Commodity Price Movements and Financialization: What We

Know and What We Don'tJames D. Hamilton

University of California at San Diego

What is “financialization”?

• Financial investors buying commodity futures– S&P Goldman Sachs Index– Dow Jones UBS Commodity Index

• Take long position in near futures contract• Sell contract and take new position in next

contract near expiry

Solid line: Oil price. Dashed line: Long positions in oil futurescontracts of commodity index funds as inferred using the methodology of Masters (2008). Source: Singleton (2011).

Monthly price of West Texas Intermediate ($/barrel) and city gate price of natural gas (in $/1000 cubic feet times 6). Data source: EIA.

2000 2002 2004 2006 2008 2010 2012 20140

20

40

60

80

100

120

140

160

Price of crude oil and natural gas

wti nat gas*6

Both WTI and n gas are in DJ and GS

Monthly price of West Texas Intermediate ($/barrel) and London spotprice of rhodium ($/ounce divided by 30). Data source: EIA and Kitco.

2000 2002 2004 2006 2008 2010 2012 20140

50

100

150

200

250

300

350

Price of crude oil and rhodium

wti Rhodium/30

There is no futures market in rhodium

Relation between crude oil price and Masters’ estimate of CIT subsequently broke down

Source: Hamilton and Wu, International Economic Review, forthcoming.

Masters’ imputed CIT for oil

• CFTC Supplemental Commitment of Traders estimates CIT for 12 agricultural commodities

• Masters assumed all reported CIT was either following GS index or DJ index

• GS does not include soybean oil• Given known weights of DJ for crude oil

and soybean oil, Masters inferred holdings of crude oil for DJ funds

• Likewise, GS includes KC wheat whereas DJ does not

• From SCOT reported CIT for KC wheat, Masters inferred total crude oil futures contracts held by GS-based funds

• GS also includes feeder cattle and DJ does not

• This gives second estimate of GS crude oil• Masters' imputed CIT for crude oil is the

sum of his estimates for DJ and GS

Green line is based on holdings of soybean oil, feeder cattle, and KC wheat. Blue is price of crude oil

• Actually, method does not require finding commodities held in only one fund

• Given known weights of both funds, observed SCOT for any two agricultural commodities gives two equations in two unknowns with which could calculate an imputed sum of DJ and GS crude oil holdings

Estimates of GS and DJ holdings of crude oil contracts imputedUsing Masters’ method from soybean oil and one other commodity

Source: Hamilton and Wu, International Economic Review, forthcoming.

• CFTC also has direct estimates (“Index Investment Data”) of crude oil CIT (quarterly since 2007, monthly since 2010:M6)

Number of crude oil futures contracts held by index investment funds as inferredfrom CFTC estimates of index fund positions in soybean oil, KC wheat, and feeder cattle (dashed) and direct CFTC estimates of crude oil (solid). Source: Irwin and Sanders, Energy Economics, 2012.

2007 2008 2009 2010 2011 2012 20130

20

40

60

80

100

120

140

160

0

100

200

300

400

500

600

Oil price and net number of long index con-tracts

oil price oil contracts

Oil prices and CIT oil positions based on Index Investment Data

2007 2008 2009 2010 2011 2012 20130

2

4

6

8

10

12

14

050100150200250300350400450

Natural gas price and net number of long index contracts

gas price gas contracts

Natural gas prices and CIT gas positions based on Index Investment Data

• Masters (2009):– "Buying pressure from Index Speculators

overwhelmed selling pressure from producers and the result was skyrocketing commodity prices."

• Claim involves two links:– 1) increased volume on the buy side

drives up the price of futures contract– 2) higher futures prices produce

increase in spot prices

1) Could increase volume on buy side increase futures price?

Answer: yes, if counterparties require higher expected returns in compensation for taking on more nondiversifiable risk

(Hamilton and Wu, Journal of International Money and Finance, 2014; International Economic Review, forthcoming)

• Easily testable: if CIT volume leads to compensation to counterparties, should help predict excess returns on futures contracts

• Empirical evidence that it does not: – Brunetti, et. al. (2011)– Sanders and Irwin (2011a,b)– Stoll and Whaley (2010)– Alquist and Gervais (2011)– Irwin and Sanders (2012)– Buyuksahin and Harris (2011)– Hamilton and Wu (forthcoming)

Tests of whether notional CIT exposure in given commodity predicts weekly returns

(2006-2012)

Source: Hamilton and Wu, International Economic Review, forthcoming.

demand

supply

P0

P2

Δ inventories

2) Could higher futures pricesproduce increase in spot prices?

r = -0.23

Actual inventory changes and predicted changes if price change over 12 Months was due solely to speculation and supply and demand elasticities = 0.2.Source: Knittel and Pindyck (2014)

• Conclusion: “financialization” could not explain long-run movements in relative commodity prices

• However, “speculation” accounts for 100% of high-frequency movements

Hurricane Katrina (Aug 2005) had a large and permanent effect on oil production

Source:www.econbrowser.com/archives/2008/09/effects_of_hurr.html

Gulf of Mexico offshore crude oil production, 2005-2006 (1000 b/d)

0

300

600

900

1200

1500

1800

2005 2006 2007

Hurricane Alex (June 2010)

• June 27: National Hurricane Center warns Alex could develop into Category 3 hurricane and damage oil production facilities in Gulf of Mexico

• June 29: clear there will be no effect on oil production (www.theoildrum.com/node/6671)

WTI spot and NYMEX futures prices

Hurricane Alex (June 2010)

666870727476788082

6/23/2

010

6/24/2

010

6/25/2

010

6/26/2

010

6/27/2

010

6/28/2

010

6/29/2

010

6/30/2

010

7/1/201

0

7/2/201

0

spot1m futures2m futures3m futures4m futures

Data source: EIA

U.S. inventories of crude oil (excluding Strategic Petroleum Reserve):

• June 18, 2010-- 365.1 M• June 25, 2010-- 363.1 M• July 2, 2010-- 358.1 M

P0

P2

ΔN2

Very short run: elasticities are very low and inventory changes are negligible

5-year assessments: elasticities are not zero

World field production of crude oil up 2.3 mb/d since 2005 (= 3% increase)

World GDP increased 27.7% from 2005 to 2013

2002 2004 2006 2008 2010 201260

65

70

75

80

85

90

95

100

actual oil production

Growing income would predict growing energy use (elasticity = 0.7)

Cross-section scatterplot (log scale) of energy use and GDP per capita for indicated years. Source: David Stern (http://www.sterndavidi.com/animation.gif)

Projected demand growth based on growth of world GDP assuming constant price and

Stern’s income elasticity of 0.7

2013 shortfall = 13.5 mb/d (16% of production)

2002 2004 2006 2008 2010 201260

65

70

75

80

85

90

95

100

actual oil productionexpected production

Example: long-run price-elasticity of oil demand = 0.25

• Δ ln Qt = 0.25 Δ ln Pt • Δ ln Pt = 0.16/0.25 = 0.64• P2005 = $60/barrel (in 2014 $)• P2013 = 60 exp(0.64) = $114/barrel• If short-run price elasticity is less than

long-run, price should have been higher than $114 before coming down

Why did global oil production stagnate?

Source: Steven Kopits (Douglas-Westwood, 2012)

Norway oil production (1000 b/d) and % of world total

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

0

500

1000

1500

2000

2500

3000

3500

0

1

2

3

4

5

6

Norway oil production

Norway production Percent of world total

• If resource depletion becomes a factor in pricing, producers need to know transversality conditions

• Very hard to calculate, rely on futures markets for price discovery, information assimilation

• If “financialization” impedes price discovery, could cause bigger problems

Gulf of Mexico rig utilization rates and price of WTI

Source: Knittel and Pindyck (2014)

Oil production of listed majors has declined even as capital spending surged

Source: Steven Kopits (Douglas-Westwood, 2014)

Middle East production stagnated despite huge increased drilling effort

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 20130

5

10

15

20

25

30

0

50

100

150

200

250

300

350

400

450

Middle East oil production and active drilling rigs

oil production rig count

Data source: EIA (field production plus condensate) and Banker-Hughes.BH stopped counting Iran in Jan 2006, accounting for the drop at that date.

But excessive preoccupation by academics with “financialization”, and not enough consensus on big

picture, may also impede price discovery

2002 2004 2006 2008 2010 201260

65

70

75

80

85

90

95

100

actual oil productionexpected production