Hung Q. Tran EIA Workshop on Financial and Physical Oil Market Linkages

Washington D.C. September 27, 2012

The Role of Financial Investment

in Commodity Markets

In early 2011, the IIF was asked by the French G-20 Chair to bring together senior market practitioners to add their perspectives to the debate on the potential role of financial investment in driving trends in commodity markets.

The IIF Commodities Task Force, including market professionals, academics and other researchers, was convened in February 2011, and a CTF Workshop was held in Paris in July 2011.

The Task Force submitted its report to the G-20 in September 2011.

Financial Investment in Commodity Markets: Potential Impact on Commodity Prices and Volatility

A review of the academic literature and studies by official sector bodies suggests that despite periods of correlation, there is little robust evidence of a causal link between financial investment in commodities and trends in commodity prices and volatility.

In recent years, rising demand from emerging markets has contributed to the trajectory of commodity prices and volatility, exacerbated by periodic or structural supply constraints.

Financial investment is an integral part of commodities trading; excessive regulatory constraints on investment could dampen price signals, impair market liquidity and efficiency.

IIF Commodities Task Force Report: Key Messages

4

Concern about the link between commodity prices and inflation…

-1

0

1

2

3

4

5

6

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12-60

-40-20

020

40

6080

100InflationCommodity prices (rhs)

World Inflat ion vs. Commodity Pricespercent change, yoy

5

050

100150200250300350400450

2005 2006 2007 2008 2009 2010 2011 2012

Exchange-traded productsMedium-term notes

Indices

Commodity Assets Under ManagementUSD billions

Source: Bloomberg, MTN-I, ETP issuer data, Barclays Capital

…contributes to fears that financial investment drives trends in commodity prices and volatility.

6

-10

-5

0

5

10

15

20

25

'05 '06 '07 '08 '09 '10 '11 '12300

400

500

600

700

800Flows to commodity funds (lhs)Commodity prices (rhs)

Total Commodity Investment InflowsUSD billions index

Source: Bloomberg, MTN-I, ETP issuer data, Barclays Capital

However, correlation between flows to commodity funds and commodity prices is not consistent…

7

…and periods of higher volatility are not always associated with high financial investment

0

10

20

30

40

50

60

70

'92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12

Commodity Price Volatility, 1992-presentGoldman Sachs Commodity Index, 60-days

8

0

200

400

600

800

1000

1200

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12400600800

1000120014001600

18002000Open Interest

Front month futurescontract price (rhs)

Soybeans: Open Interest & Price000s of contracts US cents per bushel

Those who believe financial investment drives prices point to correlation between futures prices and open interest in some commodities…

9

-1.0-0.8-0.6-0.4-0.20.00.20.40.60.81.0

'70 '73 '76 '79 '82 '85 '88 '91 '94 '97 '00 '03 '06 '09 '12

Correlation between Commodit ies and Equity PricesGSCI index and S&P500, 30-day rolling correlation, 90-day mav

…and more correlation between previously uncorrelated asset classes (“financialization” of commodities markets).

10

-100

-80

-60

-40

-20

0

20

40

'00 '02 '04 '06 '08 '10 '12

Copper Prices: Daily Difference Between Futures and Cash PricesUSD/MT, 20-day mav

Periods of divergence between cash & futures prices have triggered concern about “mispricing.” These arguments have been used to justify position limits.

11

600

700

800

900

1000

1100

1200

2006 2007 2008 2009 2010 2011 201290

140

190

240

290

340Total long positionstotal weighted futures price (rhs)

Commodity Index Traders' Long Posit ions vs. Price:Wheat, Corn, Cotton, Cocoa, Soybeans000s of contracts weighted average futures price

Another fear is that long-only index traders create “new demand” for commodities, outweighing the market-stabilization effect of financial investment.

12

-300

-250

-200

-150

-100

-50

0

50

2007 2008 2009 2010 2011 20120

2

4

6

8

10

12

Non-Commercial Net LongFront month futures contract price (rhs)

Natural Gas: Net Noncommercial Posit ion & Price000s of contracts USD per metric ton

However, correlation between price and financial investment varies greatly among different commodities over time. For some, correlation is low.

13

During specific periods, correlation between financial investment and price has been low or even negative; moreover, evidence of causality is limited.

-0.4

-0.2

0.0

0.20.4

0.6

0.8

1.0

Corn Platinum Wheat Milk Oil Livecattle

Naturalgas

2007-08

2009-12

Correlation: Non-Commercial Posit ions vs. Futures Priceselected commodities, net non-commercial positions

14

25

30

35

40

45

50

55

'06 '07 '08 '09 '10 '11 '12

Wheat: Share of Index Trading in Total Open Interest percent

While index traders are often blamed for “new demand,” driving up prices, for many commodities their share of financial investment is relatively low.

15

For many commodities, the level of long positions relative to short hedging—the “Working’s T” ratio—has tended to be appropriate and stable over time.

0.8

0.9

1.0

1.1

1.2

1.3

1.4

2006 2007 2008 2009 2010 2011 20120.8

0.9

1.0

1.1

1.2

1.3

1.4

Soy WheatCopper Oil

Working's T: Soy, Wheat, Copper and Oilindex, absolute value

16

5060708090

100110120130140150

2008 2009 2010 2011 2012

Rind index

Broad commodity prices

Traded vs Non-Traded (RIND Index) Commodity Pricesindex, rebased end-2007 = 100

Prices of non-traded commodities, which reflect industrial demand, tend to move in synch with traded commodities (which attract financial investment)—another indication that fundamentals are dominant.

Financial investment provides valuable and necessary information about projected changes in fundamentals to the market.

Financial investment is an essential part of spot and futures markets, as it helps equilibrate price differentials between the two markets.

Financial investment thus has a vital role in enhancing market liquidity and mitigating price risk for commercial market participants (hedgers).

The Vital Role of Financial Investment

Tighter regulation has not been backed by convincing impact analyses or evidence that financial investment is a significant driver of higher prices/volatility.

No robust definition of financial investment has been put forward to adequately separate this activity from hedging and other commercial trading activity.

Measures to enhance transparency are broadly welcomed; however, position limits and other regulatory measures could have unintended and damaging consequences.

Industry Concerns about Further Regulation

Hung Q. Tran EIA Workshop on Financial and Physical Oil Market Linkages

Washington D.C. September 27, 2012

The Role of Financial Investment

in Commodity Markets