“One of the great mistakes is to judge policies by their intentions rather than results.”
— Milton Friedman
In December 2018, a leading European bank sent its customers investing tips for the next year. To navigate “an increasingly challenging investment environment,” the bank advised, “The latter stages of the economic cycle have historically been one of the better times to invest in commodities. Overall demand tends to stay high while inventories run low.”
Until recently, commodities interested mostly those who produced, traded, or consumed them (except precious metals, which is a different story). Commodity derivatives (futures, options, swaps) were invented to help farmers (and, later, miners and the oil industry) mitigate market risk through harvesting and economic cycles, and were predominantly used for this purpose from the nineteenth century until the 1990s. Derivatives speculation was mostly confined to insiders: merchants, brokers, and other intermediaries with the information advantages, resources, and clout to make contrarian financial bets.
The situation changed when hedge funds discovered commodities as an alternative asset class and started trading them to offset financial market fluctuations and to profit from the price fluctuations of commodities themselves. The derivatives came in handy, allowing the building and unwinding of trading positions without the physical ownership of barrels, bars, and bushels.
As the news spread, large institutional investors (banks, insurers, pensions, and mutual funds) started to pile in, ultimately followed by ordinary folk. For exchanges and brokers that facilitate such transactions, it was a gold mine. Commodity derivatives were previously mostly traded by market participants for risk management—but their hedging needs and therefore the size of the related derivative market were limited by production, trade, and consumption. Speculative trading, on the other hand—and the income it generates—is literally unlimited. The more commodity derivatives were traded, the more money flowed to investors, exchanges, and brokers, creating a whole new ecosystem.
Take crude oil as an example. In 1995, when oilmen pumped 22.8 billion barrels globally, trading in nymex WTI and ICE Brent futures, the world’s two most popular crude derivatives, accounted for 33.5 billion barrels. Last year, production increased to 30.2 billion barrels, but these futures markets alone swelled to 541.6 billion barrels, becoming eighteen times bigger than the global physical output. This is without taking into consideration all other derivatives, other categories (e.g., options, swaps), other oil grades (e.g., Medium Sour, Urals), derivatives for products of oil refining (e.g., gasoline, fuel oil), other exchanges (e.g., MCX, tocom), and cross-trading (the same derivative may be traded on several exchanges, e.g., ICE WTI, and, bilaterally, over the counter). On the whole, the derivative market has grown far beyond its physical cousin. Nobody really knows its size and fully understands the interplay between the two.
Considering that the revenues of commodity exchanges and brokers depend on trading volumes, the incentives are obvious. In the early days, the exchanges were not-for-profit organizations controlled by their members. For example, two of the forebears of CME Group, the Chicago Board of Trade and the Chicago Butter and Egg Board, were founded in 1848 and 1898 as voluntary associations of prominent merchants. (This setup didn’t guarantee orderly trading, though, as various instances of market manipulation, such as the Ferruzzi soybean scandal of 1989, indicate.) In the 2000s, both exchanges demutualized, turned into for-profit stock corporations, and merged. Today, most prominent commodity exchanges are for-profit companies. According to CNN, last year institutional investors owned around 87 percent of CME Group and 92 percent of Intercontinental Exchange (ICE), the two major bourses in the Western commodity markets.
In less than three decades, commodity investing has turned from exotic to mainstream. It is marketed by any broker and investment advisor worth their salt, and exchanges vie for global dominance in commodity futures and related services, which has become a big business.
From 2003 to 2017, the combined net income of CME Group and ICE jumped twenty-nine times, from $175 million to more than $5 billion, with profit margins around 60 percent. In 2017, CME Group alone cleared more than four billion derivatives with a notional value of more than $1 quadrillion. Both exchanges report trading and clearing fees together, but if the London Stock Exchange is any guide, the latter may rake in more than the former because of increased regulation. The rise of quantitative funds, automated trading, and passive investing increase demand for data feeds and services, which already bring LSE twice as much revenue as trading.
According to the Futures Industry Association, global trading in futures and options grew from 188 million contracts in 1984 to 30.3 billion contracts in 2018. Having accounted for 17.3 percent of this market last year, commodities are on course to become the second-most traded derivative category, ahead of equities. Most of that trading had nothing to do with the needs of the real economy—that is, the original purpose of risk reduction that derivatives were originally invented for—it was pure speculation. But these processes have a direct bearing on overall economic performance and the fortunes of many businesses.
When trading in commodity derivatives exceeds a certain level, several unintended consequences result. This happens for a few reasons:
- As explained below, financial intermediation dematerializes commodity price discovery, shifting it from present fundamentals to future expectations, influenced by financial markets;
- Commodity derivatives can be quickly converted into cash and constitute only a fraction of the global investment universe;
- Derivatives create a link between physical and financial markets through which capital may flow freely and quickly, directed by mouse clicks and trading algorithms;
- In a derivative market, hedgers and speculators coexist but have diametrically opposed interests in volatility. While the former need more certainty, the latter thrive in choppy markets that breed trading opportunities.
Unencumbered by the need to produce or consume a physical commodity, investors pursue their own agenda. When they constitute most of its futures trading, such commodity becomes a pawn in the financial chess game.
As a result, the more commodity pricing becomes financially intermediated, and the more commodities turn from mere raw materials into investable assets, the more their markets get manipulated, intertwined with, and sometimes displaced by financial market dynamics and other phenomena unrelated to the fundamentals of supply and demand. Why does this matter? Because the markets so “financialized” fail to fulfill their core functions of price discovery and efficient allocation of economic resources. Such distortions damage the welfare of market participants across commodity sectors, especially SMEs and developing countries, but also society at large.
Consider the following example: Indonesia is a leading exporter of nickel ore. As of 2009, its government mulled export restrictions on unprocessed minerals to boost domestic smelting. Initially not taken seriously, the government’s deliberations intensified in 2012–13 and culminated in a ban on nickel ore exports in early 2014. Nickel prices jumped on fears of ore shortages, even though mounting stocks suggested a supply glut. It took only months for several producers, especially in the neighbouring Philippines, to ramp up ore mining and exports, which again sent nickel prices south (but with nickel stocks, financed at near-zero interest rates, growing regardless). Facing a budgetary squeeze, the Indonesian government decided to relax the ban in 2017, which apparently triggered the unwinding of related investment positions.
Two lessons can be learned from this story: First, financial investors have less information about commodities than those involved in their production, trade, and consumption (an obvious fact that is often neglected). Second, having no firsthand knowledge of each market’s structure and undercurrents but continually seeking actionable trading information, investors are prone to overreact to newsfeeds, misprice commodities, and aggravate boom-and-bust cycles.
The increased market volatility underlines the importance of risk management for the real economy—but no longer the relevance of financial derivatives for price discovery. A financialized commodity market is stacked against the industry because its derivatives aren’t used for their original purpose of risk reduction but instead mostly to “make” markets for and between investors looking for returns. Those who produce and consume commodities become hostage to investors that hold the ultimate pricing power.
The implications are manifold: Prices are inflated for end users when too much capital flows into bullish positions and depressed for producers when investors dump futures; uncertainty and volatility are increased for both. Moreover, producers don’t get the right signals from the market, which leads, inter alia, to wrong decisions about which crops to seed, plants to build, capacity to add. This can lead to wealth destruction and bankruptcies for communities, businesses, and those who put too much faith into investment research (and ignore the fact that issuers of such research may trade for their own account). Perversely, the more sway financial investors hold over price formation, the more hedging becomes regulated, expensive, and necessary for the real economy.
Market Organization and Price Discovery
Commodity markets are organized in two different ways, which may be exemplified by aluminium and steel. The former is traded and priced in centralized derivative markets, the latter in decentralized commercial markets.
Like crude oil, aluminum is traded on commodity exchanges where (and only where) its price is negotiated and set. A typical aluminum supply agreement doesn’t indicate a fixed price but simply incorporates the exchange price with some premium or discount. In practice, this means that aluminum smelters delegated the price discovery function—in other words, a right to price their entire production—to a centralized trading venue, where sellers and buyers could meet and negotiate prices based on supply and demand (the “fundamentals” in economic parlance). Over time, market participants who never touch aluminium massively outnumbered those who produce, distribute and consume it.
The steel market remains decentralized, which means that each company negotiates prices with other market participants based on its operational requirements, available information, and best business judgement. A typical supply agreement indicates a concrete, fixed price of steel. The only way to have a reliable indication of the current steel market is to pick up the phone and call companies directly engaged in the physical supply chain. Independent price reporting agencies research this market and provide benchmark prices that may be used as a gauge.
Centralization makes all information about the aluminum market instantaneously available to all—suppliers, end users, traders and financial investors. The fact that the latter know much less about market technicalities doesn’t prevent them from having a decisive role in aluminium price formation, however.
Once a commodity market becomes centralized, it is nearly impossible to roll it back to a decentralized state. A few years ago the industrial community was outraged by scandals involving large investment banks and trading houses that snapped up key storage facilities worldwide and created artificial bottlenecks in the physical flow of aluminum and other metals, apparently profiting from higher end prices and warehousing rents.
High-profile lawsuits, investigations, and U.S. Senate hearings ensued. As the head of global commodities at one of these banks was quoted in a class-action complaint, “Just being able to trade financial commodities is a serious limitation because financial commodities represent only a tiny fraction of the reality of the real commodity exposure picture. . . . We need to be active in the underlying physical commodity markets in order to understand and make prices.” The public outcry resulted in disposals of warehousing assets by banks and some penalties but left the market structure unchanged. A contest for the right to “make prices” goes on, with new contenders and higher stakes.
Another difference between aluminum and steel is how their prices are negotiated (or “discovered” in finance-speak). In the case of aluminum, a future price is first negotiated in a derivative market on a commodity exchange, which then rolls backs to the present through “arbitrage,” determining aluminium’s current (spot) price. In other words, the aluminium market is driven by future price expectations, which direct prices for physical material now. Over the years, aluminum’s derivative market has become increasingly integrated into global financial markets.
The steel market, by contrast, is grounded in the present and driven by commercial rather than derivative transactions. Steel prices reflect the current state of production, trade, and consumption in the real economy. The more these prices fluctuate, however, the more sellers and buyers need to manage related price risk. This is the only reason to shift from one market structure to another—and that’s why “risk management” remains the foundation of financial marketing.
Even though several commodity exchanges have been developing steel futures for more than a decade, they are largely dismissed by market participants, especially producers unwilling to leave price discovery to financial intermediaries. A notable exception is China, where the world’s largest physical market coexists with a vast derivative market (more on this below).
The aluminum market’s transformation didn’t happen overnight. Initially, the producers dismissed financial derivatives as most steel producers do today. After aluminum futures were launched by the London Metal Exchange (LME) in 1978, trading in them languished for a decade before merchants, who needed hedging tools, started to support exchange pricing, eventually followed by end users. Then trading volumes started to grow quickly. In 2012, when the LME was purchased by Hong Kong Exchanges and Clearing for $2.2 billion and became a for-profit corporation, futures trading reached 1.5 billion tons, thirty times the world output.
Since steel prices are volatile, there is a growing need to manage market risk. This need gives the exchanges a powerful argument in wooing customers. Slowly but surely, steel price formation will start moving from a decentralized commercial market to a centralized derivative one. As one derivative trader put it, “It may be emotional or irrational but after all, the volume of orders will decide which way the price will go.” Such sentiments call for a quick review of the efficient market hypothesis (EMH), a key argument to make price discovery centralized and financially intermediated.
When Rational Theories Meet Irrational People
The EMH claims that, in an efficient market, the prices of traded assets reflect all available information and instantly change to reflect new information. In other words, the markets always get the prices right, and assets are always traded at fair value. By facilitating the flow of information between a large number of market participants, a centralized exchange does a better job of price discovery than decentralized physical markets. The last financial crisis has proven (again) that reality is more complicated.
For a start, the EMH doesn’t make a distinction between physical and derivative markets and doesn’t take into account that the subjects, objects, and motives of each are very different. Indeed, financial markets may process information faster, but speed often comes at the expense of quality, resulting in overshooting, undershooting, and misallocation of resources. This happens because most market participants tend to react similarly to newly available information, and adjustments of their exposure to risk takes place almost in unison.
The EMH also states that in an efficient market information and power should be dispersed. This goes against the business logic of commodity exchanges, where the exact opposite is taking place. Indeed, it is much harder to “corner” a decentralized market where every participant has its own view about the current price and the price going forward.
The EMH also claims that newly available information induces economic agents to update their expectations appropriately. In derivative markers, however, participants are mostly concerned with guessing how such information may influence the behavior of other participants. Back in 1936, John Maynard Keynes used the metaphor of a beauty contest in which the judges are trying to guess the contestant that the other judges will vote for instead of making their own choices. In the same way, the “fundamental” value of a commodity asset is less important in a derivative market than expectations about the behavior of other participants.
For most investors, news and rumors about events that might change supply/demand fundamentals are actionable; any real change, which is noticeable only to physical market participants, is not. Since futures markets are centralized, they command much more visibility, which is billed as transparency. Greater visibility shapes expectations for all market participants irrespective of their motive for participating in derivatives markets. Because of this, the futures markets dominate the price formation in the spot markets and not the other way around.
In the Chinese derivative steel market, for example, bullish trading escalates in response to news about government infrastructure spending, completely ignoring the fact that the goal of such spending is to avoid a slump in steel demand, not to increase it. Even for increased demand, a 70–80 percent capacity utilization leaves ample room for extra production and cannot immediately result in higher prices, which is confirmed by regular price divergence in future and physical markets. When the narrative benefits one group in the supply chain, however, it happily plays along, inadvertently accelerating the transfer of price formation to a derivative market.
Another example is ferrosilicon, a raw material for steel production, for which futures were recently launched by the Zhengzhou Commodity Exchange (ZCE). As in steel, ferrosilicon derivative and physical markets coexist for the time being; in the former, trading concentration during one to two months and high trading velocity indicate heavily speculative trading. Yet because it is much more visible and some group is always benefiting more from the futures “market view” instead of relying on its own judgment, the physical market clearly follows its derivative counterpart.
To summarize, commodity derivative markets are not the efficient markets described in economics textbooks. In theory, each market participant is too small to influence prices and only has information concerning individual supply and demand. In financial markets, of which commodity derivatives form an integral part, the uniformity of available information provokes herding and highly correlated movements in and across markets, with the power of influencing both future and spot prices of all traded assets.
China Joins the Fray
Today, any analysis based on Western exchanges becomes less relevant because derivative trading is moving east. China leads the pack not only in terms of sheer volumes but also in its determination to turn its exchanges into global trading venues.
As the world’s largest consumer and producer of many commodities, China has a legitimate interest in having a say in their price formation. But how can it break into commodity pricing “franchises” that have been developed for decades and sometimes centuries? Apparently, the answer is maximum liberalization of the domestic derivative markets to grow their size and impact. Since the Chinese financial market is still developing and highly regulated, derivative trading is aimed at retail investors—a situation unique in the world.
So far, the results are startling. In 2016, the volume of trading in reinforcing bar (rebar) futures on the Shanghai Futures Exchange surpassed 9.3 billion tons, exceeding the entire Chinese steel output by a factor of 12 and becoming the most traded commodity future contract in the world. Last year, the volume of trading shrank by almost half, to 5.3 billion tons, but remained the most traded metal derivative globally. According to the Futures Industry Association, “The decline in Chinese volume reflects an important feature of the domestic market. Much of the trading in China stems from speculative trading by retail investors, which tends to be less steady than institutional trading.” The opportunism of these investors has been chronicled by Reuters and Bloomberg.
In 2018, eight of the top ten metal and agricultural derivatives were traded on Chinese exchanges. In just one year after launch, the volume of trading in ZCE apple futures climbed to third place in global agricultural rankings and overtook CBOT corn, which has been around since 1877. Energy derivatives lagged behind (just two out of the top ten), but this is going to change too.
What do these developments mean for commodity pricing? A short answer may be more financialization, including those commodity markets that escaped it before.
In the West, even though the exchanges’ revenue model has changed, investors still assumed that a commodity derivative should first be adopted by the industry for its original purpose, namely risk management. The LME’s first venture into ferrous markets, a billet future launched in 2008, may have failed because of this reason. In China, on the other hand, futures are ostensibly launched as a matter of government policy, with financial investors in mind, irrespective of industrial needs and participation in derivative trading.
Amid such financialization on steroids, it may take just several market cycles to completely move price formation onto an exchange. Coming back to the ferrosilicon example, even though market participants may publicly dismiss futures trading as speculative, producers use the bull narrative as an excuse to raise prices; when the futures market tanks, the same applies to buyers. When exchange pricing becomes more attractive, some parties start delivering or withdrawing physical material from exchange warehouses and then suggest referencing the exchange price in supply agreements. This way, an exchange doesn’t need consent or participation from the supply chain to obtain a license to “make” prices through a derivative market; it simply needs a volume of trading by financial participants that is high enough.
The Next Chapter
Economics is sometimes called the dismal science because it is hard to test its many hypotheses. Statistical analysis is often muddied by many variables, some correlated with others.
In academia, a debate about the influence of financial markets on commodity prices goes on. One faction, relying mostly on the EMH and the analysis of the Commitments of Traders (COT) reports published by the U.S. Commodity Futures Trading Commission, asserts there is none. Another, taking a more observant approach, disagrees: the recent financial scandals such as LIBOR, when several banks rigged the world’s interest rates to the tune of trillions of dollars, could hardly be explained by formulae and rational economic logic, while the COT methodology may be confusing if not misleading. In the meantime, more commodity prices became correlated with financial markets, revealing the real forces behind them.
In this respect, financialization of commodities is part of a wider modern economy narrative. In the current low-yield environment, in which Germany sells thirty-year debt at a negative yield, investors are scrambling for alternatives. Commodity investing (or, avoiding politically correct euphemisms, speculation) provides one. The recent wave of commodity exchange privatizations in the West has turned them into money-making machines for shareholders (mostly investment funds), forgoing the original purpose of both exchanges and the derivatives traded on them. Finally, as China continues asserting its role in commodity pricing, the increasing economic rivalry with America and its exchanges encourages a derivative arms race, in which laissez-faire meets coordinated policy.
A combination of these factors may destabilize not only markets—consider, for example, renewable energy transition—but also entire commodity-dependent nations. What can be done about it?
In derivative markets, only regulation may curb excessive, market-distorting speculation. The problem with this approach is that it’s hard to quantify and implement. Both academics and businesspeople agree that some level of speculation is good to grease markets, but where is the threshold between “benign” and “bad” speculation, and who should be granted or denied a right to speculate? The longer such debate continues, the harder may be the final reckoning.
Innovation may be a better answer for commercial markets, shifting the onus from regulation to self-governance. One way is to decouple risk management from finance. In hindsight, the former’s reliance on the latter is no more than historical path dependence. Commodity users and producers may be better served by decentralized hedging platforms that are closed to financial interests. This would provide the real economy with all the benefits of traditional risk management while keeping price formation grounded in fundamentals, taking hedging back to its roots. Price volatility insurance currently developed by Lloyd’s insurance market offers another solution. The more options that will be around to reduce market uncertainty, the better for the real economy.
As for banks hawking investment products to their customers, it would be better to keep commodities to themselves. The world economy should not dance to the tune of financial markets. Their gyrations should not unduly influence hardworking people and businesses. As farmers know better than most, whatever a man sows, this he will also reap.