Spring 2016

Dr. Ajeyo Banerjee welcomes readers to the inaugural issue of the Global Commodities Applied Research Digest (GCARD). This bi-annual publication is generously sponsored by the CME Group Foundation, and the purpose of this new digest is to highlight the key findings of applied research on topical commodity issues.

Ms. Hilary Till writes that she has always enjoyed the commodity markets as an active participant. These markets are like a big tent that comfortably encompasses a wide variety of talented professionals and includes, for example, global-macro strategists, street-smart practitioners, careful fiduciaries as well as brilliant quants. In helping to create the first issue of the GCARD, she has been delighted to stretch the boundaries of this big tent even further to include influential policy advisors and distinguished academics. The Spring 2016 GCARD includes a diverse set of topics from across commodity industry segments in order to present as comprehensive a picture of commodity research as possible.

In the “Research Council Corner” section, we are pleased to include articles from the following three distinguished members of the Research Council: Thomas Brady, Ph.D., of the Newmont Mining Corporation; Bluford Putnam, Ph.D., of the CME Group; and Marcelle Arak, Ph.D., of the University of Colorado Denver Business School. Dr. Arak’s article is co-authored with Sheila Tschinkel, Visiting Faculty in Economics at Emory University.

Prevalent in the literature concerning economic contributions of mining is the view that royalty rates and taxes, which governments levy on mineral extraction, are the primary sources of benefits a host-country receives from a typical mining operation. Instead, this article recommends a careful analysis of the more holistic benefits of mining by host countries.

In the oil markets, there are several long-term supply and demand forces in play as well as some shorter-term response factors that make for a very difficult mix to analyze going forward. In summary, the article’s forward-looking analysis suggests that the era of relatively low prices could last for many years. That said, there are always small probability events, such as further conflict in the Middle East, which could lead to upside price risks, in which case economic conditions would definitely not be the predominant price driver, concludes the article.

This article focuses on the low price elasticity of demand for crude oil in the short run and notes the implications of this observation. Further, the authors discuss what the threshold level of coordination is for a core group of oil swing producers, which would maximize revenue assuming that “other producers do not change their output in response.” The authors observe that the required level of coordination has not occurred and perhaps is not possible, given “varying foreign policy interests and economic structures.” Therefore, the price of oil could to continue its slide.

This collection of four digest articles provides answers to the following questions:

• When has OPEC spare capacity mattered for oil prices?
• What are the sources of return for CTAs and commodity indices?
• What are the risk-management lessons from high-profile commodity derivatives debacles?
• What determines whether commodity futures contacts succeed or not?

The goal with each of the four digest articles is to provide both industry participants and policy makers with useful insights on the frequently opaque, and always dynamic, commodity markets.

Oil prices are usually influenced by quite a number of factors. But there have arguably been times when OPEC spare capacity has been the most important factor for driving oil prices. This paper discusses the circumstances when this has likely been the case in the past.

This survey paper discusses the (potential) structural sources of return for both CTAs and commodity indices based on a review of empirical research from both academics and practitioners. The paper specifically covers (a) the long-term return sources for both managed futures programs and for commodity indices; (b) the investor expectations and the portfolio context for futures strategies; and (c) how to benchmark these strategies.

Until recently, one could only gain expertise in commodity-derivatives relationships if one had worked in niche commodity-processor companies or in banks that specialized in hedging project risk for natural-resource companies. The contribution of this paper is to help fill the knowledge gap in the risk management of commodity derivatives trading. The paper emphasizes the constant challenges to a trader when attempting to navigate the very dynamic flows of both the commodity markets and the prevailing risk environment. The paper also emphasizes that operational controls are paramount in an age of increasing legal and regulatory risk, particularly for firms involved in large-scale commodity derivatives trading.

Why do some futures contracts succeed and others fail? Although the U.S. futures markets have evolved in a trial-and-error fashion, a survey of relevant research suggests key elements have determined whether particular futures contracts succeeded or failed. This knowledge could be useful for new financial centers as they build successful futures markets. This paper shows that there are three elements that determine whether a futures contract succeeds or not: 1. There must be a commercial need for hedging; 2. A pool of speculators must be attracted to a market; and 3. Public policy should not be too adverse to futures trading.

The “Research Digest Articles” section concisely covers original research on (1) metals hedging; (2) energy policy; (3) the logistical planning of a grain-trading firm; (4) commodity pricing; and the (5) development of commodity exchanges. The five research summaries were written by the Contributing Editor of the GCARD.

As summarized by Hilary Till, Contributing Editor, Global Commodities Applied Research Digest

In this article, the authors find a counterintuitive result. While one might expect that firms with both an informational advantage and a robust financial condition to use these competitive advantages to vary their hedging programs according to their market views, the researchers, in fact, find the opposite result. This finding should be of interest to investors in gold equities, who should probably have a skeptical view regarding a firm’s decision to “selectively” hedge, which the authors also refer to as speculation.

As summarized by Hilary Till, Contributing Editor, Global Commodities Applied Research Digest

In this paper, the authors examine whether one might attribute at least some of the past spikes in corn prices to renewable fuel mandates in the US. The authors provide statistical evidence that corn price dynamics changed after these mandates were put into effect: namely, corn prices began having a stronger response to global demand factors that, in turn, drive demand for crude oil. This increased connection between oil prices and a food staple is an important public policy issue. Although the authors do not suggest policy innovations, one might conclude that when food prices spike, perhaps there should be a temporary trigger to divert corn stocks to food rather than fuel.

As summarized by Hilary Till, Contributing Editor, Global Commodities Applied Research Digest

In the paper, “Optimal Trading and Shipping of Agricultural Commodities,” the authors use a case-study approach to show the benefits of jointly planning trading and logistics for a specific Argentinian grain-trading firm. Given the low profit margins of such firms, such an approach should be of interest to comparable firms in Latin America. The paper’s methodology may also be applicable to large firms in other geographic locations, which are similarly involved in the trading and shipping of grain.

As summarized by Hilary Till, Contributing Editor, Global Commodities Applied Research Digest

In this study, the authors examine what potentially drives convenience yields. Typically, convenience yields are regarded as the benefit that a holder of commodity inventories receives for being able to avoid the cost of potential stock-outs. The authors examine to what extent commodity-specific and broad macroeconomic variables can explain the variability of convenience yields for a set of commodities. Amongst the authors’ results are that convenience yields (in all cases but one commodity) “exhibit statistically significant positive relationships with” expected inflation and expected industrial production in the US. This is a helpful result for investors whom are interested in choosing futures strategies that provide exposure to key macroeconomic variables.

As summarized by Hilary Till, Contributing Editor, Global Commodities Applied Research Digest

In this article, the author questions to what extent a government should be “hands off” in the development of commodity exchanges. Given the scale of institutional development required for the establishment of a commodity exchange, the author is skeptical about limiting the government’s role. In the Chicago model, the government’s role is limited to providing the relevant legal framework and oversight functions. Instead, the author advocates an approach in which commodity exchanges are government-run. In making his case, the author compares the experience of two African countries.

In early 2015, the J.P. Morgan Center for Commodities (JPMCC) at the University of Colorado Denver Business School established a prestigious Research Council, which, in turn, consists of distinguished academics and accomplished practitioners across commodity segments. The JPMCC’s Research Council has thus far met in April and December 2015, and is chaired by Professor Colin Carter, University of California, Davis and co-chaired by Dr. Margaret Slade, Professor Emeritus, Vancouver School of Economics, University of British Columbia. In this issue of the GCARD, we cover the agricultural panel’s presentations from April 2015, which were delivered by distinguished academic and practitioner members of the Research Council. Future issues of the GCARD will cover academic panels on energy, metals-and-mining, and on renewable energy.

At the April 2015 J.P. Morgan Center for Commodities’ (JPMCC’s) Research Council meeting, Professor Brian Wright, University of California, Berkeley, discussed the puzzling behavior of grain prices during the last 10 years. Mr. Peter McCallum, Bunge Limited, moderated the session while Professor Colin Carter, University of California, Davis, and Ms. Nancy DeVore, DHF Team, LLC, discussed Wright’s research from both academic and practitioner perspectives, respectively.

Undergraduate and graduate degrees in business rarely offer an in-depth exploration of commodity markets. This article argues that a supplemental professional education in the commodity markets is not only needed, but is also imperative for a well-rounded business education.

This article advocates that investors take a practical and informed approach to understanding the rebalancing aspect of commodities allocations so as to be better positioned to harness the real returns of this critical (but sometimes difficult to evaluate) asset class.

This issue’s “Editorial Advisory Board Commentaries” section of the GCARD includes articles from two accomplished members of the board. This issue’s authors are (1) Jan-Hein Jesse, Founder, JOSCO Energy Finance and Strategy Consultancy, Amsterdam, and an international expert for the International Energy Agency, Paris; and (2) Richard Heckinger, Associate Editor, Journal of Financial Market Infrastructures, and a member of the Working Group on Financial Markets for the Federal Reserve Bank of Chicago.

This article describes the incumbent and new-entrant crude oil benchmarks at a time the oil markets are going through a period of great turbulence. The article starts with an introduction about the current state of the industry and market, including a description of benchmarks and the price discovery process in general. The next sections describe each benchmark – WTI, Brent, and Dubai in more detail. The article ends with the pending introduction of Shanghai crude oil futures contracts, which may create a new benchmark for Asian markets.

The liquidation and settlement of claims stemming from the collapse in October 2011 of the futures commission merchant and broker–dealer entities of MF Global (MFG) Group took nearly four years to settle. Various investigative initiatives have revealed evidence that customer monies were probably used at times to fund the proprietary trading of the firm in violation of law and regulation in certain jurisdictions and contrary to international principles. This paper examines the conflicting business objectives of MFG overall, its proprietary trading strategies and its eventual collapse, with some lessons learned.

In the inaugural issue of the GCARD, the Contributing Editor interviews Dr. Colin A. Carter, who became the Chair of the J.P. Morgan Center for Commodities’ Research Council in the Fall of 2015. Dr. Carter is also a Distinguished Professor of Agricultural and Resource Economics at the University of California, Davis where he has been a researcher and educator for over 30 years. Professor Carter’s research covers the grain and livestock sectors in China as well as the economics of biotechnology, global agricultural commodity markets, and biofuels policy in the United States.