Index Inflows &
Commodity Price Behaviour
By Daniel Ahn
SINCE THE FALL of 2007, commodity
priceshavestagedaremarkablybroad-
Figure 1: Price of WTI Crude (RHS),
based rally across the energy, agricul-
Cumulative WTI Index Flows (LHS)
tural, and metals complex, despite a
recent sell-off in the past few weeks.
Thisdramaticriseinpriceshassparked
a fierce debate over its nature, with
someanalystsarguingthattheincreas-
es are an efficient market response to
tight supply-demand fundamentals.
However, others have been quick to
point to the rise of non-fundamental
factors,suchasspeculativeactivity.
Thestellarreturnperformanceofcom-
moditiesasothertraditionalassetclass-
Sources: Lehman Brothers estimates, CTFC, Bloomberg
es have wilted has attracted a large
number of purely financial investors to Congress to crack down on speculative investment in commodities.
themarket.Inparticular,exchange-trad- But a more nuanced analysis is necessary before placing the blame
ed commodity index funds have onthedoorstepofspeculators.
emergedasaprimarychannelforfinan-
cial investment. These index funds typi- The ‘Financialization’ of Commodity Markets
callyoperateviatotalreturnswapagree- Although financial exchanges for commodities have been around
ments between the investor, notably sincethe19
th
Century,theybeganattractingattentionasafrontier
pension funds and other institutional asset class for portfolio allocation only recently. Academic studies
investors,andthecounterpartyfinancial documentedtheseeminglygoodrisk-returnprofiles,lowornegative
institution, often banks. By engaging correlations to traditional asset classes and the business cycle, and
through a financial intermediary using low cross-commodity correlations. This researchinspiredinstitution-
swaps,theseindicesexploittheso-called alinvestors,startingwithuniversityendowmentsandpensionfunds,
swap loophole that exempts these toexplorelong-termpassiveallocationsintocommoditiesstartingin
investments from speculative position theearly1990s,alsoroughlywhentheGSCIwasfirstcreated.
limitsimposedbytheCFTC. Size and activity on commodity exchanges have boomed since
By far the largest two indices by mar- then.Figure2showsthetotalopeninterest,brokendownbyfutures
ket share are the S&P Goldman Sachs andoptions,onthetwomajorexchangesforpaperoil:TheNewYork
CommodityIndex(GSCI)andtheDow- Mercantile Exchange (NYMEX) and the InterContinentalExchange
JonesAIGCommodityIndex(DJ-AIG).
Despitetheirrelativeyouth,commod-
Figure 2: Open Interest for WTI & Brent on NYMEX & ICE
ityindexfundshavequicklyemergedas
a major force on the exchange floor.
Indeed, as Figure 1 demonstrates for
crude oil, index inflows in commodities
have coincided with dramatic price
increasesoverthepasttwoyears.Many
market commentators and politicians
havetakenthisas prima facie evidence
of the role of speculative activity in
drivingupcommodityprices,particular-
lyforoil.
Indeed, political constituents in the
UnitedStates,frustratedbyrecordhigh
food and energy prices, have pressured
Sources: NYMEX, ICE
42 SEPTEMBER 2008 COMMODITIES NOW
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