As commodity markets have continued their expansion an extensive and complex financial industry has developed to service them. This industry includes hundreds of participating firms, including asset managers, brokers, consultants, verification agencies and a myriad of other institutions. Universities and other training institutions have responded to this rapid expansion of commodity markets as well as their substantial future growth potential by launching specialized courses on the subject.

The Economics of Commodity Markets attempts to bridge the gap between academics and working professionals by way of a textbook that is both theoretically informative and practical. Based in part on the authors’ teaching experience of commodity finance at the University Paris Dauphine, the book covers all important commodity markets topics and includes coverage of recent topics such as financial applications and intuitive economic reasoning.

The book is composed of three parts that cover: commodity market dynamics, commodities and the business cycle, and commodities and fundamental value. The key original approach to the subject matter lies in a shift away from the descriptive to the econometric analysis of commodity markets. Information on market trends of commodities is presented in the first part, with a strong emphasis on the quantitative treatment of that information in the remaining two parts of the book. Readers are provided with a clear and succinct exposition of up-to-date financial economic and econometric methods as these apply to commodity markets. In addition a number of useful empirical applications are introduced and discussed.

This book is a self-contained offering, discussing all key methods and insights without descending into superfluous technicalities. All explanations are structured in an accessible manner, permitting any reader with a basic understanding of mathematics and finance to work their way through all parts of the book without having to resort to external sources.

Preface xi

List of Figures xiii

List of Tables xvii

Acronyms xxv

Part I Commodity Market Dynamics 1

1 Individual Dynamics: From Trends to Risks 3

1.1 Backwardation, Contango and Commodity Risk Premium 9

1.2 Understanding Commodities’ Momenta 13

1.2.1 Persistence of Shocks in Commodities 18

1.2.2 The Nature of Momentum in Commodity Markets 20

1.2.3 Time Series Momentum and the Number and Nature of Regimes 32

1.3 Volatility to Returns Spillovers and Tail Events in Commodities 43

1.3.1 Spillover Effects in Commodity Markets 43

1.3.2 Twenty Years of Jumps in Commodity Markets 51

References 61

2 Cross-Asset Linkages 69

2.1 Common Risk Factors in Commodities 77

2.1.1 Literature Review 78

2.1.2 PCA and the Estimation of the Number of Common Components 80

2.1.3 Empirical Findings 82

2.2 Volatility Spillovers in Commodity Markets 90

2.2.1 The Volatility Spillover Index 96

2.2.2 Four Empirical Applications 98

References 110

Part II Commodities and the Business Cycle 115

3 The Reaction of Commodity Markets to Economic News 117

3.1 Measuring the Impact of Price Discovery on Asset Prices 117

3.2 Key Insights from the Academic Literature 118

3.3 Database of News 119

3.4 An Example: S&P 500, 10Y and USD 121

3.5 Commodity Indices 122

3.6 Dependence on the Business Cycle: NBER Recessions/Expansion Phases 123

3.7 Rolling Analysis 125

3.8 Preliminary Findings 128

3.9 Market-by-Market Analysis 129

3.9.1 Database for Commodity Prices 129

3.9.2 Precious Metals 130

3.9.3 Industrial Metals 132

3.9.4 Energy 135

3.9.5 Agricultural Commodities 138

3.10 Concluding Remarks 143

References 143

4 Economic Regimes and Commodity Markets as an Asset Class 145

4.1 Index Performances, the Fed and the NBER Crises 145

4.2 Measuring the Business Cycle 147

4.3 To Which Business Cycle are the Commodity Markets Related? 148

4.4 Commodity Performances Depending on the Nature of Each Economic Regime 155

4.5 Performance Analysis 160

4.6 Concluding Remarks 167

References 167

Part III Commodities and Fundamental Value 169

5 Cross-Commodity Linkages 177

5.1 A Primer on Granger Causality Testing and Cointegration 177

5.1.1 Granger Causality Testing 177

5.1.2 Cointegration without Structural Breaks 177

5.1.3 Cointegration with Structural Breaks 179

5.2 Dataset and Unit Root Test Results 181

5.3 Cointegration in Agricultural Markets 183

5.3.1 Literature Review 184

5.3.2 Results of Granger Causality Tests for Agricultural Products 188

5.3.3 Cointegration Analyses for Agricultural Products 189

5.3.4 Grains and Soft Commodities 190

5.3.5 Agriculture–Energy Linkage 196

5.4 Cointegration in Industrial Metals Markets 202

5.4.1 Literature Review 203

5.4.2 Results of Granger Causality Tests for Industrial Metals 204

5.4.3 Cointegration Analyses for Industrial Metals 204

5.5 Cointegration in Precious Metals Markets 208

5.5.1 Literature Review 209

5.5.2 Results of Granger Causality Tests for Precious Metals 211

5.5.3 Cointegration Analyses for Precious Metals 212

5.6 Cointegration in Energy Markets 219

5.6.1 Literature Review 220

5.6.2 Results of Granger Causality Tests for Energy Markets 222

5.6.3 Cointegration Analyses for Energy Markets 223

5.6.4 Petroleum Products 225

5.6.5 Oil and Gas Prices 231

5.7 Concluding Remarks 235

References 236

6 Cointegration with Traditional Asset Markets 241

6.1 Dataset and Unit Root Test Results 241

6.2 Cointegration Between the GSCI Sub-Indices, S&P 500 and US 10-Year Rate 241

6.2.1 Literature Review 244

6.2.2 Results of Granger Causality Tests Between the GSCI Sub-Indices, S&P 500 and US 10-Year Rate 245

6.2.3 Cointegration Analyses for the GSCI Sub-Indices, S&P 500 and US 10-Year Rate 246

6.3 Cointegration Between the GSCI Sub-Indices and Exchange Rates 254

6.3.1 Literature Review 254

6.3.2 Results of Granger Causality Tests Between the GSCI Sub-Indices and Exchange Rates 256

6.3.3 Cointegration Analyses for the GSCI Sub-Indices and Exchange Rates 257

6.4 Concluding Remarks 266

References 266

7 Cointegration with Industrial Production and Inflation 269

7.1 Dataset and Unit Root Test Results 269

7.2 Cointegration Between the GSCI Sub-Indices and Industrial Production 269

7.2.1 Literature Review 274

7.2.2 Results of Granger Causality Tests Between the GSCI Sub-Indices and Industrial Production 275

7.2.3 Cointegration Analyses for Industrial Production and Commodity Prices 276

7.3 Cointegration Between the GSCI Sub-Indices, Inflation and Monetary Indices 300

7.3.1 Literature Review 300

7.3.2 Results of Granger Causality Tests Between the GSCI Sub-Indices, Inflation and Monetary Indices 302

7.3.3 Cointegration Analyses for Commodities, Inflation and Monetary Indices 306

7.4 Concluding Remarks 320

References 321

Index 323

About the authors

DR. JULIEN CHEVALLIER is a Tenured Associate Professor of Economics (Professeur des Universités). He undertakes research and lectures on time-series econometrics applied to financial, commodity and energy markets. Dr. Chevallier has research connections with various universities, including the University Paris Dauphine. He received his Ph.D. in Economics from the University Paris West in 2008, and his M.Sc. in Economics from the London School of Economics in 2005. Dr. Chevallier has previously held visiting research positions at the Grantham Institute for Climate Change of Imperial College London, at the Centre for Economic Performance of the London School of Economics, at Georgetown University, and at the World Bank. Dr. Chevallier is the author of the book Econometric Analysis of Carbon Markets (Springer). He has published articles in leading refereed journals, including Applied Economics, Energy Economics, Resource and Energy Economics and The Energy Journal. Furthermore, Dr. Chevallier currently serves as Associate Editor at Energy Economics, at the International Journal of Global Energy Issues, and at the Journal of Stock & Forex Trading.

DR. FLORIAN IELPO is Investment Manager & Associate Researcher at CES – Université Paris 1 Panthéon Sorbonne. He acts as an Investment Manager in the asset management branch of a bank in Switzerland. In the meantime, he is an Associate Researcher at the Centre d’Economie de la Sorbonne in Paris, France. His expertise is built on an on-going combination between professional skills gained from building decision tools and strategic decision making, and active academic research focusing on the application of econometric tools relating economics and finance. Florian completed his Ph.D. in Financial Econometrics from the Sorbonne University in Paris, France while working as an Economist in the banking industry. He then occupied various positions, moving from an Econometrician position to becoming an Active Investment Manager. He teaches selected aspects of applied finance at the Sorbonne and Dauphine Universities and at the Ecole Nationale des Techniques Avancées (ENSTA) in Paris, France. Florian’s peer-reviewed scientific publications can be found in various journals such as Quantitative Finance, the Journal of Forecasting, Finance Research Letters or the Journal of Investing.

"Too many textbooks market themselves as being commodity specific but are often nothing more than glorified maths books with a loose connection to the asset class.  Thankfully, this book avoids that mistake and offers a very broad but rigorous analysis for investors interested in accessing the different commodity markets."
—Neil C Schofield, Director, Financial Markets Training

“This book represents an important contribution to the literature on commodity markets.  One of the innovations in this work is the use of advanced econometric techniques to shed light on linkages between different commodity markets and their dependence on macro-economic variables.  Thus, the book complements recent research on the role that commodity inventories play in driving commodity prices. This book will prove valuable reading to students of commodity markets as well as analysts that forecast commodity markets or construct portfolios involving commodities.”
—Dr Robert Kosowski, Director of the Risk Management Laboratory & Associate Professor, Imperial College Business School

“The Economics of Commodity Markets written by Julien Chevallier and Florian Ielpo is an exceptionally valuable and up-to-date reference for investment professionals and researchers interested in commodity markets.  The book reviews how econometric and economic techniques are applied to descriptive analysis of different commodity markets and study of interactions between, and co-movements across, different asset classes (including commodities and traditional investment vehicles, such as stocks and bonds). Any trader or investment manager will find Part II of the book, covering the impacts of business cycles and macro-economic events on commodity prices, very useful in formulating and testing different portfolio strategies. The book fills a gap in the literature and should be mandatory reading for anybody interested in these dynamic and rapidly evolving markets.”
—Vincent Kaminski, Rice University, Houston