The Flip Side Of Financialization Of Commodities

Recently, a paper by Ilia Bouchouev (“From risk bearing to propheteering”) was published that had some very thought-provoking analysis. The paper traced the development of the use of futures and concluded that while futures markets in the past (specifically, he was considering energy markets but notes the idea started with agricultural commodities) tended towards backwardation – in which contracts for distant delivery dates trade at lower prices than those for nearer delivery dates – this is no longer as true. While others have noticed that futures markets do not seem to provide as much ‘roll return’ as in the past, Mr. Bouchouev suggested that this is not a random occurrence but rather a consequence of financialization. (My discussion of his fairly brief paper will not really do it justice – so go and read the original from the Journal of Quantitative Finance here).

Let me first take a step backward and explain why commodities markets tend towards backwardation, at least in theory. The idea is that a producer of a commodity, such as a farmer growing corn, has an affirmative need to hedge his future production to ensure that his realized product price adequately compensates him for producing the commodity in the first place. If it costs a farmer $3 per bushel to grow corn, and he expects to sell it for $5 per bushel, then he will plant a crop. But if prices subsequently fall to $2 per bushel, he has lost money. Accordingly, it behooves him when planting to hedge against a decline in corn prices by selling futures, locking in his margin. The farmer is willing to do this at a price that is lower than his true expectation, and possibly lower than the current spot price (although, technical note: Keynes’ ‘Theory of Normal Backwardation’ refers to the difference between his expected forward price and the price at which he is willing to sell futures, so that futures prices are expected to be downwardly biased forecasts of prices in the future, and not that they are expected to be actually lower than spot ‘normally’). He is willing to do this in order to induce speculators to take the other side of the trade; they will do so because they expect, on average, to realize a gain by buying futures and selling in the future spot market at a higher price.

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