Journal of Energy Markets

Risk.net

The informational role of spot prices and inventories

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

  • With rational expectations, trading in the spot market for any commodity tends to reduce but not eliminate differences in beliefs regarding the future price.
  • The degree to which beliefs remain misaligned is determined by economic fundamentals of the spot market, which creates an incentive for speculation in the futures market. We show how variations in spot market fundamentals cause the scope for futures speculation to vary systematically across commodities and over time.
  • Passive commodity investors who participate in the spot market magnify differences in beliefs and expand the scope for financial speculation even though they do not themselves speculate.
  • To the extent that speculative futures trading is perceived to be excessive, the cure for the problem (or at least its cause) may be sought in the underlying spot market.

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.

To continue reading...

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an indvidual account here: