The informational role of spot prices and inventories

James L. Smith, Rex Thompson and Thomas K. Lee

Abstract

ABSTRACT

We argue that fundamental determinants of speculative futures trading may have been misinterpreted by some as "excessive" speculation in the energy markets in recent years. Using a rational expectations approach, we show why and how differences in beliefs, as well as the volume of speculative futures trading, may rationally vary across commodities and through time. We demonstrate that equilibrium differences in beliefs are determined by characteristics of the underlying commodity, including storage costs, the amplitude of shocks, the accuracy of information available to informed investors, the numbers of informed and uninformed traders and the elasticity of demand and supply. We argue that speculative futures trading serves to reconcile these differences in beliefs, and may periodically rise or fall in concert with the underlying factors that create differences in beliefs. We also demonstrate that passive investors magnify equilibrium differences in beliefs and expand the scope for financial speculation, even though they do not themselves speculate.