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The Impact of Financialization on Commodity Markets

By Lidiane Cunha

A change in investing in a key commodity market in Canada and the world

Oil is one of the most traded commodities around the globe, as well as Canada’s largest commodity export. “The oil market is also one with the highest proportion of index investing in the commodity market,” says Fabio Moneta, an Associate Professor at the University of Ottawa’s Telfer School of Management.

To understand the impact of index investing in the oil market, we first need to delve into two different investment strategies: active and passive. Investments are considered active when investors purchase and sell funds in hopes of beating the stock market’s average returns, outperforming benchmark indexes such as the TSX, S&P 500 and Dow Jones Industrial Average. Investments are considered passive when investors simply follow a benchmark index to match its performance.

Passive investment has become a popular strategy over the years, accounting for 37% of combined U.S. mutual fund and exchange traded fund (ETF) assets by 2017. In 1995, only 3% of these funds were passive. Investors who buy, sell and trade oil and other commodity funds seem to have followed this trend. They have been increasingly relying on benchmark indexes in their trading activities. “The first commodity ETF was launched in 2004, but today investors can access over 90 of such funds,” says Moneta.

Due to costs associated with the physical storage of commodities, commodity ETFs do not directly purchase assets. Instead, such funds trade in “futures contracts” for commodities. Futures contracts have been traded in Chicago since 1864. They are standardized agreements to buy or sell an asset at a predetermined price and at a specified time in the future. Futures contracts play an important role in the commodity market. For example, they allow commodity producers and users to reduce the risk of a price change by fixing the future transaction price.

What’s this project about?

These recent practices represent a significant economic development. They are contributing to an increase in financial capital invested in commodities, a process that finance scholars and experts refer to as the financialization of commodities. But what impact do they really have on commodity markets such as the oil market?

This is one of the main questions motivating Moneta’s new research project. He will examine how passive investment and financialization influence the oil futures market and other commodity futures markets. To carry out this research, he has been awarded a Social Sciences and Humanity Research Council Insight Development grant.

Project title: Oil Investing and the Financialization of Commodities

Who will benefit from this study?

Understanding the impact of passive investment and the financialization of commodity markets will benefit investors, finance practitioners and market regulators. Commodity producers and consumers could also benefit from Moneta’s insights. Increasing our knowledge of investment practices in the oil market could be of great importance to Canadians:

“Right now, Canada relies heavily on commodity markets, especially the oil market. These new financial phenomena must be carefully understood because they involve the Canadian economy.”

Moneta’s research will also answer important questions about the impact of the financialization of commodities on futures markets. “Futures markets provide price discovery and price signals concerning aggregate demand and supply of commodities,” Moneta says. Investors and other finance experts use these estimates to make significant investment decisions that can have broader market implications. “Therefore, it is crucial to examine if the financialization of commodities and other non-fundamental forces affect the futures markets,” he adds.

Learn more about the Social Sciences and Humanities Research Council Insight Development Grants.