COMMODITY INDICES
(ICE).Figure3showshowtradingactivityforcrudeoilhasriseneven ic auction system like their associated
faster. The rapid increase of trading activity on the NYMEX and ICE futures contracts, but rather on the
for paper oil starting in 2006 has far outpaced the growth in the basis of longer-term negotiated volume
physical market for crude oil. The daily trading volume on NYMEX is contracts between suppliers and buy-
now more than 6x that of entire global oil consumption, while ICE is ers. Hence, even if the price of nearest-
close behind at more than 5x world consumption. term futures goes up, this has only a
Furthermore, these figures underestimate the true size of financial limited short-term effect to the eco-
marketsforcommodities,astheydonottakeintoaccountunobserv- nomics of physical agents.
able activity happening directly over the counter (OTC) between The fundamentals of many commodi-
counterparties, rather than on public exchanges. But anecdotal ty markets are also notoriously opaque.
reports indicate that OTC activity has risen commensurately with There is simply no credible data avail-
that of exchanges. ableforkeyaspectsofthefundamental
balance, such as the amount of Saudi
‘Financialization’ of commodity markets has stirred
spare capacity or the size of Chinese
practitioners, academics, and policymakers alike to
inventories.
ponder the ramifications
The lack of insight into elasticities and
fundamentals makes market observers
This‘financialization’ofcommoditymarketshasstirredpractition- uncertain about even the validity of
ers, academics, and policymakers alike to ponder the ramifications. their model structure. This model uncer-
Many observers have asked if it is possible for purely financial actors tainty forces information-starved mar-
to affect a futures price, which is ultimately linked through spot mar- ket participants to copy the behaviour
kets to fundamental supply and demand. of others, leading to “herding behav-
A corollary to this sceptical view is the argument that the apparent iour.” The shortage of information also
lack of inventory build is proof that physical tightness rather than leads market observers to focus inordi-
speculative activity is driving prices higher. The theory goes; if spec- nately on the handful of available sig-
ulative market prices are above the equilibrium price of oil, con- nals, such as weekly changes in US
sumers would demand less than producers are supplying. The result- inventories. Markets may interpret a
ing excess supply must appear in inventories. sharp drop in US crude inventories as a
Taking the example of crude oil, we offer several objections to this bullish statement lending more cre-
analysis. First, reported inventory numbers come only from the dence to theories of supply shortages
United States and other OECD countries, not the entire globe. And and peak oil.
the deteriorating demand outlook in these developed economies Although we believe the alarm over
has discouraged commercial refiners from holding inventory. peak oil is premature, the paucity of
More importantly, we argue that the physical spot market for oil is reliableinformationlendsplausibilityto
only weakly responsive to financially traded futures prices. A large such theories, while the inelasticity of
supply or demand response requires high up-front fixed costs from supply and demand prevents an imme-
producers and consumers, e.g., to open a new producing basin or diate physical response to persuade
upgrade the efficiency of equipment, therefore causing a nonlinear market participants otherwise.
reaction to price and extreme short-run inelasticity. This inelasticity The ‘herding’ behaviour of market
also implies violent price responses to relatively small imbalances in participants also creates an opportuni-
supply and demand, making it difficult for market participants to for- ty for the activity of less-informed,
mulate price expectations. purely financial investors to distort
Furthermore, physical sales for crude take place not on an electron- expectations. We have already men-
tioned the microstructure effects of a
Figure 3: Daily Trading Volume in WTI & Brent
long index purchase, which must bid up
on NYMEX & ICE
the order price because of limited liq-
uidity and the need to give sellers an
incentive to accept the order.
Yet the anonymity of markets allows
participants potentially to misinterpret
an uninformed index investment as a
bullish statement by a trader with supe-
rior information. If participants then
‘herd’ around this investment, prices
can shift to a new level based on mar-
ket reactions to an invalid signal.
Hence, index inflow can affect market
expectations and, thus, have medium-
Sources: NYMEX, ICE, IEA, Bloomberg
term price effects beyond the simple
COMMODITIES NOW SEPTEMBER 2008 43
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