Supply Shocks, Futures Prices, and Trader Positions

Commodity futures prices respond to changes in expected physical supply. Demand for futures positions by firms who trade in the physical commodity is accommodated by speculators. But how do hedgers and speculators in a... [ view full abstract ]

Commodity futures prices respond to changes in expected physical supply. Demand for futures positions by firms who trade in the physical commodity is accommodated by speculators. But how do hedgers and speculators in a commodity futures market adjust their positions in response to changes in expected physical supply? What implications do their position changes have for equilibrium prices? A simple model of net short hedging predicts that a positive supply shock leads to lower prices and more selling by hedgers. However, recent literature finds negative correlation between prices and hedger positions as measured by CFTC data. To understand the joint determination of prices and positions in response to changes in physical supply, we construct a novel measure of variation in physical corn supply - accumulated rain during the growing season - and explicitly estimate its effect on corn futures prices and trader positions. We find that hedgers (generally net short) increase short positions when physical supply contracts due to a lack of rainfall. They do not hedge more when their physical positions are larger. This effect persists even after accounting for the price impact of the physical supply shock and it is particularly strong under backwardation and tight inventories.