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A Milestone Year: Power in the Commodity Markets

Fortnightly Magazine - May 15 1996

this traditional way, power prices in paper markets should react predictably to changes in demand and supply for paper kilowatts. Sudden shifts may occur, brought about by professional speculators.

Speculators, such as managers of commodity funds, will doubtless follow the tradition of moving in and out of commodity market segments for reasons that will have little or nothing to do with the supply and demand of particular fuels. For example, they might move on the fact that a computerized trading program will have noted a historic propensity for a commodity to rise in value when another commodity has moved in the opposite direction. Large players might suddenly decide to abandon power as a financial investment, thus triggering a sudden decline in demand and price for paper kilowatts, and consequently, a decline in the value of physical power. How will the players in physical markets anticipate such moves? Not easily. Nor will financial market forecasters anticipate them with any greater acumen.

The challenge will be to know how and to what extent paper markets diverge from their physical counterparts. One way in which they diverge is in the type of data that explains transactions for the paper market. Important data include: 1) the volume of NYMEX transactions, 2) the open interest at the end of each trading day, and 3) the "Commitment of Traders" (COT) reports released twice a week by the CFTC.

At first glance, futures data tell a simple story: A short exits from every long. As trading volume and open interest change, the long and short positions taken by the commercials (hedgers), noncommercials (speculators), and small traders will also vary from day to day and week to week. As Figure 3 shows, in the NYMEX crude oil futures market the commercials claim the largest share of open interest. But the impetus for a price change in any paper market at any given time will likely come from the speculators.5 As with data in the physical market, the COT data are imperfect at best. Thus, COT data will provide clues, but not much more. Their exact meaning will stand revealed only through continuous market analysis.

In any case, given any particular market condition, a large and sudden increase in demand for long positions will tend to move prices up; a rise in demand for short positions will tend to move prices down. Let us assume, for example, that on a given day a speculator decides to go short with the purchase of 5,000 contracts. Initially, news of such a large increase in the number of demanded shorts drives down the price. The order for 5,000 short contracts amounts to a search for 5,000 long contracts; in the open outcry process that follows on the NYMEX floor, the bid price will fall until the necessary number of longs are attracted to take offsetting positions.

Futures markets allow investors to participate in the determination of commodity prices. Funds flow from stocks to bonds to real estate to currencies and commodities. From day to day and week to week, billions of dollars flow into