Stochastic Fundamental Volatility, Speculation, and Commodity Storage

Abstract:     
Commodity price spikes are often accompanied by allegations that speculative excess has caused prices to depart dramatically from levels justified by fundamentals. Since prices guide real resource allocations, distortions in prices should lead to distortions in real variables, such as inventories. In 2005-2006 critics of speculation pointed to anomalous increases in stocks in the face of rising prices as evidence of speculative distortion. This article demonstrates, however, that when the volatility of fundamental shocks is stochastic, such comovements occur in competitive markets. Since agents use inventories to smooth out the effects of unpredictable net demand shocks, a positive volatility shock induces an increase in inventories. For inventories to increase (holding the level of the net demand shock constant), prices must rise to reduce consumption and encourage production. The analysis implies that an increase in speculative stocks is at best a necessary, but not sufficient, condition for the existence of a speculative price distortion.

Keywords: commodity prices, speculation, storage

JEL Classifications: G12, G13

Working Paper Series