Lorenzo Naranjo and Carmen Stefanescu note that commodity futures volatility has been rising since the era of ‘financialisation’ – but also that the correlation with equity market volatility long pre-dates this period
In recent years, there has been renewed interest among both practitioners and academics in understanding the determinants of commodity prices. Commodity prices are influenced by their use as inputs to the real economy: if spot commodity prices are abnormally high, we can expect high-cost producers to enter the market, increasing supply and consequently exerting downward pressure on prices. If spot prices drop, high-cost producers will put their production processes on hold, decreasing supply and generating upward pressure on prices.
Hence, commodity prices tend to revert over time towards a long-run mean, unless a structural break in the economy changes the long-run equilibrium. The degree of mean-reversion will be determined by the volatility of the demand, the level of inventories, costs associated with stopping and restarting production and other idiosyncratic shocks affecting supply, such as geopolitical conflicts and natural disasters.
In addition to the large physical markets, for each commodity there is usually a deep and active derivatives market in which participants trade for hedging, but also for speculative purposes. Commodity futures – standardised contracts between two parties to take long (buy) or short (sell) positions in a specified asset for a price agreed on initiation, with delivery and payment occurring at a specified future date – are probably the most commonly traded derivatives. Entering such contracts entails posting a relatively small amount of cash or margin.
These contracts can be used by commodity producers and consumers to hedge their exposure to commodity price swings, but they can also be used by other investors who might want to take a directional view on certain commodities. The main advantage of futures for such investors is that they do not need to own the commodity in order to gain exposure to price changes.
Even though futures contracts on certain commodities have existed for decades, it is not until recently that commodities have become an investable asset class. Flows into commodity funds have soared since 2005. This ongoing financialisation has caused commodities prices to move more in sync with each other, and with the market overall.
This phenomenon is better understood when we look at the gross (long plus short) open positions taken by speculative-type investors that the Commodity Futures Trading Commission (CFTC) publishes in its weekly Commitments of Traders (COT) reports.
These provide a breakdown of the open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. Each report shows the total open interest, for both long and short positions, for two types of traders: reportable positions or ‘large traders’, and non-reportable positions or ‘small traders’.
According to the CFTC, the aggregate of all traders’ positions represents 70-90% of the total open interest in any given market.
Large traders are subdivided between commercial traders or ‘large hedgers’, and non-commercial traders or ‘large speculators’. All of a trader’s reported futures positions in a commodity are classified as commercial if the trader uses futures contracts in that particular commodity for hedging. A trading entity is generally classified as a commercial trader if it declares and files to the CFTC that it “is engaged in business activities hedged by the use of the futures or option markets”, with the CFTC reserving the right to re-classify a trader. A trader may be classified as a commercial trader in some commodities and as a non-commercial trader in other commodities.
Even though a single trading entity cannot be classified as both a commercial and non-commercial trader in the same commodity, a financial organisation trading in financial futures may have a banking entity whose positions are classified as commercial and have a separate money-management entity whose positions are classified as non-commercial.
The positions of small traders can be derived from subtracting the long and short reportable positions from the total open interest, but whether small traders are speculators or hedgers is unknown.
Using this information, we compile the long and short positions for each type of trader in 20 different commodities from five sectors: energy, grains, livestock, food and fibre, and metals. We do this for a period of 27 years that begins in January 1986 and extends to June 2012.
We then compute the gross interest by investor type as the sum of long and short positions. Figure 1 plots the average gross interest by investor type. First, it is interesting to note that the gross interest of commercial traders increased substantially until the financial crisis in 2008, and that there was another run-up until the euro-zone crisis in January 2011.
Second, it is also interesting to see that the gross positions of small traders were, until 2003, larger than the ones of non-commercial traders, about the same size until 2005, after which the gross positions of non-commercial traders or speculators have grown significantly.
It is natural, then, to look into the effects of this financialisation of commodities on price volatility. To do so we construct a value-weighted portfolio of the 20 commodities, compute weekly returns and then estimate a GARCH model to extract the volatility. We display the volatility of commodities alongside the S&P500 stock market volatility index (VIX) in figure 2. We can observe that the volatility of commodity portfolio moves in sync with the VIX, even before the financialisation started. Also, we can see that the volatility of commodities is high when there is high market uncertainty, which is consistent with the fact that commodities are used in productive activities.
In figure 2 we also fit a squared polynomial for each time-series. Consistent with mean-reversion, the fitted curve is quite flat for the VIX. On the other hand, the same curve is upward sloping in the latest period for commodities. The fact that commodities’ volatility has been increasing in recent years could be due, in part, to the recent financialisation in the commodities industry. However, whether financialisation is contributing to stronger price swings in the commodities industry is still an open question that needs further research. What is clear, however, is that commodities react to similar signals as the stock market – but have been doing so for a long time before significant financialisation of the futures markets.
Lorenzo Naranjo and Carmen Stefanescu are both assistant professors of finance at ESSEC Business School