Does “Paper Oil” Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements

My coauthor Michel Robe and I presented our new research paper, entitled "Does 'Paper Oil' Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements", at Universidad Carlos III in Madrid on May 25 and at the ISTCE Business School's Annual Conference on Commodities and Energy Markets in Lisbon on May 27, 2011. 

Abstract:

We construct a uniquely detailed, comprehensive dataset of trader positions in U.S. energy futures markets.  We identify considerable changes in the make-up of the open interest between 2000 and 2010 and show that these changes impact asset pricing.  Specifically, dynamic conditional correlations between the rates of return on investable energy and stock market indices increase significantly amid greater activity by speculators in general and hedge funds in particular (especially, funds active in both equity and energy markets).  The impact of hedge fund activity is markedly lower in periods of financial market stress.  Our results support the notion that the composition of trading activity in futures markets helps explain an important aspect of the distribution of energy returns, and have ramifications in the debate on the financialization of energy markets.  

The Role of Financial Players on Financialisation of Commodities

On May 6 2011, I presented at the symposium of the Scientific Council, organised by AMF and CRE.  My presentation was entitled  "The role of financial players on financialisation of commodities." It was based on my two related articles:

• The Role of Speculators in the Crude Oil Futures Market
• Speculators, Prices and Market Volatility

Mechanics of the Derivatives Markets

This supplement to the April 2011 OMR is designed as a reference document for member governments and subscribers. It forms part of an ongoing work programme examining the mechanics of oil price formation and the interactions between the physical and paper markets. Further research will be forthcoming in the OMR, the MTOGM and in the form of stand‐alone papers in months to come. The work programme is being supported by contributions from member governments, most notably those from Japan and Germany. We are grateful for that support. Further impetus for this work comes from the joint work programme the IEA is undertaking alongside the IEF and OPEC secretariats, as requested by IEF, G8 and G20 Ministers.  

The work is overseen by David Fyfe, and the supplement’s main author is Bahattin Buyuksahin, to whom all enquiries should be addressed.

Volatility: How to Measure It*

Prices for oil, like those of many other commodities, are inherently volatile. In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating, price levels. In the last six months alone, oil prices have fluctuated in a wide range from $75/bbl to $125/bbl.

Volatility: Not Unique to Exchange-Traded Commodities*

Fluctuations in commodity prices, particularly in crude oil prices, have been hotly debated in recent years. Some argue that underlying market fundamentals, especially the unexpectedly strong demand shock attributed to continued strong economic growth in Asia and other emerging economies, is the main reason for the resurgence of commodity prices and for the fluctuations in prices since 2004. Others argue that speculative activity in commodity derivatives markets is the main force behind surging commodity prices. They further claim that commodities have become a new asset class in investors’ portfolios, and prices are now more affected by macroeconomic news rather than by commodity-specific physical market conditions.

Pre-emptive Moves Against Speculation*

Speculators have never been popular, and they may never have been as unpopular as they are today. Increasingly they are blamed for fluctuations in commodity prices, particularly in energy prices, even though a market lacking speculators to take the other side of price hedging transactions for physical market players would arguably be one that would be much more volatile.

Institutional Investors Embrace Commodities as New Asset Class*

Investor interest in commodities, including oil, has risen dramatically over the last decade and commodities have become a new asset class in institutional investors’ portfolio. Partly, this development is due to diversification benefits. In addition, the development of new investment vehicles, such as exchange traded funds, has allowed individual investors to get exposure to movements in commodity prices. Due to the storage and trading costs associated with direct physical investment in commodities, the main vehicle used by investors to gain exposure is via commodity indices (baskets of short maturity commodity futures contracts that are periodically rolled over as they approach expiry), exchange traded funds or other structured products. These instruments provide generally long-only exposure to commodities.