I didn’t do it! The hedge funds did!

(c) 	08-06-08 iofotoHedge funds have been blamed for a lot of things – the recent financial crisis, illicit financial market activity, bad weather, natural disasters, the Middle East conflict…

What they haven’t been blamed for are high and rising oil prices, and in turn high and rising gas prices, which anyone in North America who drives something with an engine can certainly attest to.

That party’s over, and hedge funds are to blame.

A recent research paper written by Bahattin Buyuksahin of the International Energy Agency and Michel A. Robe of American University – Kogod School of Business take a stick to hedge funds over their purported increased involvement in the energy markets.

The paper, entitled, Does ‘Paper Oil’ Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements, (click here to download from SSRN) argues that financial speculators, hedge funds in particular, who take positions in both equity and energy futures markets have a “material” impact on both energy prices and volatility.

For those not quite in the know (we admittedly weren’t) financialization is a new term used to show financial leverage surpassed capital and financial markets to dominate traditional economics leading up to the financial crisis.

More specifically, the paper portends that dynamic conditional correlations between the rates of return on investable energy and stock market indexes increase significantly amid greater activity by speculators. (See chart below.)

It further notes that the impact of hedge fund activity is markedly lower in periods of financial market stress, suggesting hedge funds that run for the hills when financial markets get a little wonky do indeed have an effect on overall price movements and general liquidity.

Our results support the notion that the composition of trading activity in futures markets helps explain an important aspect of the distribution of energy returns, and have ramifications in the debate on the financialization of energy markets.

Focusing on U.S. energy futures markets as well as commodity index trading and general index trading activity, the paper’s authors draw on various public and private data to show how speculators and hedge funds distort price movements not only in oil futures markets but in prices of energy-related stocks as well.

By examining all different potential players, including non-commercial traders, floor brokers and traders, other non-commercial traders not registered as managed money traders and hedge funds, the authors conclude by process of elimination that hedge funds are the most plausible culprits affecting energy-equity linkages.

To prove the point, the paper further explores the positions of individual managed money traders to compute hedge funds’ contribution to the total energy futures open interest. The authors calculate hedge fund market share across the three nearest-maturity futures with non-trivial open interest as well as across all contract maturities. And that doesn’t even take into account the Lehman Brothers crisis.

The conclusion: Changes in the overall amount of speculative activity in commodity futures markets have explanatory power for the time variations in the correlation between the returns on investable equity and on energy futures indices – and that this explanatory power can be traced to hedge funds.

In contrast, we find that the positions of other kinds of financial participants in the commodity-futures market (swap dealers and index traders, traditional commercial traders, floor brokers and traders, etc.), whether or not they take positions in both types of markets, do not help explain cross-market correlation patterns.

In English: Cross-correlation patterns appear to show that hedge funds involved in both equity and commodity futures markets play a big, bad role in causing energy market distortions, which in turn affects both the price of oil and the prices drivers pay at the pumps. “Intuitively, hedge funds could be an important transmission channel of negative equity market shocks into the commodity space,” they state.

Yet another finger being pointed at hedge funds. While we suspect the authors have a somewhat valid hypothesis, we can’t help but wonder just which finger they are pointing at hedge funds.

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  1. Sam
    June 6, 2011 at 2:57 pm

    Your definition (or at least wording) of financialization appears off. Interesting article otherwise. Thanks!

  2. Bahattin Buyuksahin
    June 7, 2011 at 3:13 pm

    As one of the author of the paper, I would like to comment on two items in your article:

    1. As another commentator observed, the definition of “financialization” you used for the blog is not the one we have in mind. As noted in the Wikipedia page to which you refer, the most “popular” academic use of the term in the financial economics literature is the following: financialization is understood to mean the vastly expanded role of financial motives, (…) financial actors and financial institutions in the operation of domestic and international economies.

    2. On your take on the content of the paper, we have the following comments:

    The article you examined analyzes the impact of hedge funds on the correlation between returns on commodity and equity investments. Importantly, our paper did not analyze the impact of hedge funds on either the level or the volatility of energy prices.

    Insofar as readers are interested in levels or volatility, they should instead look at the following my two articles,:

    “Speculators, Prices and Market Volatility”. Working Paper, IEA and Johns Hopkins University. http://ssrn.com/abstract=1736737

    “Do Speculators Drive Crude Oil Futures Prices?” Energy Journal, 32 (2), 2011. http://www.iaee.org/en/publications/viewabstract.aspx?id=2421

    Those articles in fact provided evidence that speculators, particularly hedge funds, actually reduce the volatility by providing liquidity to the market without having any impact on price level.

    Going back to correlations, we do document in the paper you cited that hedge funds in general (and those that trade cross-market in particular) help explain some of the increased correlation between equities and commodities. Our regression analyses, however, show that this effect is secondary to that of macroeconomic and market-specific fundamentals.

    Importantly, we do not qualify the impact of hedge funds as either good or, as you claim, “bad”. We merely point out the explanatory power of hedge fund activity in linking the markets for different financial assets — in line with the predictions of economic theory that cross-market arbitrageurs help link otherwise segmented markets.

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