by HOU XINTONG (Yicai Global) Sept. 3 — Affected by the recent Turkish crisis, copper prices have fallen into a bear market, and US crude oil has fallen to its lowest level in 10 weeks. Even gold, which is often regarded as a safe-haven asset, has also sharply fallen. So, what macro and micro factors that affect the commodities prices? Does the existing risk model fully consider all kinds of risks?
The experts who attended the recently held 2nd J.P. Morgan Center for Commodities(JPMCC), believed that we must pay attention to event risks.
Bluford Putnam, Managing Director & Chief Economist of CME group, argues that many existing risk models do not pay enough attention to the event risks.“When there are two scenarios, the market prices the probability-weighted outcome. So, when the outcome becomes known, there may occur dramatic price movements and market volatility,” he explained.
He stated that financial markets have been more impacted by polarized elections, but commodity markets have been more impacted by trade wars and weather changes, he said. Weather shifts, such as the El Nino that is forming now suggest a more severe drought for Australia and Europe (wheat), less drought for Argentina (soybeans), he added.
Prof. Jeffery Frankel, Former Chief Economic Advisor of President of the United States and, Chair Professor of Harvard University pointed out, although individual commodities are of course influenced by individual micro causes, the extent to which prices of different commodities move together is striking.
He believes that some macroeconomic factors influence commodity prices jointly. These include Economic Activity, Monetary policy or more precisely real interest rate, exchange rates, and other determinants of net convenience yield.
The Symposium, entitled “New Directions in Commodity Research,” was held at the Business School of University of Colorado Denver from August 13th to 15th, 2018. It attracted top scholars, policy makers and key industry practitioners from all over the world to share their critical thinking on commodities and the latest research combined with reality, covering the macro and micro factors affecting commodity prices, factors making a successful commodity futures market, the relationship between commodity markets and financial markets, China’s crude oil prices and futures markets andsoon.
International Commodity Prices Might Face Downward Pressure in Next One or Two Years
Prof. Jeffery Frankel pointed out that some of the big price swings on commodities since 2000 can be explained by GDP. In the meantime, High real interest rates will exert a negative impact on the real prices of commodities.
“High real interest rates reduce the price of storable commodities through multiple channels, such as by increasing the incentive for extraction today, by decreasing firms’ desire to carry inventories, by encouraging speculators to shift out of spot commodity contracts, and into treasury bills.”, he further explained.
Besides, he believes that international commodity prices might face downward pressure in next one or two years in consideration of the rising US interest rate and the stronger dollar.
He also clarifies the fact that the financial market volatility is not a significant determinant when controlling for real interest rate and GDP, implying that commodities probably are not yet a safe haven asset.
As we all know, one of the main determinants of the real price of commodities is the global real economic activity. And there have been numerous proposals for quantifying global real economic activity.
Lutz Kilian from University of Michigan stated that among the choices of measuring global commodity market, an index derived from bulk dry cargo shipping rates and various indices of real commodity prices can effectively capture the changes in latent global real output and explain the role of expectations in business cycles.
Terry N. Barr, Chief Economist of America’s largest agricultural cooperative bank CoBank also pointed out that the commodity markets have seen significant volatility amid a commodity super cycle and a global financial crisis since the early 2000s, thus managing risk has become a major strategic concern of the management and boards of major companies and individual producers in the food, fiber and agricultural sector.
We are in the midst of major domestic and global transitions– socially (aging and declining populations, rising millennial influences), politically (rising populism and anti-globalization), economically (more diverse global growth and extraordinary monetary and fiscal policies) and technologically (artificial intelligence, biotechnology, nanotechnology, etc.), he said.
Assessing risk in the global commodity markets in the longer term will need to examine these transitions in addition to the traditional supply and demand balance sheets, he said. And only in this way can we develop the robust strategies that can effectively manage emerging risks, he added.
Robert I. Webb, professor of the University of Virginia summarizes three factors that are critical to a successful derivatives market.
Firstly, the price volatility of the underlying cash market contributes to the futures market, but the price volatility should still be combined with the investors need to hedge to help ensure the success. When trading is dominated by individual speculators, there is no intrinsic need to hedge. So a good amount of public order flow (particularly from bona fide hedgers) is important to a well-functioned futures market, and related to this the liquidity of the derivatives market matters and Lower Cost of Trading helps the liquidity.
Secondly, the futures contracts should also be well designed to incentivize traders towards determining the best price. Besides, the first mover advantage also matters for the futures market success as it is difficult to introduce a futures contract when an actively traded similar futures contract exists. Thus, timing is also important in listing new contracts. And another factor is if an exchange has actively traded related futures contracts that facilitate spread trading.
Last but not the least, having sufficient speculators willing to risk their own capital is very important. Large institutions may not always be good speculators, as sometimes they become risk averse just when the market needs them most, he said.
Andrei Kirilenko, Professor of Imperial College and former Chief Economist of CFTC studies the risk averse arbitrageurs who arbitrage between the physical (cash) and futures markets and finds that in equilibrium, during the periods of sharp upward spikes in prices in the physical market, future prices are higher than physical prices, i.e., contango or super-contango. She also finds strong positive association between speculative floating inventory and the slope of Brent futures prices as well as negative association between speculative floating inventory and the costs of using vessels as speculative storage.
K. Geert Rouwenhorst, Professor of Yale University School of Management, who is one of the most famous researchers on commodity futures investment find that prices tend to continue in the direction of the limit after the limit day through studying price limits on commodity futures. But he said that he didn’t find evidence supporting that limits can mitigate speculation. On the contrary, limits appear to only delay the trading behavior of market participants. In addition, he also find that price limits are associated with high futures price volatility, but high price volatility does not lead to high speculative activity.
China Needs Reforms for Its Structural Problems in Crude Oil Futures
This symposium discussion also involved Chinese scholars and China-related issues.
China’s crude oil futures market has been developing rapidly in the past years. On March 26, Chinese crude oil futures formally launched at the Shanghai International Energy Exchange, with these contracts denominated by the Chinese yuan. The current progress and future trends of China’s crude oil futures have caused a lot of concern.
“Both the trading volume and the growth rate of Chinese crude oil futures’ open contracts are striking. In only a few months, they soon went beyond the level that the West Texas Intermediate and Brent crude oil futures took several years to reach,” said Jian Yang, JPMCC Research Director and J.P. Morgan endowed chair at the University of Colorado Denver. “However, there are still some structural problems in the Chinese crude oil futures, including the excessive concentration of deals on a single contract, which does not form a significant future price curve. Besides, the ratio of trading volume to open contracts is also too high, indicating too many speculators but few hedgers. For the exchange, it is necessary to optimize the design of future contracts and in the meantime, educate investors, while attracting as many as possible hedgers.”
Moreover, regarding the potential impact from China’s crude oil futures on the internationalization of the yuan, as well as its pricing power over crude oil, China’s crude oil futures are promising enough to help the country contend for the pricing power over crude oil, Yang told Yicai Global. However, how effective these Chinese crude oil futures will depend on whether this crude oil futures market can truly give full play to price discovery and hedging, rather than the temporary growth in trading volumes.
“To some extent, China’s crude oil futures will boost the internationalization of the yuan, but it is difficult to fundamentally promote this, especially before yuan turns into a freely convertible currency. After all, the internalization of a currency relies on other more fundamental factors,” he said.
Associate Professor Huang Zhuo at the National School of Development at Peking University analyzed the effect of predicting the volatility of commodity futures through the uncertainty of macroeconomy. When using larger data set to measure the precariousness of overall macroeconomics, this uncertainty is better predictive of commodity volatility, he said. However, macroeconomy’s role in the anticipation of different commodities varies and works better in the fields of energy and metal futures. For all commodities, the predictability of volatility has significantly improved during the post-2005 period and economic depression.
Zheng Xinye, the vice president of the School of Economics in Renmin University studied the effect of China’s fuel prices and policies. He found that the actual petrol prices in China are commonly lower than the upper limit defined by the government, which means that the government’s regulations do not work under most circumstances. In contrast, the market structure is capable enough to effectively mitigate the gap between the actual fuel prices and the upper limit. The more fierce the market competition is, the greater the deviation between the actual price and the defined upper limit will be. This shows that the government should release the control of gasoline prices on a large scale, starting from regions with less centralized markets, higher incomes, and richer resources.
Founded in 2012, JPMCC is the only university-affiliated research center supported by J.P. Morgan, which is a leading research center dealing with commodities in the US. That features a considerable strength. “The research team of this center gathers chair professors from top universities like Harvard, Yale, and Princeton, while members to the advisory committee come from over 20 international commodity-related firms like J.P. Morgan and CME Group, whose research is closely related to business practices,” Yang said.
Editor: Emmi Laine