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2023 | OriginalPaper | Chapter

4. Financialization and the Theory of Hedging Pressure

Author : Ilia Bouchouev

Published in: Virtual Barrels

Publisher: Springer Nature Switzerland

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Abstract

In this chapter the focus shifts to flow imbalances. Particular attention is paid to causes and consequences of the influx of financial investors to the oil market, the phenomenon dubbed financialization. We track the market transition from the early days of normal backwardation to the subsequent regime of normal contango and combine them into a more general economic framework that describes the hedging pressure equilibrium.

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Footnotes
1
Among many studies of commodity markets in the 1920s, the newspaper article published by Keynes (1923) is credited with a particularly significant contribution. In this article, the author highlighted that the value of agricultural inventories after the harvest is so large relative to financial resources of producers that they cannot themselves bear the risk of inventory value to drop. Thus, the imbalance requires the service of professional speculators. Keynes was careful to distinguish between agricultural and extraction commodities, such as oil, for which the demand for temporary credit is lower due to the ratable nature of production.
 
2
Hicks (1939), chapter 10.
 
3
The term normal backwardation was introduced in Keynes (1930), volume II, chapter 29.
 
4
Keynes (1923).
 
5
Keynes (1923).
 
6
This approach follows the mean-variance hedging framework originally developed by Stoll (1979) and Hirshleifer (1988).
 
7
The theory of hedging pressure has been combined with the canonical theory of storage by Gorton et al. (2012), Acharya et al. (2013), and Baker (2021).
 
8
See Backhouse (2002).
 
9
Several attempts have been made to provide individual drivers with hedging instruments, typically by selling them prepaid gasoline cards to be used at retail gas stations, but such attempts never gained the economy of scale.
 
10
The term fully funded means that the entire notional value of the futures contract is held as collateral. We use log-returns which are additive for the reasons of analytical tractability, as explained in Chap. 2. While it is not recommended to average simple returns, the annualized arithmetic average of monthly returns over this period would have been even higher at 15.6%. These returns do not include any additional return on collateral.
 
11
A typical initial cash margin requirement for energy futures is 10–20% of the contract’s notional value. Therefore, the returns on cash required to hold futures are 5–10 times higher than returns on a fully funded position.
 
12
The idea of investments in diversified commodity indices has been covered extensively in the literature. For earlier studies of this subject that predate the introduction of energy futures, see Greer (1978), Bodie and Rosansky (1980), and Fama and French (1987). The addition of petroleum futures markedly improved the performance and the overall attractiveness of commodity indices for investors, as documented in the influential work of Gorton and Rouwenhorst (2006), and Erb and Harvey (2006). See also Till and Eagleeye (2007), Ashton and Greer (2008), Tang and Xiong (2012), Fattouh and Mahadeva (2014), Büyükşahin and Robe (2014), Hamilton and Wu (2014), Cheng et al. (2015), and references therein.
 
13
In the USA, a recession is formally defined by the National Bureau of Economic Research (NBER) as “a significant decline in economic activity spread across the market, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production, and wholesale-retail sales.” In practice, two consecutive quarters of negative GDP growth is often taken as an indicator of a recession.
 
14
This observation was first made in Hamilton (1983).
 
15
Hamilton (2003) developed a nonlinear metric for net oil price increases and applied it to explain oil price shocks mostly with supply disruptions driven by geopolitical events. In contrast, Kilian (2009) attributed a much larger role in many oil shocks to growth in global demand for commodities and to the so-called precautionary demand, which is associated with speculative buying in anticipation of rising uncertainty and shifts in future expectations. The latter approach was formalized via a structural vector autoregressive model (VAR) in Kilian and Murphy (2014) that decomposes contribution of supply disruptions, business cycle-related demand, and speculative oil-specific demand for inventories to the real price of oil. Another VAR model was used by Kilian and Vigfussion (2017) to quantify the contribution of oil shocks to past US recessions.
 
16
See, for example, Alexander (2001).
 
17
Many of the previous references on commodity indices also discuss superior investment performance of commodity futures during periods of high inflation. Neville et al. (2021) conducted the comprehensive empirical study of hedging against inflation surprises using not only various financial assets but also some systematic trading strategies. Passive investment in petroleum futures is shown to be by far the best hedge. Similar conclusions have been reached in many publications by sell-side research analysts.
 
18
The thesis of normal contango was suggested in Bouchouev (2012).
 
19
This approach to the derivation of the hedging equilibrium was proposed in Bouchouev (2020).
 
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Metadata
Title
Financialization and the Theory of Hedging Pressure
Author
Ilia Bouchouev
Copyright Year
2023
DOI
https://doi.org/10.1007/978-3-031-36151-7_4