Financial investments and commodity prices

• Published date: 01 December 2022
• Author: Peng Liu,Zhigang Qiu,David Xiaoyu Xu
• Date: 01 December 2022
• DOI: http://doi.org/10.1111/irfi.12361

ORIGINAL ARTICLE

Financial investments and commodity prices

Peng Liu

1

| Zhigang Qiu

2

| David Xiaoyu Xu

3

1

SC Johnson College of Business and School

of Hotel Administration, Cornell University,

Ithaca, New York, USA

2

School of Finance, Renmin University of

China, Beijing, China

3

Department of Finance, Red McCombs

School of Business, University of Texas,

Austin, Texas, USA

Correspondence

Zhigang Qiu, School of Finance, Renmin

University of China, Beijing, China.

Email: zhigang.qiu@ruc.edu.cn

Abstract

In this paper, we show that financial investments dilute the

relationship between convenience yields (a proxy for funda-

mentals) and commodity prices. On average, the explana-

tory power of convenience yields on the movements of

commodity prices decreased from 63% to 33% after 2004,

when institutional investors rapidly started building their

positions in commodity futures. We develop a model of the

commodity market with financial investments and test the

model predictions using futures prices of 21 US-traded

commodities and index traders' positions on 12 agricultural

commodities. Because of correlated financial demands for

different commodity futures, we identify comovements in

spot prices for fundamentally independent commodities.

KEYWORDS

commodities, convenience yield, financial demand

JEL CLASSIFICATION

G13; D03; D53

1|INTRODUCTION

Commodity financialization is new to the commodity market. Since 2004, commodities have enjoyed increasing rec-

ognition as a new financial asset class as an increasing number of institutions invest in commodity futures for the

sake of portfolio diversification.

1

Prior to the 1990s, the Prudent Investor rule prohibited pension plans from buying

commodity future contracts. However, the collapse of the equity market in 2000 and the discovery that there is no

correlation between commodity performance and stock market movements have led money managers of pension

funds, hedge funds, and other institutions to begin investing in the commodity market. For example,there was a total

$15 billion investment in commodity indexes in 2003, but the amount grew to $319 billion in 2019.

2

Thus, commod-

ity financialization should have had a significant impact on the commodity market in the last two decades.

Received: 7 March 2020 Revised: 14 June 2021 Accepted: 1 July 2021

DOI: 10.1111/irfi.12361

© 2021 International Review of Finance Ltd.

International Review of Finance. 2022;22:637–661. wileyonlinelibrary.com/journal/irfi 637

The rising volume of financial investments in commodity future markets, both at exchanges and over-the-

counter (OTC) markets, changes the market structure significantly. For example, Tang and Xiong (2012) show that

there was a structural break in the commodity market around 2004, and indexed commodities became more corre-

lated. In fact, in this paper, we show that the relationship between convenience yields, a proxy for fundamentals, and

commodity prices are diluted after 2004. The convenience yield is measured by a combination of convenience yield

and storage cost, which is extracted from observable futures prices. For expositional simplicity, we still used the term

“convenience yield”(hereafter) although it is net of the commodity's storage cost. On average, the convenience

yields movement accounts for 63% of spot price movements before 2004; however, the effect changes to ~33%

after 2004. It seems that increasing financial investments and unusual movements of commodity prices are highly

correlated. Is it just a coincidence, or is financial demand a driver for the movement of commodity prices?This ques-

tion is important and cannot be ignored. In this paper, we identify the effects of financial demand on commodity

prices by providing both theoretical and empirical analyses.

We adopt a demand-based framework to analyze the effect of financial investments on commodity pricing. We

use the convenience yield as a summary of the economy regarding real demand (or fundamentals) for a certain com-

modity. This indicates that real demand has less explanatory power regarding price movements after 2004. In tradi-

tional models on commodities such as Hirshleifer (1988 and 1990), there are two classes of players: hedgers and

speculators. Hedgers short-sell futures to hedge their physical production (or inventory); speculators provide liquidity

to hedgers. Since financial investors have become important in the commodity market, especially in recent years, we

add financial investors on top of hedgers and speculators in the model. Both hedgers and speculators make trading

decisions based on the maximization of utility, but trades from financial investors are assumed to be exogenous.

3

The model predicts that the equilibrium commodity spot price is a combination of the convenience yield and

financial demand; that is, stronger financial demand increases commodity spot prices since commodity futures have

only zero net supply. Intuitively, when financial investors buy commodity futures for the sake of diversification; even

though they buy commodity futures at a relatively higher price (than the value determined by fundamentals), they

are better off because of the reduction in risks of their portfolios. Given that many commodity markets are much

smaller than the mainstream financial market, financial demand from major financial institutions may cause a large

price change in commodities. We also show that the volatility of commodity prices increases with the presence of

financial investors

4

. Furthermore, our model predicts that the prices of two commodities can be strongly correlated

if they are subject to a correlated financial demand, even when the underlying real demand is independent of each

other, which is consistent with Tang and Xiong (2012).

To test the model predictions, we obtained data on 21 commodities traded in the US futures market to test

model predictions. We find that, adjusted by the real demand (represented by convenience yields), commodity prices

increased steeply after 2004. Moreover, the explanatory power of convenience yields on commodity prices is wea-

ker after 2004 than before 2004. Considering commodity index investment as one type of financial demand, we

show that commodity prices do depend on commodity index position. Moreover, we identify comovements in spot

prices for fundamentally independent commodities because financial demands are correlated. Applying a principal

component analysis, we shows that the first principal component explains 37.7% and 63.0% of the variation in spot

prices before 2004 and after 2004, respectively.

In the literature, there have been heated debates about whether high commodity prices, especially during the

2007–2008 period, were caused by real demand or by financial demand. Masters and White (2008) argue that

money inflows into the commodity market have sent oil and other commodity prices beyond their fundamental

values. However, Krugman (2008) and Hamilton (2009) argue against the financial demand story, claiming that the

inflated prices of commodities were due to high worldwide demand and the inelasticity of the world supply. Their

main evidence is that if investment causes high oil prices then people would expect to see stock buildups; in contrast,

the publicly announced oil inventory data (such as the one published by the Energy Information Administration of

the USA) did not support the stockpile of inventory. From our point of view, however, it is very difficult to track

638 LIU ET AL.