Commodity pricing theory mainly focuses on the transference of a “risk premia” from risk-adverse hedgers to speculators. This insurance-like context was first proposed by Keynes (1930) in his theory of normal backwardation. Essentially, Keynes believed that hedgers have to pay speculators a risk premium to convince them to accept their risk.
Dr. Richard Spurgin (2000) explained it in the following way. There are four types of participants in futures markets: short hedgers, long hedgers, speculators and arbitrageurs. Short hedgers are commercial producers and long hedgers are commercial consumers.
Arbitrageurs perform a special function, and exist to ensure consistent pricing across different types of instruments relating to a particular asset and its relationships (e.g., cash, futures, forwards, options, etc.).
[Note: A discussion of commodity pricing theory as it relates to price convergence between the futures and spot price is a technical topic and overly complicates the purpose of this article. Suffice it to say that the futures-spot convergence is the principal objective that validates the futures markets’ economic purpose.]
Speculators, on the other hand, are assumed to “hold the difference between the long hedger, short hedger and arbitrageur positions.” Accordingly, speculators are key to ensuring the futures markets operate smoothly, as shall be illuminated by Dr. Spurgin’s “hedging response function.”
The hedging response model is intuitive and serves as a good basis for understanding the functionality of the commodity futures market, as well as for formulating legislation and regulations that promote the economic purpose of these markets without hindering innovation or normal speculative activities.
According to Dr. Spurgin’s hedging response function, there are four asymmetric scenarios which theoretically produce excess return to speculators, and two symmetric scenarios which are zero-sum:
A) a rise in commodity price (beneficial to producers) generates more initiative from producer short hedgers to lock in higher prices, hence a net short hedging position is established;
B) a rise in commodity price (detrimental to consumers) causes consumers to be more concerned about guarding against margin pressure than producers are concerned about locking in higher prices, hence a net long hedging position is established;
C) a drop in commodity price (beneficial to consumers) generates more initiative from consumer long hedgers to lock in lower costs, hence a net long hedging position is established;
D) a drop in commodity price (detrimental to producers) causes producers to be more concerned about guarding against margin pressure than consumers are concerned about locking in lower costs, hence a net short hedging position is established; and
E) a symmetric response results when the transaction is ‘speculator versus speculator,’ or
F) a ‘long hedger versus short hedger.’ Theoretically, the majority of futures transactions result in a symmetric response, and therefore it is the “net” hedging response that is of most interest.
In accordance with Dr. Spurgin’s hedging response model, speculators fulfill an economic purpose by plugging the asymmetrical difference between a net long or net short hedging response. This is the reason why speculators provide an economically important role in the functionality of these markets.
Anecdotally, “Scenario B” seems to be the current predominant “hedging response function” in the oil markets. If that is the case, then the question is, who are the “long hedgers” that are reflexively reacting or producing higher prices?
There is evidence to suggest that a major constituency in this regard is the financial “investors” seeking to hedge inflationary expectations vis-à-vis commodity index funds. Another key constituency according to various news media accounts has been international governments who are ensuring they have sufficient stockpiles of a particular commodity (e.g., strategic oil reserves). This is in addition to traditional commercial long hedgers who can add to upside price pressure, as well as speculators engaged in “trend-following” strategies.
However, the lynchpin is that if the hedging response is “Scenario B,” then on a net basis it is speculators who are actually the main sellers of futures contracts versus long hedgers.
Speculators who are short (i.e., selling futures) are betting against the bullish trend on the speculation that prices will drop. But in order to be enticed to do so, they must be paid an excess premium for making such a bet, resulting in upward price pressure. That is the likely reason why we have been seeing oil prices consistently rise.
If one agrees with this analysis as well as the viability of Dr. Spurgin’s model to provide insight into the workings of the futures markets, then the next logical question is whether the categorization of various constituencies accurately reflects a bona fide hedger or more accurately speculators.
For example, should index funds continue to be categorized as a commercial, or re-categorized as either a non-commercial, or a separate category? The euphemism amongst veteran futures traders is that index funds represent “dumb money,” and that nobody wants “to get run over by a stampede of cattle.” Yet, an argument can also be made that long-bias index funds provide a “hedge” against inflation. On the other hand, the term “bona fide hedger” implies a commercial that is capable of making or taking spot delivery.
There is an additional scenario referred to as a “market squeeze” which Dr. Spurgin does not discuss in his paper on the hedging response function. For example, commercial short hedgers who initially entered positions at a lower price by selling futures under “Scenario A,” get caught in a “short squeeze” whereby increasing upward pressure forces “short covering” (i.e., buying).
This particular scenario often causes spikes in volatility, similar to what we experienced during February and March of this year in the wheat contract. Again, however, it was speculators who ultimately provide the liquidity which allowed these market participants to exit their positions.
Accordingly, we can arrive at the following conclusion…
It would be reckless and irresponsible for the U.S. Government to force regulators to raise margin requirements under current market conditions, specifically with respect to the oil markets.
In April 2008, U.S. Sen. Byron Dorgan, a North Dakota Democrat, told Congress, “There is an orgy of speculation in futures markets. This is a 24-hour casino with unbelievable speculation.” He and others in Congress have been raising the idea of changing margin requirements that traders must pay up front in order to engage in oil speculation. Dorgan said stock speculation requires a 50% margin, but commodities like oil demand a much lower threshold, just 5% or 7%.
According to Senator Dorgan’s and other Congressional members’ analysis/opinion/rhetoric, excessive speculation is driving prices up, not fundamental demand-supply factors. If this is the case, then increasing margin should theoretically bring about an exodus of speculators from the futures market, causing oil prices to come back down.
But as our analysis reveals using Dr. Spurgin’s model, the oil market currently indicates that there is a net hedging response where long hedgers are willing to pay short speculators excess premia to enter into a contract. As Michael Masters posited, the predominant long hedgers may very well be the commodity index funds. Yet it should also be noted that these same index funds will not be materially impacted by an increase in margin because they are fully-funded.
Hence, while the hedging response function may or may not be causing the market to steadily rise, it is prudent to err on the side of caution. If our thesis is correct, then raising margin requirements will result in a disastrous short covering rally.
At $135 a barrel per oil, we are beginning to see indications of demand destruction. It may in fact be the case that threats from Congress are already having a detrimental impact on the oil markets.
Governments and regulators should beware… the law of unintended consequences rules the market!