Economics of Commodity Markets

October 25-26, 2013
Kenneth Singleton, Stanford University, and Wei Xiong, Princeton University, Organizers

Suman Banerjee, Nanyang Business School, and Ravi Jagannathan, Northwestern University and NBER

Destabilizing Commodity Market Speculation

Banerjee and Jagannathan show that under quantity competition with only a few strategic sellers and a large number of small price-taking consumers/retailers. a speculator with a deep pocket and access to sufficient storage facilities can have a destabilizing effect on commodity prices. The speculator can profit by lowering the price when buying and raising the price when selling commodity contracts, thereby increasing the commodity price volatility. There is no information asymmetry or private information in the model. Also, the authors do not consider any explicit coordination among these strategic sellers and/or the speculator. While possible, the authors' results also suggest that destabilizing speculation may be difficult to sustain.

John Birge and Ignacia Mercadal, University of Chicago; Ali Hortacsu, University of Chicago and NBER; and Michael Pavlin, Wilfrid Laurier University

The Role of Financial Players in Electricity Markets: An Empirical Analysis of MISO

As in most commodities markets, deregulated electricity markets allow the participation of purely financial (virtual) traders to enhance informational and productive efficiency. Among other things, the presence of financial players is expected to help eliminate predictable pricing gaps between forward (day-ahead) and spot prices which may arise in the presence of market power by physical suppliers or buyers. However, Birge, Hortacsu, Mercadal, and Pavlin find that the impact of financial players on reducing pricing gaps has been limited. A forward premium persists. Surprisingly, some large financial players appear to be betting in exactly the opposite direction of the pricing gap, sustaining large losses while doing so. The authors find evidence consistent with participants using forward market bids to affect congestion and thus increase the value of their financial transmission rights (FTR), that is, these financial players incur losses with one financial instrument to make larger profits with another, introducing artificial congestion to the system. The authors point to the challenges of achieving market efficiency through purely financial players when the underlying physical market is segmented and subject to the exercise of market power in each segment.

Eugenio Bobenrieth, Pontificia Universidad Católica de Chile; Juan Bobenrieth, Universidad del Bío-Bío; and Brian Wright, University of California at Berkeley

Bubble Troubles? Rational Storage, Mean Reversion and Runs in Commodity Prices

High and volatile prices of major commodities have generated a wide array of analyses and policy prescriptions, including influential studies identifying price bubbles in periods of high volatility. Bobenrieth, Bobenrieth, and Wright consider a model of the market for a storable commodity in which price expectations are unbounded. The authors derive its implications for price time series and empirical tests of price behavior. In this model commodity price is equal to marginal consumption value, and hence bubbles as defined in financial economics cannot occur. However the model generates episodes of price runs that could be characterized as "explosive" and might seem to be bubble-like. At sufficiently long holding periods, a price path can yield average returns consistent with mean reversion, even though the long-run expectation of price is infinite.

Alexander David, University of Calgary

Exploration Activity, Long Run Decisions, and Roll Returns in Energy Futures

David presents evidence that firms' inventories as well as their long-term expenditures on exploration and development (E&D) each help to predict the slope of the oil futures curve one year ahead. In addition he shows that roll strategies in futures contracts conditioned on E&D expenditures rather than on inventories have had a stronger performance over the past 25 years. Historical data display significant components of very low (less than once in six years) and very high (more than once every two months) frequency variation in prices, which supports the presence of both long- and short-term risk. Building on the work of Litzenberger and Rabinowitz (1995), the author develops a theoretical model where firms change E&D expenses over the business cycle to manage the value of their extraction options. Firms optimally invest in short bursts when aggregate resource demand shifts from a stable to a volatile regime, and when their capital stock is far from the new optimum level. Such adjustments happen infrequently only when the stable regime has persisted for a fairly long period. The model is able to shed light on the stylized facts.

Wenjin Kang, National University of Singapore; Geert Rouwenhorst, Yale University; and Ke Tang, Renmin University of China

The Role of Hedgers and Speculators in Liquidity Provision to Commodity Futures Markets

Kang, Rouwenhorst, and Tang study the dynamic relation between position changes and short-horizon returns in commodity futures markets. In contrast to the Keynesian view that speculators provide liquidity to hedgers, the authors find that hedgers provide short-term liquidity to speculators. Speculators follow momentum strategies and trade more impatiently than hedgers, who trade as contrarians. Commodity futures prices predictably increase (decrease) following hedgers' buying (selling) activity. This predictability is stronger when hedgers face more binding funding constraints and higher inventory pressure. These findings are consistent with the view that hedgers receive compensation for providing liquidity to speculators.

Yu-Chin Chen, University of Washington, and Dongwon Lee, University of California at Riverside

What Makes a Commodity Currency?

The "commodity currency" literature highlights the robust exchange rate response to fluctuations in world commodity prices that occurs for major commodity exporters. The magnitude of this response, however, varies widely among countries. Empirical analysis by Chen and Lee finds that, in accordance with theory, the long-run relationship between the real exchange rate and commodity prices depends on the nation's export market structure, its monetary policy choices, and its degree of trade and financial openness. The authors also show that in the short run, the commodity price-exchange rate connection is much weaker for their large set of economies than has been observed in prior literature based on a small set of advanced economies. Given concerns for the Dutch disease or resource curse that operate through the real exchange rate, the authors' findings are of particular relevance for monetary policymaking and for globalization strategy in commodity-exporting developing economies.

Domenico Ferraro and Pietro Peretto, Duke University

Commodity Price, Long-Run Growth and Fiscal Vulnerability

Long-lasting commodity price declines are often associated with abrupt tax revenue shortfalls in commodity-exporting countries. Therefore, reliance on the tax base of the commodity-exporting sector makes the country's fiscal stance vulnerable to exogenous variations in commodity prices: fiscal vulnerability. Ferraro and Peretto study the short- and long-run effects of commodity price changes and how fiscal policy interacts with the amplification and propagation of external shocks to these prices. To this end, they develop a Schumpeterian small open economy (SOE) model of endogenous growth that does not exhibit the scale effect. Because of the sterilization of the scale effect, commodity prices have level effects on economic activity but no steady-state growth effects. A general implication of the analysis is that the economy dynamic response to commodity price changes depends both on the structure of the tax code in place and on the policy response necessary to balance the government budget. The authors show that asset income taxation has negative steady-state growth effects. Furthermore, a positive tax rate on asset income acts as an automatic amplifier of external shocks to commodity prices and makes the effects of these shocks more persistent.

Martijn Boons, Finance Department, Tilburg University; Frans de Roon, CentER, Tilburg University; and Marta Szymanowska, RSM Erasmus University

The Stock Market Price of Commodity Risk

Boons, de Roon, and Szymanowska find that commodity risk is priced in the cross-section of U.S. stock returns. Because of the Commodity Futures Modernization Act (CFMA) in 2000, investors can hedge commodity price risk directly in the futures market, primarily through commodity index investments, whereas before the CFMA they could gain commodity exposure mainly through the stock market. As a result, the authors find that the mean returns on high-minus-low commodity beta stocks changes from –8 percent per year before CFMA to 11 percent per year after CFMA. In addition, as stock market investors increasingly participate in commodity futures markets after CFMA, the authors find that stock market risk also affects mean commodity futures returns.

Gurdip Bakshi, Xiaohui Gao, and Alberto Rossi, University of Maryland

A Better Specified Asset Pricing Model to Explain the Cross-section and Time-Series of Commodity Returns

Bakshi, Gao, and Rossi show that a model featuring an average commodity factor, a commodity carry factor, and a commodity momentum factor is capable of describing both the cross-sectional and time-series variation of commodity returns. Going beyond extant studies, the authors' empirical results indicate that more parsimonious one- and two-factor models that feature the average and/or carry factors are rejected and the momentum factor contains additional information beyond that conveyed by the carry factor. Furthermore, they find that additional factors (such as value or volatility) are statistically and economically insignificant. Together the three factors appear to forecast real economic activity, returns of bonds, equities, and commodity currencies, and they correlate with economic fundamentals. The authors explore economic interpretations of their findings and the sources of model performance.

Anh Le, University of North Carolina, and Haoxiang Zhu, MIT Sloan School of Management

Risk Premia in Gold Lease Rates

Gold is an important global reserve asset, widely held by the official sector and by private investors. Le and Zhu study a measure of the opportunity costs of holding gold, the gold lease rates, which are interests paid in gold for borrowing gold. Gold lease rates are economically significant in magnitude and display substantial variations over time. Using a term structure model with "unspanned" risk factors, the authors find that risk premia in gold lease rates are highly time-varying and strongly increasing in the level and slope of gold lease rates, as well as in gold volatility. Expected excess returns of "gold bonds" are mostly positive, suggesting that they are perceived as risky investments.

Robert Ready, University of Rochester; Nikolai Roussanov, University of Pennsylvania and NBER; and Colin Ward, University of Pennsylvania

Commodity Trade and the Carry Trade: A Tale of Two Countries (NBER Working Paper 19371)

Persistent differences in interest rates across countries account for much of the profitability of currency carry trade strategies. The high interest rate "investment" currencies tend to be "commodity currencies," while low interest rate "funding" currencies tend to belong to countries that export finished goods and import most of their commodities. Ready, Roussanov, and Ward develop a general equilibrium model of commodity trade and currency pricing that generates this pattern via frictions in the shipping sector. The model predicts that commodity-producing countries are insulated from global productivity shocks by the limited shipping capacity, which forces the final goods producers to absorb the shocks. As a result, a commodity currency is risky as it tends to depreciate in bad times, yet it has higher interest rates on average because of lower precautionary demand, compared to the final goods producer. The model's predictions are strongly supported in the data. The commodity-currency carry trade explains a substantial portion of the carry-trade risk premia, and all of their procyclical predictability with commodity prices and shipping costs, as predicted by the model.

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