The Great Debate

Wanted: more commodity hedgers

September 13, 2010

For the last decade, investors such as pension and hedge funds have been the fastest-growing segment of commodity derivatives markets. The most successful banks and dealers have been those which marketed themselves most effectively to this new group of customers.

In the next five years, however, expanding the use of derivatives as hedging instruments for producers and consumers will re-emerge as the priority area. Banks and dealers will be searching for natural counterparties for all the pension funds and hedge funds wanting to use futures and options as a source of returns, diversification and inflation protection.

Separating derivatives users into “hedgers” and “speculators” is notoriously hard. Problems with the U.S. Commodity Futures Trading Commission (CFTC)’s classification of commercial and non-commercial users are well-known. Even the more detailed categories contained in the new disaggregated commitments of traders reports are not completely satisfactory.

But one detailed study of the NYMEX oil market by the Commission’s own economists showed the share of futures and option contracts attributable to producers, consumers and merchants shrinking from 39 percent in 2000 to 15 percent by H1 2008.

Producers, consumers and merchants boosted open interest by 80 percent over the nine years covered by the study. Dealers, investors and others increased their positions a massive 550 percent over the same period.


Unbalanced growth has damaged returns to investors. Unlike equities and bonds, derivatives are zero-sum instruments. Gains for some market participants are exactly offset by losses for others.

There is a natural “ecology” in commodity derivatives markets. For investors in aggregate to achieve positive returns, producers, consumers and merchants must be willing to make losses (in aggregate) to lock in stable prices.

John Maynard Keynes popularised the concept of “normal backwardation” to explain how producers, consumers and merchants are willing to pay a premium to investors to transfer price risk and enjoy certainty. It is central to the positive return to commodity investors found by Gary Gorton and Geert Rouwenhorst in their famous study of futures contracts between 1959 and 2004.

But net hedging interest (after producer shorts and consumer longs are cancelled out) imposes a limit on the total amount of risk premium available to investors and the number of investors who can participate in the market before their average returns are pushed to zero.


In practice, speculators appear on both sides of the market, which is why there are more speculative positions than the minimum strictly needed to cover the net long/short position left by hedgers. Professor Holbrook Working developed a measure of this “excess speculation” in a famous paper published in 1960 (the speculative T index).

Some excess speculation is a market lubricant and supplies liquidity. But too much is self-defeating. Speculators increasingly find themselves on both sides of the market, trading with themselves rather than hedgers, driving average returns down. If excess speculation increases too much, average returns fall towards zero.

Net hedging interest therefore imposes a natural limit on the amount of speculation which the market can profitably sustain.

The limit can be high and variable. Reviewing 11 agricultural markets, Working found excess speculation ranged from 7 percent (wool) to 28 percent (soybeans). More recently, excess speculation in WTI-linked oil futures and options increased from 25 percent in 2006 to peak at 100 percent in late 2008, before declining steadily to around 50 percent in 2010.

But speculative/investment activity cannot grow faster than hedging without becoming unprofitable. This is what happened after publication of the Gorton and Rouwenhorst paper in 2004. Investors piled into commodities as an asset class, outstripping increased demand for hedging, pushing markets into a persistent contango and bidding away the risk premium which had been embedded in futures over the previous 45 years.


For commodity derivatives to start producing a net positive return for investors again, dealers and promoters need to find new sources of demand for hedging to provide natural counterparties for all the new investors. But the challenge will not be easy:

(1) Much of the investor demand for exposure to commodities as an “asset class” is linked to a belief in the commodity “super-cycle.” The same belief that prices are on a high and rising trend has discouraged producers from hedging forward production. Many oil and mining companies now make a virtue of the fact they are unhedged, giving investors full exposure to the commodity price.

Super-cycle theories have actually limited demand for hedging at precisely the time investors needed producers to take out more short positions.

(2) Consumers have shown interest in protecting themselves against sudden price rises, especially when prices were spiking in 2006-2008. But even here, demand for hedging has largely been restricted to traditional users (such as airlines) and remains mostly short-term (extending 12-24 months forward). Efforts to expand hedging to a wider range of customers and further into the future have had limited success.

(3) Most consumers and producers still want to hedge only short-term price risks associated with fixed sales and inventory. Airlines for example want to hedge fuel price risks against fixed-price ticket sales up to 12 months forward. Interest in longer-dated hedging programmes remains very limited.

In contrast, investors are looking for longer-dated positions to benefit from the super-cycle and provide diversification and inflation protection. The result is a maturity mismatch. Hedgers mostly want positions with a maturity of 24 months or less, while investors want positions with a maturity of 3-5 years or more.

Lack of liquidity has forced investors to replicate a long-dated position by taking shorter-dated ones and rolling them forward. This combination of excess speculation and constant rolls has pushed markets into contango and reduced investor returns further. One trader has likened it to flying off on a six-month holiday and paying a premium to leave the car in the short-term car park.

But it is not easy to see how to overcome this mismatch. The arguments for consumers or producers locking in prices 3-5 years ahead or more are not strong.

Producers do not want to give away that much upside, and long-dated options are prohibitively expensive. Consumers cannot forecast their requirements accurately more than 1-2 years forward. Over a 3-5 year horizon, it may be more efficient to recover rising input costs by raising their selling prices rather than try to fix them through hedging programmes.

The opportunity cost for both producers and consumers of locking in prices years in advance at the “wrong” level is large.

Until now, much of the emphasis has been on developing innovative new products to attract investors. In December 2009, Britain’s Financial Services Authority (FSA) argued even more (long-dated) speculation might be needed to provide sufficient liquidity for hedgers who wanted but were unable to put on sufficiently long-dated risk management programmes.

But that may be putting the argument the wrong way around. With average returns to investors falling, many markets now look like they have reached natural size limits. To grow further, banks and dealers need to unlock new sources of hedging demand, implying a more balanced and organic approach to growth.

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