Summer 2024

Research Digest Articles

As regulations regarding shipping decarbonization and greenhouse gas emissions in general are becoming increasingly strict, ship owners have been facing the trilemma of investing in a cheaper but much more polluting conventional vessel or in a more expensive but eco-friendly one or postponing their investment decision. This paper quantifies the price premium paid for ecofriendly cargo-carrying vessels and examines the determinants of it. Weekly data from January 2019 until December 2023 indicates that eco vessels trade at an average premium of close to 25% compared to their conventional counterparts. However, the corresponding income premia are on average between 9% and 15%. The paper’s findings further suggest that the price premium is time-varying and highly dependent on the prevailing market conditions; in expansionary freight markets, it is significantly lower than in normal/recessionary ones. Empirical estimation using nonlinear threshold autoregressive models indicates that recent price premia and changes in the fleet supply are strong drivers too with fuel costs and market liquidity having ambiguous effects. However, the magnitude and significance of these drivers vary based on the market state and segment. Finally, the paper documents the adverse effect that the current technological and regulatory uncertainty has on investment in newbuilding vessels. These findings have important implications for industry participants, policymakers, and regulators.

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Selective hedging adds a speculative incentive to the pure risk-minimizing goal of traditional hedging. This article investigates the merit of diverse selective hedging strategies vis-à-vis the traditional minimum-variance hedging strategy for 24 commodities. The main assessment tool is the out-of-sample hedging effectiveness, defined as the expected utility gain from hedging versus not hedging. The speculative element of the selective hedges hinges on forecasting approaches that range from the simple historical average return to sophisticated machine learning algorithms. The findings do not endorse selective hedging because this strategy struggles to capture an abnormal return, due to the low time-series predictability of individual commodity futures returns, while it increases risk notably compared to traditional hedging. The findings survive various reformulations of the hedges and rebalancing frequencies, longer estimation windows and time-varying risk aversion inter alia.

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The authors present a new term-structure model for commodity futures prices based on Trolle and Schwartz (2009), which is extended by incorporating seasonal stochastic volatility represented with two different sinusoidal expressions. The authors obtain a quasi-analytical representation of the characteristic function of the futures log-prices and closed-form expressions for standard European options’ prices using the fast Fourier transform algorithm. They price plain vanilla options on the Henry Hub natural gas futures contracts, using their model and extant models. The authors obtain higher accuracy levels with their model than with the extant models.

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J.M. Keynes coined the term normal backwardation, a situation where a futures price for a particular expiry month is less than the expected spot price for that month. He argued hedgers pay speculators a risk premium, giving rise to normal backwardation. The authors study the behavior of commodity futures before and since financialization of the markets, which started about 20 years ago. They find the poor returns to managed futures in recent years are likely due to the impact of financialization and the associated outside money suppressing the futures risk premium.

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The authors analyze the pricing dynamics evident between the commodity and equity markets of nine commodity-exporting economies over the 2000-2023 period, corroborating previous findings that the correlation between these asset prices increases at times of financial distress. Prior research attributes this pattern to the contagious transmission of price shocks originating in commodity markets. They find no compelling evidence for such claims of contagious spillovers. Specifically, evidence that the documented correlation increase originates from commodity price shocks disappears once the authors control for the influence of certain systemic global factors, namely time variation in risk aversion and investor sentiment, which can initiate commonality across asset price movements. Indeed, the authors are unable to reject the hypothesis that no contagion exists between asset prices in their selected markets.

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Practitioner Insights

The global energy market has experienced profound transformations since the original version of this article was published in 2020. That article accurately predicted the declining role of oil indexation in pricing Liquefied Natural Gas (LNG) due to several structural issues.

Current trends indicate that the industry continues to move away from oil indexing to price LNG, as this pricing system can create quite an economic disparity between the current market price when the gas is delivered (via cargo or pipeline) and the contracted price.

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Supply chains are being impacted in completely different ways from five powerful global transitions. Rising protectionism may remove the beneficial influence which globalization has had on inflation. The pandemic’s disruption of supply chains coupled with the geopolitical challenges in Ukraine, the Middle East, and China have reinforced the need for supply chains to be optimized for resiliency and not for lowest cost. Changing weather patterns and the fossil fuel transition have added their own challenges as to how companies manage their supply chains as climate and environmental policy regulation evolve and supply chains become more fragile. This practitioner perspective examines the future of supply chains through the lens of complex systems, focusing on the potential longer-term macroeconomic risks of higher inflation and slower growth in global trade.

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The outbreak of major conventional warfare on European soil in February 2022 came as a shock to the economies of Western Europe and beyond, if not entirely as a surprise to observers of geopolitical developments in the region.  After a stalled initial Russian invasion of Ukraine, followed by a partial retreat, a lengthy phase of stalemate set in.  By the time of writing the final outcome seemed as likely to be determined by the outcome of elections elsewhere than of battlefield victory, despite Russia’s overwhelming superiority in manpower and hardware.

This article follows the evolution of the divergent responses and motivations between domestic Western nations and key players in other continents, with a portrayal of the shifting price patterns in markets as market power games have played out.  With reference to specific groups of commodity markets and examples of current market fallout, as well as Western preparedness, or lack of, for looming future threats, a picture of policy discord laced with deception emerges as well as frequent bouts of economic hysteria often tinged with hypocrisy.

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Asset managers seeking to build a large and successful commodity business can benefit from an awareness of investor concerns regarding climate and the energy transition. This paper describes the steps an asset manager can take to realize that outcome, and concludes with a case study from the author’s own achievement in creating and building a very large and successful commodity investment management business.

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California’s Cap & Trade program plays a pivotal role in the state’s climate strategy by regulating greenhouse gas emissions through the trade of emission permits known as allowances. While previous research, notably by Borenstein et al. (2015, 2019), suggested that market prices tend to be constrained by administrative price floors or ceilings, recent observations challenge this perspective. Despite the California carbon market being in surplus, with more Carbon Credit Allowances (CCAs) issued than utilized, CCA prices deviated from the floor beginning in May 2021. In this paper, the authors propose the concept of the “rate-adjusted price floor” to resolve the apparent anomaly. The rate-adjusted price floor considers the inflation+5% annual escalator in the auction reserve price, adjusted for prevailing market interest rates. The authors demonstrate that the divergence in CCA pricing from the nominal price floor through spring of 2023, when program reform was announced, can be explained by the rate-adjusted price floor. The article’s findings suggest that the observed price behavior was consistent with the Borenstein et al. model once considering prevailing market interest rates.

In conclusion, the authors assert that CCA prices, despite trading above the nominal floor, continued to be floor-bound until the anticipation of substantial supply reduction, emphasizing the necessity of supply-side reforms for achieving a balanced market. This analysis provides insights into the pricing dynamics of carbon markets and highlights the importance of considering both the current, as well as future floor prices, in understanding pricing behaviors.

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With the lithium-ion battery sector this year entering the terawatt era (Twh) – driven by demand from the Electric Vehicle (EV) and Battery Energy Storage Sector (BESS) – there remains little doubt over lithium’s central importance to the energy transition. But how has lithium pricing evolved in the market? The recent slump in lithium prices has triggered a range of questions in the market:  how sustainable are current spot prices? Has lithium’s marginal cost of production become more dynamic compared to previous years? What next for lithium prices and pricing? This paper sheds light on some key features of lithium’s evolving pricing landscape; the drivers of volatility in the market; and the implications ahead as lithium’s journey to market maturity continues apace.

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China’s export controls on gallium, germanium, and graphite, crucial for various industries, have sparked concerns about global supply chain disruptions. These restrictions, seen as a response to prior actions targeting semiconductor exports to China, aim to strengthen China’s domestic supply chain. The initial impact of gallium and germanium restrictions was limited, but graphite restrictions could be more severe due to its importance in EV batteries. China’s dominance in production could lead to price fluctuations and supply shortages, prompting affected countries to explore alternative sources. The situation highlights trade tensions and the necessity for diversified supply chains.

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Interview

Professor Colin A. Carter is a Distinguished Professor of Agricultural and Resource Economics at the University of California, Davis. His research covers the grain and livestock sectors in China as well as the economics of biotechnology, global agricultural commodity markets, and biofuels policy in the United States. More recently, he has been researching the impact of the Russia-Ukraine War on agricultural prices and trade flows. In this interview, Professor Carter discusses the various major changes in the agricultural futures markets; how the grain futures markets responded to the Russian-Ukraine War; and what advice he would give students and young professionals who are interested in pursuing a career in the commodity markets.

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Bayes Equation

Bayes Business School’s name is inspired by Bayes’ theorem of conditional probability, which states that beliefs should be updated in proportion to the weight of relevant new evidence.

Commodity Insights Digest