USDA’s Economic Research Service has released a report examining whether speculation in commodities markets skews the relationship between cash and futures prices. Over the past five years, the report notes, increased participation by nontraditional investors such as commodity funds, index funds, managed funds and swap has altered the mix of participants in agricultural commodity futures markets.
That increase coincided with historic price increases in those commodities, in some cases beyond the effects of market fundamentals. Some evidence suggests a weakening of market convergence – or the relationship between cash and futures prices. This raises concerns over the ability of futures markets to perform their traditional roles of risk transfer and price discovery for producers and users of ag commodities.
The report documents a dramatic increase in open interest in grain contracts in recent years. During the period from January 2000 to January 2004, the number of corn contracts increased by 18 percent, soybeans by 94 percent and wheat contracts declined by 3.6 percent. Then, between January 2004 and June 2008, corn, soybean and wheat contracts increased by 298 percent, 125 percent and 226 percent respectively. Cash prices also increased dramatically during that same period. Since June 2008, open interest in all three contracts has declined by 24 percent to 50 percent.
The report notes that the emergence of commodities as an asset class has caused a structural change in the level of open interest and composition in futures markets. Issues surrounding price levels, price convergence, and price volatility have caused commercial users of futures markets, such as elevators, merchandisers, and producers, to re-evaluate pricing and risk management strategies. There is evidence, the report notes, showing the link between futures and cash prices has weakened, but market participants continue to use futures markets as a price discovery mechanism. Risk managers have encountered difficulties in managing their price risk due to changing market conditions, but elevators and merchandisers have adapted to the new conditions and have resumed providing risk management products.
“Regulatory agencies and exchanges have implemented modifications to contract specifications and have acted swiftly to identify the performance problems and discuss or enact solutions,” the report concludes. “Time and further research are needed to assess whether performance concerns will continue or dissipate in futures markets and whether further modifications in contract design and market regulation are warranted.”
Click here for the full report.