RDP 2017-03: Financialisation and the Term Structure of Commodity Risk Premiums 1. Introduction

Commodities are important inputs into the real economy. Commodities like wheat or cattle affect welfare directly through their role as consumption goods, while other commodities like copper affect welfare indirectly through their use as inputs into other goods. As such, it is important to understand how commodity prices, both spot and futures, are set and whether there are any distortions to these prices. The functioning of commodity markets is of particular relevance to Australia, given its role as a major commodity exporter.

A common theory used to explain commodity futures prices – the net hedging pressure theory (Cootner 1960) – states that the futures price is equal to the expected spot price at the maturity of the contract less a risk premium. This theory views futures markets as a risk-transfer mechanism between market participants. The risk premium is an inducement paid to speculators, investors who have no natural exposure to the commodity, so that they are willing to take on producers' and consumers' natural exposures to commodity prices.^[1] The key determinant of the risk premium is the balance of producers wishing to hedge their natural long positions and consumers wishing to hedge their natural short positions – the net hedging position.^[2]

For example, commodity producers, such as farmers and miners, may wish to enter into a short position in the futures contract, which is an agreement to sell the commodity at a specific date in the future at a price agreed upon when entering the contract. This provides insurance against a decline in the spot price and offsets their natural long position in the commodity. Commodity consumers, such as airlines and manufacturers, may want to enter into a long position in the futures contract to insure against increases in the spot price, and thereby agree to buy the commodity at a future date at a specified price. This will offset their natural short position in the commodity. If the hedging activity of producers for a particular commodity is greater than that of consumers there will be an excess of commercial market participants looking to enter short positions, and so speculators will need to be enticed to go long to balance the market. To achieve this, there will have to be a positive expected return to taking a long position – a positive commodity risk premium. Conversely, if consumers' hedging activity is greater there will be an excess of commercial market participants looking to enter long positions, and so speculators will need to be enticed to go short. To achieve this, there will have to be a positive expected return to taking a short position in the contract – a negative commodity risk premium.^[3]

Despite the theoretical foundation, the empirical identification of commodity risk premiums for individual commodities has been inconclusive, as has the identification of a relationship between net hedging positions and risk premiums (Rouwenhorst and Tang 2012). A number of explanations have been put forward to explain this, including: commodity price volatility relative to average returns; a lack of reliable long-run data; and the time-varying risk-bearing capacity of speculators and intermediaries.

An alternative explanation is that the existing literature, which investigates both the existence and determinants of commodity risk premiums, typically focuses on risk premiums accruing to positions in relatively short-term commodity futures contracts. Few papers have examined risk premiums accruing to positions in longer-term futures contracts, or compared risk premiums for futures contracts on the same commodity but with different maturities (the term structure of commodity risk premiums).^[4] It is unlikely that risk premiums would be constant along a futures curve. For example, if speculators require a term premium to compensate for price uncertainty over a longer time period, the commodity risk premium is likely to be larger (in absolute terms) for longer-maturity futures contracts.

Moreover, the net hedging pressure theory should be more relevant when considering horizons over which participants want to hedge. These horizons could be longer than those considered in most of the literature, as producers and consumers will want to match the maturity of their hedges to their production or consumption schedule, respectively, to avoid basis risk.^[5] For example, if a farmer has to plant their crop a year in advance, they may wish to lock in a price now at which they can sell their crop in a year's time.^[6]

Still, a number of studies have found evidence of a positive risk premium when analysing returns to commodity indices, as the volatility of individual commodity returns is diversified away when included in an index. For example, Gorton and Rouwenhorst (2006) found evidence of a commodity futures risk premium that is similar in size to the historical risk premium of equities. Moreover, they found that commodities are effective in diversifying bond and equity portfolios.

The significant increase in the size of markets for commodities futures and for other commodity-related derivatives during the mid 2000s, as well as in the assets under management (AUM) of commodity-related investment funds, can be seen as an attempt by speculators to earn these premiums (Figures 1 and 2). This growth exceeded growth in physical commodity markets and in some other financial markets for much of this period (Domanski and Heath 2007). The marked increase in the size of commodity-related financial markets is typically referred to as the ‘financialisation’ of commodities markets.

There has been substantial debate, both in the academic literature and in policy circles, about whether financialisation has a significant or distortionary influence on commodities markets.^[7] For example, some market participants, economists and policymakers have suggested that the rise of commodity-related investment funds caused a large and distortionary increase in oil and food prices over the mid 2000s (e.g. Masters 2008). This would have had significant negative implications for welfare, particularly in poorer nations where food and energy account for a larger share of household expenditure. Others have suggested that the increase in prices mainly reflected increased demand from China and so was an efficient response to market forces (e.g. Killian 2009). In fact, some argue that financialisation should increase welfare. Larger financial markets should be associated with fewer frictions, more efficient price discovery, and potentially a lengthening of futures curves and an associated decrease in basis risk from imperfect hedges. This debate has important real-world implications given how crucial commodities, particularly food and energy, are for macroeconomic outcomes and therefore welfare (e.g. Killian 2008).

Past analysis has typically focused on whether financialisation has affected price levels, volatility and correlations (both among commodities and between commodities and other financial assets). Most closely related to this paper, a portion of the literature has focused on whether changes in the number of outstanding futures contracts (open positions) held by different types of speculators affect commodity returns and risk premiums. This is one channel through which financialisation may have affected commodity prices as financialisation has, for example, been associated with an increase in the size and importance of commodity-related investment funds. Still, there has been little research on whether financialisation as a whole has affected commodity risk premiums and, in particular, whether it has affected the shape of commodity futures curves by influencing risk premiums differently across the curve.

There are a number of reasons why financialisation could have had different effects on premiums for futures contracts with different maturities. For example, the increase in activity in commodity futures markets has been greater at the short end of commodity futures curves (Figure 3). This would suggest that financialisation may have a more significant effect on the short end of the curve, for example by bidding down risk premiums on short-maturity contracts (and therefore bidding up prices for these contracts). Alternatively, as markets for longer-maturity contracts appear to have been less developed prior to financialisation, and given the percentage growth has been larger for longer-maturity contracts, financialisation could have had a larger effect on the long end of the curve.

The two main innovations of this paper are its focus on risk premiums accruing to longer-term commodity futures and its use of a simple difference-in-difference (DD) approach in examining the effect of financialisation on commodity risk premiums. The latter exploits the fact that many commodity-related investment funds base their asset allocations on major commodity indices. As such, financialisation is likely to have had a larger effect on commodities included in these indices, relative to its effect on other commodities.

To preview the results, we identify statistically significant risk premiums on longer-dated futures contracts and find evidence that, for a given commodity, risk premiums are typically not constant along futures curves. We also find evidence of a significant relationship between net hedging positions and risk premiums, which tends to be more significant for longer-dated contracts. This finding supports the net hedging pressure theory.

Having identified these premiums, we then focus on whether they have been affected by financialisation. Using our DD approach, we find little statistical evidence that financialisation has had a significant overall effect on the ‘residual’ (or idiosyncratic) portion of commodity risk premiums for a broad basket of commodities. But we do find evidence of lower risk premiums for some specific commodities, which could reflect either decreased market segmentation or a secular increase in demand for long positions. This is most evident for short-maturity contracts. We also find evidence that financialisation has led to increased correlation between commodity futures returns and returns on other non-commodity assets, pushing up the ‘systematic’ portion of commodity risk premiums. This is more evident for longer-maturity contracts with maturities between 6–18 months, which could indicate that markets for longer-maturity contracts have become more integrated. Taken as a whole, these results suggest a more neutral interpretation of the effects of financialisation, compared to the fairly negative interpretation laid out in some of the literature

The rest of the paper is arranged as follows: Section 2 reviews the relevant literature and theory; Section 3 discusses the data used; Section 4 tests the net hedging pressure theory; Section 5 examines the effect of financialisation on risk premiums; and Section 6 concludes.

Footnotes

The net hedging pressure theory is a generalisation of Keynes' (1930) theory of normal backwardation, which suggested that a positive risk premium will need to be offered by producers who wish to hedge in order to entice speculators to take long positions in futures contracts. [1]

In this context, the natural long position refers to the fact that producers will own the commodity in the future and so receive less money if the spot price falls. The natural short position refers to the fact that consumers need to buy the commodity in the future and this will be more costly if the price rises. [2]

This treatment is fairly static. For a more sophisticated dynamic equilibrium treatment see, for example, Baker (2016). [3]

Hamilton and Wu (2014) and Singleton (2014) are two exceptions. [4]

In this context, the basis risk is the risk that the price of the commodity changes between the expiration of the hedge and the actual purchase or sale of the commodity. [5]

This may not always be possible, as futures curves for most commodities do not extend much past six months to a year (oil is a notable exception). Firms sometimes rely on over-the-counter derivatives to address this problem. [6]

While the term ‘distortionary’ is somewhat multifarious, in the context of commodity market financialisation it tends to refer to prices being pushed away from levels justified by fundamental producer and consumer supply and demand, which may lead to inefficiently high or low production. This implicitly assumes that only producer and consumer demand for futures contracts is legitimate. [7]