Economic Significance of Non-Hedger Investment in Commodity Markets

Abstract

Popular contention is that trading in futures markets by investors without a physical position (that is, non-hedgers) has lifted commodity prices. This contradicts the standard finance assumption that futures markets shadow the physical market by providing liquidity for hedgers, and at most accelerate inevitable price change. This divergence of opinion is unresolved. We test for the possibility of a link between futures market trading and physical prices by examining monthly data in 22 commodity futures markets as they grew after the 1980s. We introduce a new variable termed scaled open interest (OI) which is open interest in a commodity’s futures market divided by its global physical production. This is analogous to the hedge ratio and so deviations from its trend point to trading activity by non-hedgers. We find a cointegrating relationship in larger markets between scaled open interest and real spot price, where it is usually the price that adjusts to deviations from long run equilibrium. We use cross sections of the dataset to examine this cointegrating relationship, and suggest factors that could contribute to our findings. The most satisfactory explanation is that tax-incentivized savings have thrown up a wall of money that leads investors to seek a long exposure to commodities, which lifts their price irrespective of fundamentals.