Commodity Speculation Debate

Why is there conflicting econometric evidence in the commodities speculation debate? Critically discuss the literature from a methodological perspective with particular emphasis on the assumptions made and data and models employed. Also reflect how else (other than econometric analyses using secondary data) researchers might be able to gather evidence on this issue.

Commodities speculation debate rose over whether high prices of commodities are a result of fundamentals or pure financial speculation particularly over 2007 and 2008 spike in commodities prices. Master’s Hypothesis claims that long-only index investment was a major driver of the 2007–2008 spike in commodity futures prices and energy futures prices in particular. This claim was made by Michael Masters, a Hedge Fund Manager, who on multiple occasions have gone before the US Congress and Commodity Futures Trading Commission (CFTC) which is US regulator. . Essentially, what he means is that massive buy-side from index fund created a bubble in commodity prices with the result that prices and crude oil prices in particular far exceeded fundamental values at the peak. He has stated that CII grown massively from $13 billion in 2003 to $317 billion in 2008. At the same time the prices of the 25 commodities that make up the indices have risen on average by 200%. Today’s commodities futures market is excessively speculation and the position limits designed to protect the market has been raised or in some cases removed. The consequence of Masters Hypothesis has been significant as it has influenced polices and speculation position limits have been placed on all commodities markets.

There are two very important aspects to keep in mind through-out this commodities speculation debate. First, what speculation is and what it is not? Speculators have a directional view, and take long (or short) positions accordingly. According to Masters Hypothesis long-only index investment is speculation. Stoll and Whaley (2010), has stated that Commodity index investment is passive, fully collateralized, long-only investment by an institution or individual and is no different in principle from a stock index or bond index portfolio. Its fundamental contribution to investment management is in providing an effective diversification tool as they simply buy and hold futures contracts and before futures contract expires they roll over to the next near-by futures contract. Second, is also the most important which is that the main reason for the conflicting econometric evidence in the commodities speculation debate is because of the data constraints that is used by both sides of the debate. Essentially the econometric evidence is at the mercy of the data or proxy used. Similar and different methods have been used by both sides of the debate and again having conflicting results. These countless tests using different methods have been used on the same CFTC data where it has reached diminishing returns. The real contribution to the commodities speculation debate will come in the form of new data, especially data on the oil market as currently proxies are being used that overestimate the commodities index oil postions by 71%, Irwin & Sanders (2012). Through-out this paper we will focus on the data used in the different papers. We will first look at literature by proponents of Masters Hypothesis. Second, we will look at literature against Master’s Hypothesis. Third, way specifically is there conflicting results.

Data Constraint on measuring commodity index fund investment

Majority of the papers published in the US get their data from the CFTC, which collects market data and position information from market participants who have position levels above reporting level for a specific futures market. CFTC releases the combined futures and delta-adjusted option positons aggregated by trader category each Friday. Open Interest reflects Tuesday’s closing positions for a given market and is aggregated across all contract expiration months.  They do categorise traders within the system as largely hedgers which are commercial and Speculators which is non-commercial. Classification is largely based on traders completing the CFTC’s Form 40, where traders must describe the nature of their transactions. However, due to ongoing complaints that the legacy COT trader designation may be inaccurate. For example, speculators may have an incentive to self-classify their activity as commercial hedging to circumvent speculative position limits in some markets. To try to mitigate this problem the CFTC added two variation of the legacy COT reports.

 The first being Disaggregate Commitment of Traders (DCOT) reports which further breaks down commercial into two categories, the first being, Processors & Mercantiles, who are the traditional commercial users who engage actively in the physical markets and use futures to hedge associated price risks. The second being swap dealers who are those traders who deal primarily in swaps and hedge those transactions in the futures market. A large portion of Swap Dealers trading represents Commodity index trading. Swap dealers positions are often used as a proxy for Commodity index activity. Non-commercial is broken down into Managed Money which represents positions held by commodity trading advisors, commodity pool operators and hedge funds that manage and conduct futures trading on behalf of clients. As well as Other Reportable which represent non-commercial traders who are large enough to report but do not fit into one of the other categories.

The second Report is the Supplement Commitment of Traders (SCOT) reports which adds new category specifically to capture Commodities index trading, which is part of Swap Dealers, Managed Money and Other Reportables. When the Swap Dealers are used as proxy for Commodity Index Trading, it excludes both Managed Money and Other Reportables. Supplement COT report specifically breaks out the positions of index traders for 12 agricultural markets only. It does not provide any data of energy markets. The report is created by reviewing the CFTC Form 40 and through confidential interviews with traders known to be index traders or who exhibit trading patterns consistent with indexing. The Data collection for Supplement COT report is more stringent than the legacy COT report and the Index trading category is a better measure of Index trading positions than using Swap Dealer as proxy for reasons mentioned previously.

Even with creation of this two variation of two COT reports, CFTC found another problem with their swap dealer positons in 2008. The Disaggregate COT swap dealer positions in agricultural futures markets correspond reasonably well to index trader positions. This is mainly because swap dealers in agricultural markets conduct a limited amount of non-index long or short swap transactions. Therefore the net long futures position of swap dealers have limited error. Whereas swap dealers in energy futures markets conduct a substantial amount of non-index swap transactions on both the long and short side of the market, which means that the net long position of swap dealers in energy markets does not represent index fund positions as well as agricultural market does. For example, the CFTC estimates that only 41% of long swap dealer positions in crude oil futures markets on three dates in 2007 and 2008 were linked to long-only index fund positions (CFTC, 2008). Therefore the netting effect has a limited impact on the measurement of index investing in agricultural futures markets. However, it has a considerable measurement error for the energy and metals futures markets.

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