Researchers have made surprising discoveries about how the commodities market works.
They revealed their findings at the Alberta Finance Institute conference, hosted by the Haskayne School of Business at the University of Calgary this month.
Motohiro Yogo, a monetary advisory at the Federal Reserve Bank of Minneapolis, spoke about what the futures market can tell us about commodities prices.
Price movements can be predicted by open interest, which is the quantity of contracts outstanding in futures markets.
Open interest is highly cyclical, rising during booms and falling during recessions.
Moreover, periods of rising open interest are followed by subsequent increases in commodity prices. “This is a common phenomenon in other risky asset markets, often referred to as momentum,” says Yogo.
Yogo and his colleagues found prices don’t react to open market interest immediately.
“If markets were perfectly efficient, prices should go up at the same time as investors come in,” he says. “Instead, prices go up shortly after. Therefore, commodities markets do not seem to be fully efficient.”
Commodity hedge funds can earn superior returns by watching open interest, and policymakers can use the information make superior forecasts of commodity prices and inflation.
Excess commodities returns
Viral Acharya, C.V. Starr professor of economics in the Department of Finance at New York University’s Stern School of Business, has researched why commodities investments seem to produce high average returns, especially commodities futures.
“When the default risk of commodity producers goes up as a whole, there is an increase in demand for hedging by commodity producers,” he says. This would be like crude oil producers shorting crude oil futures to manage their future prices.
The long futures position is generally taken by financial intermediaries such as commodities and index investors, hedge funds specializing in managed futures, or the commodity desks of broker-dealer firms.
If financial intermediaries find themselves to be risk-constrained, then they will charge for providing hedging services to commodity producers.
For instance, if producers are trying to sell a lot of crude oil futures, then the price of crude oil futures will become depressed.
And when prices revert as financial intermediaries regain their risk appetite, they generate excess returns for commodity futures investors.
“Our results suggest a good time for investors to benefit from price pressure in commodity futures is to go long the futures when commodity producer default risk is heightened, and financial intermediaries, such as broker-dealers, are withdrawing from risk,” Acharya says.
National Bank of Canada’s Tim Simard brought a practitioner’s insights to the macro-economic impacts of financial commodity markets.
“Academics like you to think that oil and gas producers hedge because they are risk-averse and trying to defend against a default event. In practice, I don’t see that at all,” he says, adding they’re more interested in locking in attractive revenue numbers.