This is because a correspondence with the exchange quality will normally make the commodity more widely marketable than it would otherwise be. In this way, the exchanges would tend to promote standardization and uniformity of quality.

Another plausible impact could be that by providing an assured outlet for physical trade, the existence of exchanges would reduce the incentive for vertical upstream integration by commodity users. Such integration has been a common response to potential threats to raw materials supply, for instance because of producers’ monopoly power. This line of reasoning suggests a lesser extent of vertical integration in industries that use commodities which are traded on exchanges. Here too one can argue the direction of causality: commodities will not be traded on the exchanges until there is a reasonable degree of competition among vertically unintegrated producers.