A Washington hearing room was rapt last week as a man lectured on commodities markets. Money pouring in from investors had precipitated the “financialisation” of the sector. “Flows in these markets are having major effects on prices,” he said. “That’s the takeaway.”
But the speaker was not a populist senator or policy gadfly. He was Kenneth Singleton, a winner of econometrics awards and distinguished professor at Stanford University, presenting a paper on oil’s 2008 boom and bust.
His paper and others about related themes are starting to chip away at an official consensus that “fundamentals” such as supply, demand and stocks best explain the mountainous ups and downs of commodity prices.
Their conclusions loom large for Wall Street as regulators in the US and Europe seek to rationalise new rules to limit trading by banks, hedge funds and funds tracking commodity indices in markets from crude oil to coffee.
Mr Singleton was speaking at a conference hosted by the Commodity Futures Trading Commission, the US regulator poised to vote next month on the rules.
Research presented at the two-day forum – a first for the agency – “should be extremely helpful to our surveillance and enforcement efforts”, said Andrei Kirilenko, CFTC chief economist.
Official studies by groups such as International Organisation of Securities Commissions, the UK Financial Services Authority and the Organisation for Economic Co-operation and Development, as well as many academic ones, have for years failed to unearth evidence that speculation drove commodity prices, even during such extraordinary periods as 2007-2008.
The CFTC itself has defended the consensus. In July 2008, a week after crude had broken through $145 a barrel, a CTFC task force concluded that “changes in fundamental factors provide the best explanation for the recent crude oil price increases”. A spike in cotton four months earlier was largely blamed on merchants, not big holdings by index investors.
Wall Street is also sceptical. “Claims of non-fundamental commodity prices due to speculators rest on mathematical errors and flaws in logic,” Colin Fenton, chief commodities strategist at JPMorgan, said in a report this month.
Analyses that suggest investor flows as a cause of artificial prices often omit a much simpler explanation, he says – the marginal cost of production.
The fresh wave of research attempts to answer a difficult question. Investors have pumped more than $200bn into commodities since 2006, bringing total assets under management to $431bn, says Barclays Capital. That would intuitively seem to affect how markets function – but how?
Mr Singleton suggests in his paper that fundamental information, which appears to be objective, is imperfect. So traders act not only on what they know but what they think others know by looking at prices.
“Investing while learning about economic fundamentals, both from public announcements and market prices, may well induce excessive price volatility and drift in commodity prices,” he writes. “These phenomena are entirely absent, essentially by assumption, from the models of oil price determination that focus on representative suppliers, consumers and hedgers.”
Mr Singleton also attacks the idea that index trackers such as pension funds and exchange-traded funds are in commodity markets for the long term, damping volatility as a result.
“If index investors are just slightly too optimistic [in market rallies] or pessimistic [in market downturns] relative to the true state of the world, then their errors, while inconsequential for their own welfare, may be material for society as a whole.”
A paper by Bahattin Büyüksahin and Michel Robe finds that as commodity futures became “financialised,” the correlation between returns in commodities and equities increased “amid greater participation by speculators generally and hedge funds especially.”
“Fundamentals matter,” Mr Robe, of American University, said at the conference. “Trading activity matters as well.”
Fundamentals do still matter. With oil, for example, investors are buying a finite commodity being consumed in record volumes.
“It’s fine to talk about speculation,” James Hamilton, an economist at the University of California, San Diego, said at the conference. “But I think we should all be able to agree on the big picture: the real story driving the price of oil has been stagnating world supply in the face of a big increase in world income.”
No study makes the simple, but politically resonant, charge that speculators want to drive prices higher.
Nor are academics advocating policies, though Mr Singleton’s paper flowed from a survey he wrote for the Air Transport Association of America, which supports limits on speculative commodity positions.
The CFTC’s position limits rule would cap the size of commodity investors’ holdings and has been one of the agency’s most controversial proposals in the past year.
A divided commission is expected to vote on the measure on September 22, but changes to the initial proposal may be needed to ensure passage.
Craig Pirrong, a finance professor and widely cited futures market expert at the University of Houston, writes on his blog that the Singleton paper is “a very weak basis for policy recommendations”.
The research has emboldened proponents of a clampdown.
Sitting in the hearing room was Michael Masters, a hedge fund manager whose research ignited a fierce debate about the role of index funds in 2008.
The CFTC “sources views from the academic community, and in my view that will be helpful, if not prescriptive, to actual rules” such as position limits, he says.
Get alerts on Financial & markets regulation when a new story is published