Commodity Index Traders and the Boom/Bust Cycle in Commodities Prices

Abstract

Since 2005, the public has lived with high and volatile prices for basic energy and agricultural commodities. The public focus on this unprecedented commodity price volatility has been intense, because a large proportion of the cost of living borne by individuals and families in the U.S. (and around the globe) is represented by commodities-based costs, notably food, fuel, and clothing. Interestingly, as commodity prices have shown more price volatility, there has been an accompanying significant increase in the volume of commodities futures and swaps transactions, as well as commodities markets open interest. Moreover, Commodity Index Traders ('CITs'), a relatively new type of participant, now collectively make up the single largest group of non-commercial participants in commodities futures markets. These CITs, which represent giant institutional pools of capital, have at times been the single largest class of participant, outweighing bona fide hedgers (producers and consumers of commodities) and traditional “speculators,” who take short-term bi-directional bets and provide liquidity. Given both the size and the specific and largely homogeneous investment strategy of the CITs, many market observers have concluded that this group is most likely responsible for greatly disrupting price formation in commodities futures markets. Further, it has been posited that this distortion has directly led to recent unprecedented price volatility and higher absolute price levels for numerous food and energy commodities in markets around the world. Using a new set of analytic approaches, the authors seek to test whether the behavior of CITs has impacted commodities prices in a manner independent of fundamental supply and demand forces. Specifically, we examine the behavior of futures price spreads before, during, and after the monthly CIT 'Roll' period, a set period from the 5th to 9th business day of each month, during which funds tracking the most popular commodity index, the Standard & Poor’s Goldman Sachs Commodity Index (GSCI) must roll forward their expiring futures contracts. We find strong evidence that the CIT Roll Cycle systematically distorts forward commodities futures price curves towards a contango state, which is likely to contribute to speculative 'boom/bust' cycles by changing the incentives of producers and consumers of storable commodities, and also by sending misleading and non-fundamental, price signals to the market.