Informational Frictions and Commodity Markets

• DOI: http://doi.org/10.1111/jofi.12261
• Published date: 01 October 2015
• Date: 01 October 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 5 •OCTOBER 2015

Informational Frictions and Commodity Markets

MICHAEL SOCKIN and WEI XIONG∗

ABSTRACT

This paper develops a model with a tractable log-linear equilibrium to analyze the

effects of informational frictions in commodity markets. By aggregating dispersed

information about the strength of the global economy among goods producers whose

production has complementarity, commodity prices serve as price signals to guide

producers’ production decisions and commodity demand. Our model highlights im-

portant feedback effects of informational noise originating from supply shocks and

futures market trading on commodity demand and spot prices. Our analysis illus-

trates the weakness common in empirical studies on commodity markets of assuming

that different types of shocks are publicly observable to market participants.

IN THE AFTERMATH OF THE DRAMATIC BOOM and bust cycle of commodity prices

in 2007 to 2008, there has been renewed interest among academics and policy

makers regarding the drivers of commodity price fluctuations, in particular,

whether fundamental demand and supply shocks are sufficient to explain the

observed price cycles and whether speculation in commodity futures markets

exacerbated these cycles are subjects of debate. In this debate, it is common for

academic and policy studies to treat different types of shocks (such as supply,

demand, and financial market shocks) as observable to market participants.1

In doing so, however, these studies ignore a key aspect of commodity mar-

kets, namely, severe informational frictions faced by market participants. The

markets for major commodities, such as crude oil and copper, have become

globalized in recent decades, with supply and demand now stemming from

across the world. This globalization exposes market participants to heightened

informational frictions regarding the global supply, demand, and inventory of

these commodities.

The economics literature has developed an elegant theoretical framework to

analyze how trading in centralized asset markets both facilitates information

∗Sockin is with University of Texasat Austia and Xiong is with Princeton University and NBER.

We wish to thank Thierry Foucault; Lutz Kilian; Jennifer La’O; Matteo Maggiori; Joel Peress; Ken

Singleton; Kathy Yuan; and seminar participants at Asian Meeting of Econometric Society, Bank

of Canada, Chicago, Columbia, Emory, HEC-Paris, INSEAD, NBER Meeting on Economics of

Commodity Markets, Princeton, North America Meeting of Econometric Society, the 6th Annual

Conference of the Paul Woolley Centre of London School of Economics, and Western Finance

Association Meetings for helpful discussion and comments. We are especially grateful to Bruno

Biais, an Associate Editor,and three referees for numerous constructive comments and suggestions.

Xiong acknowledges financial support from Smith Richardson Foundation Grant #2011-8691.

1See a recent review by Cheng and Xiong (2014).

DOI: 10.1111/jofi.12261

2063

2064 The Journal of Finance R

aggregation among market participants and helps them overcome the infor-

mational frictions they face (e.g., Grossman and Stiglitz (1980) and Hellwig

(1980)). This framework, however, crucially relies on the combination of con-

stant absolute risk aversion (CARA) utility functions for agents and Gaussian

distributions for asset prices to ensure a tractable linear equilibrium, and thus

one cannot readily adopt this framework to analyze commodity markets, in

which both CARA utility and Gaussian distributions are unrealistic. It is chal-

lenging to analyze information aggregation in settings without the tractable

linear equilibrium. This technical challenge is common in analyzing how asset

prices affect real activity, such as firm investment and central bank policies,

through an informational channel.2

In this paper, we aim to confront this challenge by developing a tractable

model to analyze how informational frictions affect commodity markets. Our

model integrates the standard framework of asset market trading with asym-

metric information into an international macro setting (e.g., Obstfeld and

Rogoff (1996) and Angeletos and La’O (2013)). In this global economy, a contin-

uum of specialized goods producers whose production has complementarity—

which emerges from their need to trade produced goods with each other—

demand a key commodity, such as copper, as a common production input.

Through trading the commodity, the goods producers aggregate dispersed in-

formation regarding unobservable global economic strength, which ultimately

determines their commodity demand.

Our main model focuses on a centralized spot market through which the

goods producers acquire the commodity from a group of suppliers, who are sub-

ject to an unobservable supply shock. The supply shock prevents the commodity

price from perfectly aggregating the goods producers’ information with respect

to the strength of the global economy. Nevertheless, the commodity price pro-

vides a useful signal to guide the producers’ production decisions and commod-

ity demand. Despite the nonlinearity in the producers’ production decisions, we

derive a unique log-linear equilibrium in closed form. In this equilibrium, each

producer’s commodity demand is a log-linear function of its private signal and

the commodity price, while the commodity price is a log-linear function of global

economic strength and the supply shock. This tractable log-linear equilibrium

builds on a combination of Cobb-Douglas utility functions for households, log-

normal distributions for commodity prices, and a key aggregation property: the

aggregate demand of a continuum of producers remains log-linear as a result of

the Law of Large Numbers. We also extend the model to incorporate a futures

market to further characterize the role of futures market trading.

It is common for empirical studies of commodity markets to rely on con-

ventional wisdom generated from settings without any informational frictions

(i.e., agents directly observing both supply and demand shocks). According to

such wisdom, (1) a higher price leads to lower commodity demand as a result

of the standard cost effect, (2) a positive supply shock reduces the commodity

price, which in turn stimulates greater commodity demand, and (3) the futures

2See a recent review by Bond, Edmans, and Goldstein (2012).

Informational Frictions and Commodity Markets 2065

price of the commodity simply tracks the spot price, and trading in the futures

market does not affect either commodity demand or the spot price.

Our model allows us to contrast the effects of informational frictions with this

conventional wisdom. First, through its informational role, a higher commodity

price signals a stronger global economy and motivates each goods producer to

produce more goods. This leads to greater demand for the commodity as an

input, which offsets the usual cost effect. The complementarity in production

among goods producers magnifies this informational effect through their incen-

tives to coordinate production decisions. Under certain conditions, our model

shows that the informational effect can dominate the cost effect and lead to a

positive price elasticity of producers’ demand for the commodity.

Second, our model illustrates a feedback effect of supply shocks. In the pres-

ence of informational frictions, supply shocks also act as informational noise,

which prevents the commodity price from fully revealing the strength of the

global economy. As goods producers partially attribute the lower commodity

price caused by a positive supply shock to a weak global economy, this infer-

ence induces them to reduce their commodity demand. This feedback effect thus

further amplifies the negative price impact of the supply shock and undermines

its impact on commodity demand.

Third, futures markets serve as a useful platform, in addition to spot mar-

kets, for aggregating information regarding demand and supply of commodi-

ties. As futures markets attract a different group of participants from spot

markets, the futures price is not simply a shadow of the spot price, and instead

may have its own informational effects on commodity demand and the spot

price.

Based on these results, our analysis offers important implications for the

empirical analysis of commodity markets. In estimating the effects of supply

and demand shocks in commodity markets, it is common for the empirical liter-

ature to adopt structural models that ignore informational frictions by simply

assuming that agents can directly observe both demand and supply shocks. As

highlighted by our analysis, this common practice is likely to understate the

effect of supply shocks and overstate the effect of demand shocks. Our model

provides the basic ingredients for expanding these structural models to account

for how commodity prices impact agents’ expectations.

Our analysis also cautions against a commonly used empirical strategy based

on commodity inventory to detect speculative effects (e.g., Juvenal and Petrella

(2012), Knittel and Pindyck (2013), and Kilian and Murphy (2014)). This strat-

egy is premised on the widely held argument that, if speculators distort the

price of a commodity upward, consumers will find the commodity too expensive

and thus reduce consumption, causing inventory of the commodity to spike.

By assuming that consumers are able to recognize the commodity price dis-

tortion, this argument again ignores realistic informational frictions faced by

consumers, which are particularly relevant in times of great economic uncer-

tainty. In contrast, our model shows that informational frictions may cause

consumers to react to the distorted price by increasing rather than decreasing

their consumption. In this light, the lack of any pronounced oil inventory spike