Do Speculators Really Inflate Commodity Prices?

When food or oil prices rise, some critics blame commodity index funds. But Assistant Professor Jing Cynthia Wu and James D. Hamilton of the University of California, San Diego, find weak evidence to do so.

Commodity index funds, which became popular starting around 2004, aim to track commodity price indexes. Index investors hoping to mimic market movements generally buy positions in soon-to-expire futures contracts, and roll their positions forward before those contracts expire and meet the “spot” prices in the physical commodities markets.

Critics have claimed that index funds’ buying has pushed up prices of commodity-futures contracts. Outspoken hedge-fund manager Michael Masters presented in 2008 a compelling graph showing oil prices closely tracking an estimate of the volume of crude-oil futures held by the funds. For this argument to hold, higher buy-side volume must increase the price of futures contracts, and higher futures prices must increase spot prices.

Masters was forced to estimate how many oil contracts index funds hold in futures markets, which he did by using data from three agricultural commodities. Wu and Hamilton develop a more robust method to estimate volume, using all 12 agricultural commodities with holding data available to compute the oil holdings. At first blush, the researchers’ results seem to support Masters’s claim, particularly from 2006 to 2009, when index-fund holdings appear to track crude-oil prices.

However, Wu and Hamilton find the correlation disappears after 2009, for both Masters’s approach to estimating the buy-side holdings of oil-futures contracts as well as their approach. Moreover, they find that both approaches showed an apparent correlation between index-fund holdings in the crude-oil market and the price movements of the S&P 500 stock index between 2006 and 2009, another correlation that disappeared after 2009. This leads the researchers to conclude such correlations are coincidence.

“Our overall conclusion is thus consistent with most of the previous literature—there seems to be little evidence that index-fund investing is exerting a measurable effect on commodity-futures prices,” Wu and Hamilton note.

The researchers do find that index-fund investors have changed the risk premium in commodity futures, even if they weren’t responsible for the oil price spike of 2006. In another study, they focus on trading in NYMEX-futures contracts in light sweet crude oil. The market for light sweet crude experienced tremendous growth in 2005, as index funds began investing in its futures contracts to diversify their portfolios.

John Maynard Keynes’s theory of “normal backwardation” proposes that producers of a physical commodity using futures contracts to hedge price risk must compensate arbitrageurs for assuming that risk. Since producers often sell contracts to hedge against commodity price decreases, they compensate their counterparties by setting a futures price below the expected future spot price, giving the traders a profit—the risk premium—as the contract’s price increases to meet the spot price at expiration.

But this premium has, since 2005, reduced significantly and even at times turned negative. The researchers say that commercial commodity producers’ “natural” counterparties have shifted from arbitrageurs to financial investors, who don’t demand payment to take on the counterparty risk and will even pay a premium to invest in an asset class unrelated to their other investments. So the researchers conclude that while index-fund investors have impacted the risk premium, they haven’t necessarily caused futures prices to spike.

“If the claim about index-fund traders pushing up the price of oil futures is true, then we would observe the risk premium, on average, being significantly negative,” says Wu, adding, “But we don’t see that in the data.”