Guest Contribution: Index Funds and Commodity Prices… Here We Go Again

By Scott Irwin

Econbrowser is pleased to host another contribution from Scott Irwin, who holds the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois, and today offers some insights from his research on the current debate concerning commodity speculation.

Index Funds and Commodity Prices… Here We Go Again
by Scott Irwin

Some issues just will not go quietly into the night. The U.S. Senate’s Permanent Subcommittee on Investigations released a report on June 23, 2009 concluding that excessive speculation by large index funds in the Chicago Board of Trade (CBOT) wheat futures market resulted in over-valued futures prices, a large “carry” in the futures price structure, and a wide divergence between futures and cash prices during the 2006 through 2008 period. These are serious charges, and judging by recent newspaper headlines, there is a receptive audience in the halls of Congress and on the part of some regulators.

If you read my previous Econbrowser posts on commodity markets ( here and here ) you should not be surprised to discover that I disagree with Subcommittee’s conclusions. Rather than citing rigorous academic analysis of the problems in the CBOT wheat contract the Subcommittee chose to rely on finger-pointing by industry participants who were adversely affected by high prices and weak basis and on cursory analysis of temporal price, basis, and trading activity data. You can find an extended commentary on the Subcommittee report here by our research group at the University of Illinois.

To begin, the Subcommittee repeats the mistake of other “bubble” proponents by equating index fund money flows into wheat futures with demand for the physical commodity. Simply observing that large investment dollars flowed into the long side of the wheat futures market at the same time that futures prices rose substantially does not necessarily prove anything. Several recent studies use “Granger causality tests” and “cross-sectional” regression tests to establish that lagged position changes by any group, including index traders, do not help to forecast current futures price changes in a statistically significant manner (see our commentary and this paper for a brief review of the studies). This provides compelling evidence that index funds were not responsible for the run-up in grain and oilseed markets, particularly in the wheat market. Historically, price “spikes” have not been uncommon in the grain markets as market participants react to developments that are less permanent than anticipated. Such episodes are frequently attributed to speculation rather than the underlying fundamental factors responsible for the market situation.

If problems in the CBOT wheat futures market were not due to a speculative bubble in futures prices, then what was the problem? Our research at the University of Illinois pinpoints two major factors contributing to the lack of convergence between cash and futures price in wheat. The first factor is the tendency for spreads in the futures market to reflect a relatively high percent of full carry (contango) since 2006. The second factor is long-term structural deficiencies in the delivery system for CBOT wheat.

Large carrying charge markets contribute to lack of convergence by “uncoupling” cash and futures markets when futures prices are above cash prices. The delivery instrument for wheat was a warehouse receipt until recently when it was changed to a shipping certificate (starting with the July 2008 contract). Those longs who receive certificates or receipts from shorts in the delivery process are not required to cancel those instruments for shipment. The instruments can be held indefinitely with the holder paying "storage" costs at the official rates specified by the CBOT in contract rules. The taker in delivery (the long) may choose to hold the delivery instrument rather than cancelling the instrument by load out of physical grain if the spread between the price of the expiring and next-to-expire futures contracts exceeds the cost of owning the delivery instrument. Therefore, as the magnitude of the nearby spread exceeds the full cost of carry for market participants with access to low-cost capital, those participants can (and do) stand for delivery but do not cancel delivery certificates or receipts for load out. The lack of load out, then, means that deliveries do not result in cash commodity purchases by the taker that would contribute towards higher cash prices and better convergence.

The chart below illustrates the relationship between the magnitude of the carry in wheat and the basis (cash – futures price) at the primary delivery location for wheat, Toledo , on the first delivery date of each expiring wheat futures contract over March 2000 through July 2009. The percent of full carry is computed as (price of next-to-expire contract minus price of expiring contract)/(storage plus interest costs).


The chart is constructed so that the zero line for basis on the left y -axis scale corresponds to 80% of full carry on the right y -axis scale. While the pattern is not perfect, there is a consistent tendency towards poor convergence (wide basis) whenever the carry exceeds about 80% and better convergence when the carry is below 80%. Note that this pattern is evident not only during recent years but also in 2000-2001, when wheat experienced another period of non-convergence, albeit at much smaller basis levels. A similar relationship exists for corn and soybeans.

Of course, this only moves the debate back one step to explaining the large carrying charge in the wheat futures contract since 2006. The Senate Subcommittee concludes that the rolling of positions by index funds is responsible for the persistence of the large carry. Rolling refers to in dex funds entering market positions in the nearby contract and then moving the positions to the next contract before the maturity of the nearby contract. The evidence, however, does not support a conclusion that such rolling widened the spreads.

The following chart shows the behavior of nearby spreads for CBOT wheat during the first 13 business days of the calendar month prior to contract expiration for the March 1995 through March 2009 contracts. The time window for the analysis is centered on days 5 through 9, the time period of the so-called “Goldman roll” when index funds tend to roll their positions from the nearby to the next deferred contract.


The averages reveal a consistent increase in the size of the spread to the next contract (expressed as a percent of full carry) during “Goldman roll” days 5 through 9. However, the spike in the magnitude of the spread either disappears entirely or noticeably recedes during days 10 through 13, so rolling did not necessarily lead to a permanent increase in the magnitude of the spread. The spike in the magnitude of the spread during the roll period was also present long before convergence became an issue and before index funds had a major presence in these markets. This is not surprising since the time window when index funds roll to the next contract is also the same time period when many other traders roll their positions.

As noted above, the second factor contributing to recent convergence problems is underlying structural problems with the CBOT wheat delivery system. The fundamental problem is that changes in wheat production patterns, transportation logistics, and trade flows have left the contract with an increasingly narrow commercial flow of wheat to draw upon in the delivery process. For example, annual commercial shipments of wheat at facilities regular for CBOT delivery averaged only 28 million bushels over 2000-2008. By comparison, annual commercial shipments for corn and soybeans at delivery facilities averaged of 260 and 170 million bushels, respectively, over the same time period. This raises substantial doubts about the representativeness of Chicago and Toledo as wheat pricing and delivery points. Furthermore, there is a constant potential for congestion in the delivery process of CBOT wheat futures and the attendant distortion of cash and futures prices.

The underlying structural problems were generally ignored until recently when additional delivery locations were added by the CBOT starting with the July 2009 contract. Whether these additional wheat delivery locations will contribute to improved convergence performance is debatable due to the “safety valve” nature of the new location price differentials. Early evidence from the expiration of the July 2009 CBOT wheat contract is not encouraging.

Fundamental questions still remain regarding the performance of the CBOT wheat futures contract. First, what explains the increase in the level of carrying charges in the wheat futures markets since 2006? I believe it is likely a combination of CBOT contract storage rates that lagged market rates, congestion in the delivery process, and an increase in risk that had a large impact on stockholding behavior. Second, why does t he CBOT wheat contract, the most popular wheat contract in the world, appear to be widely used to trade “wheat” generically when the delivery market locations make the contract a soft red winter wheat contract at maturity? To the extent that world wheat and soft red winter wheat supply and demand fundamentals diverge, this can lead to a systematic tendency towards poor convergence performance. Third , what explains the seemingly anomalous behavior of commercial grain firms (e.g. ADM , Bunge , and Cargill ) during recent episodes of non-convergence? These firms are “regular” for delivery and can create delivery certificates virtually at will. As Craig Pirrong noted recently, it is not clear why these firms have apparently left so much money on the table by not arbitraging the very large differences between cash and futures prices. Understanding the motivation and strategies of these firms would be a far more informative line of inquiry than the current obsession with index funds.


13 thoughts on “Guest Contribution: Index Funds and Commodity Prices… Here We Go Again

  1. sjp

    Great post — thanks.

    Is there anything statistically (and economically) significant about the rate of price increase during that Goldman Roll window every month?

  2. Rams

    Ha! Let the market decide the price philosophy! And it thinks its $140 in one year and $34 soon! Wow!

  3. bartman

    I don’t want to get into a detailed analysis of supply and demand curves (you can get that from any elementary econ text), but suffice it to say that the price points you highlight are not frivolous or anomalous. The short answer is, last year everybody thought we would be bumping up against capacity constraints in oil production, such that it was feasible that the marginal new barrel might indeed cost $140. Given the contraction in the world economy and corresponding reduction in demand, we now have a pretty large cushion in production capacity, so the price of the marginal barrel is a lot lower.
    In the electricity business it is not uncommon to see prices swinging from zero to $30 to $500 per MWh in the span of a few hours. Heck, hundred dollar swings inside a half hour are not uncommon. And these price moves are not caused by speculation or manipulation, but simply by the intersection of supply and demand curves.
    It’s really not all that complicated.

  4. MikeR

    Mr. Irwin,
    Thanks for the well referenced post and you continued research in this area. I certainly don’t think we need the government to protect us from volatility by banning “excess” speculation.
    One question though… you mention that money flows into index funds or futures should not influence price, as there needs to be a seller for every buyer. However, if there is a large number of buyers who are less price sensitive, wouldn’t they have to buy at a higher price in order to convince the sellers to take the other side of the trade? Sort of like a limit order book?

  5. Rams

    Thanks for your reply. Yes the dollar swings a lot even on hourly basis. I understand your reasons and if someone pointed a gun on my head and asked me to argue for this point, I would have argued similar to you.
    However, why did the market suddenly figure one day that the world is running out of oil ? And the world would probably contract a few percentages – doesnt sound right that this contraction would take the oil price from $140+ to $34.
    Its not even about speculation – as Randall Wray calls it, its “Money Manager Capitalism” – banks store huge quantities of oil and this also is an important factor to think of.
    Funds are mostly long on Oil (net) and this itself has a tremendous pressure on the price. In the end, the consumer suffers! In a sense it sounds intellectual to talk of perfect markets, run causality tests, but its easier to err on the other side, ban trading

  6. sbenard

    This could have potentially disastrous effects on the liquidity pool for futures, ultimately leading to precisely the conditions that these political goons hope to alleviate — higher prices and even shortages of food commodities! Blue whales like Soros benefit from being the big fish in a smaller liquidity pond. The best solution is to INCREASE the size of the pond, thus nullifying the influence of large players. Shrinking the liquidity pool will INCREASE the leverage of blue whales, not decrease their influence. The antidote for high prices and market manipulation is MORE liquidity, not LESS!
    One of the primary causes of the entire credit crisis was lack of liquidity and price transparency/discovery. Now, these guys on the the verge of imposing those same conditions on the futures markets — the markets that have worked well for nearly 150 years! What are they thinking?!
    The capital flight alone, as money seeks safety in a more friendly global environment or in other futures markets outside the United States (Europe, China, Dubai, Singapore, India, etc.), would sink the Dollar, increasing commodity prices, and sending those commodities to countries that are willing to pay unhindered market prices for them. Have we learned nothing from the mess Hugo Chavez has made in Venezuela with constant meddling and manipulations? America had better prepare for higher prices, food shortages, and long lines at the gas pump! The tea leaves are clear, and they don’t take a gypsy to read them. Higher prices and shortages are on their way to America!

  7. Scott Irwin

    Good question. We have not run formal statistical tests given the relatively small sample sizes for the periods in question. We do intend to do so at some point in time. I would also say that some of the increases in the spread during the Goldman roll period are economically significant. A 5% increase in the spread translates into roughly a quarter cent increase in the spread per month or three-quarters of a cent for a three month spread. I think most traders would not regard that as a “large” jump but neither is it economically insignificant.

  8. gcs

    Since we essentially know today that funds will roll out of Sep longs during August, and will roll out of Dec longs during November, etc., if markets are efficient wouldn’t those rolls already be factored into deferred spreads? In that case we would not necesarily expect to see any impact during the time of the roll.
    If we achieved convergence, through some form of forced load out, cash SRW settlement, or whatever, would it even matter that the SRW wheat contract is used by some as a generic wheat contract?
    There are currently more than 7000 outstanding registered wheat certificates. The commercials who created them know they won’t be loaded out when the basis is weak, and have an open ended obligation to load them out when demanded at some point in the future, when the basis is strong. This could interfere with their other cash business, and would explain why they don’t keep creating new certificates.

  9. Tom

    The public needs to be educated on the difference between speculating, cornering a market, and rent-seeking in the financial system.
    Speculating is estimating what people will want and need. It is a very important job that must be done by somebody, even in orthodox communist states. One of the great advantages of modern democratic capitalist systems is that they allow almost anybody to get involved in this estimation process, reward those who are better at it. Intelligent, educated speculation should be encouraged.
    Most of the time when people complain about speculation, what they are really doing is alleging that someone or some group is cornering a market – hoarding the supply of something in order to drive up its price and make a profit at everybody else’s expense. It is economically damaging activity. These are usually empty allegations. For example, it’s generally impossible to corner a market in a commodity simply by buying up futures contracts. One needs physical storage capacity, which is expensive. The 2008 oil price spike was caused by Chinese stockpiling, not by anybody intending to sell it on at higher prices.
    Others, mainly leftist theorists, complain about speculation but are actually alleging that professional speculators are collecting a sort of rent by performing some kind of intermediation that is actually useless. I think such rents do occur, but only where government creates and sustains them – a market will quickly weed them out. G&S surely would never have made such profits in such a weak economy without various kinds of government interference in the markets.

  10. Dave Cohen

    OK, Scott

    Explain to me why the oil price rose from the $30s into the low $70s this year despite

    1. continued weak overall global demand

    2. US demand (monthly average) falling for the last 5 months (despite the summmer “driving” season) shown by EIA data

    3. weak discipline within OPEC as members sought to enhance revenues after the price got near the $60 mark (but continued to rise)

    4. stocks well above the average 5-year average range when the “rally” began, and which continue to be above that range now despite falling lately due to other factors


    And don’t tell me about wheat

  11. Sean

    Dave Cohen:
    Oil was in the $30s per barrel in the landlocked US WTI market because Cushing, where Nymex futures contracts go to delivery, was running up against storage constraints. The recession hit US consumer demand very hard, and price effects were more amplified in the relatively isolated US crude market. Brent and Dubai crude didn’t really dip much below $40 per barrel. This was considered a very high price five years ago.
    1. Global demand was weak. Is it still weak? Who knows. Most fundamental data the reliable stuff anyway comes with a lag of a few months. Forecasting agencies expect demand to rise by anywhere between 500,000 and 1mn barrels per day in the third quarter over the second quarter, and by anywhere from another 300,000 to 1.4mn barrels per day in the fourth quarter.
    2. The US is big, but it’s not the world. Chinese oil imports rose sharply in March and have stayed high. Even higher than a year-ago when they were stockpiling like mad. There are a few new refineries now in China and one big new one in India, and China and India (to a lesser degree) are where almost all the demand growth has come from in the oil market since 2004. A strong element of stockpiling is at work at a governmental and state-owned oil company level in China because prices are lower than last year. But there’s also some restocking going on at the consumer level, because the state-controlled retail price mechanism is not very secret, and motorists and private retailers know when the price will rise and stock up before then.
    3. Opec discipline has not been weak. Remember that the cut they agreed in December was massive. For the group to get 70-80pc compliance with a 4.2mn b/d cut is a big, big deal, especially considering the huge fall in revenues that the individual members suffered. Within the group, there’s cheating, a lot of it by Iran and Venezuela, but the Saudis by far the largest producer have compensated for this, as have some of the other Gulf Arab Opec producers.
    4. Stocks have been falling. Crude in floating storage was above 100mn bl a couple of months ago, now down to around 60-70mn bl, possibly 50mn bl. It’s not gone away, though, just been refined into middle distillates that are now also hanging around in floating storage. The storage surplus is made possible by higher forward prices, because the market is factoring in a recovery in demand. Prices 1-3 years out are $70-80 per barrel. Those stocks will be used, just not now.

  12. MC

    “The lack of load out means that deliveries do not result in cash commodity purchases by the taker that would contribute towards higher cash prices and better convergence”
    Could someone explain this sentence. It seems to my naive understanding that by taking the delivery instrument the taker will be taking that amount of wheat out of the cash market and so would impact cash prices.
    Is this not correct?
    Any responses would be appreciated.

  13. gcs

    The taker of a shipping certificate can simply redeliver the certificate against a subsequent futures contract, so no physical grain needs to move or even be purchased by anyone.
    If the contract were changed so that delivery was compelled somehow, convergence would be achieved primarily by futures prices falling to the cash price level, not by cash prices rising to the futures price level.

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