NEW CONKERS3 FEATURE : The Analytical Surveyor

Analytical Surveyor has worked for over 40 years in the City and West End of London as a real estate investment manager, an equity analyst, a multi-manager, a fund manager and as a researcher and strategist. In his area of expertise, he is highly regarded and currently works as a consultant.
There is an enormous amount of academic research that provides insights into the functioning of investment markets. Rarely will this help with stock selection, but much of it will help in understand how and why the market functions the way it does. The Analytical Surveyor trawls through the work that is available in the public domain and summarises the work into useable notes for investors.

Oil as a financial product:

Commodity futures were originally invented as a means of providing certainty of price for producers and buyers of the commodities, for supplies of the commodities to be produced sometime in the future.  The banks, as intermediaries, were able to take a fee in this de-risking process (where they were able to match the contracts) or take one side of the contract (and establish a speculative risk position).

A recent paper[1], which deals exclusively with oil, identifies a change that occurred with the increased presence of financial investors in commodity markets. The phenomenon, known as the ‘financialisation of commodity markets’, is estimated to have emerged around 2004.  This, it is argued, has led to two changes.  First, a dramatic increase in co-movement between commodities and the stock markets.  The second, and perhaps more significant, was the increased returns and the volatility of commodity spot prices.  From this, it might be concluded that financial flows rather than underlying commodity supply and demand were increasingly driving prices.

Although earlier academic studies (one literature review examined 100 papers on the subject) have been almost-equally divided between a positive effect of speculation and the ones finding a negative effect, more recent ones show a clear link between financialisation and commodity markets.  This brings the authors to raise the question as to whether we should start thinking of commodities as financial rather than physical assets.

Their conclusion, at least in respect of oil, is that the majority of the oil price movements today can be explained by financial variables. While financial variables could only explain 11% of the total variation in crude oil returns in the years prior to financialisation, the impact grows to 35%, becoming the main drivers behind oil price movements. They estimate an even stronger effect on crude oil volatility where the impact of financial variables grows from 19% in the pre-financialisation period to 53% since the failure of Lehman Brothers.

It is important to note that the paper draws no conclusions about the mechanisms for these changed relationships.  It is possible that, in recent years, more substitutes have been found for oil (as an energy source) and, therefore, oil commands less of a quasi-monopolistic position than it did in previous decades.  In that case, pricing of it would indeed become more of a financial consideration, in terms of a medium of exchange, rather than the result of oil supply-demand factors.

The authors intend to extend their methodology to other commodities and it will be interesting to see if a similar change can be identified elsewhere or whether oil is unique.  But whatever the answer, it appears that oil prices are now subject to financial and investing forces to a much greater extent than at any time in the past.  That introduces an increased level of uncertainty for oil producers and processors, without any prospect of reversal of that change, as well as adding to general economic volatility.  Irrespective of global-warming issues, oil companies have become riskier.

[1] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2999717  HAS CRUDE OIL BECOME A FINANCIAL ASSET? EVIDENCE FROM TEN YEARS OF FINANCIALIZATION; FEBRUARY 2017; ZENO ADAMS and MARIA KARTSAKLI


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