Forecasting commodity returns by exploiting climate model forecasts of the El Niño Southern Oscillation

Abstract

Abstract The physical and socioeconomic environments in which we live are intrinsically linked over a wide range of time and space scales. On monthly intervals, the price of many commodities produced predominantly in tropical regions covary with the dominant mode of climate variability in this region, namely the El Niño Southern Oscillation (ENSO). Here, for the spot prices returns of vegetable oils produced in Asia, we develop autoregressive (AR) models with exogenous ENSO indices, where for the first time these indices are generated by a purpose-built state-of-the-art general circulation model (GCM) climate forecasting system. The GCM is a numerical simulation which couples together the atmosphere, ocean, and sea ice, with the initial conditions tailored to maximize the climate forecast skill at multiyear timescales in the tropics. To serve as additional benchmarks, we also test commodity forecasts using: (a) no ENSO information as a lower bound; (b) perfect future ENSO knowledge as a reference upper bound; and (c) an econometric AR model of ENSO. All models adopting ENSO factors outperform those that do not, indicating the value here of incorporating climate knowledge into investment decision-making. Commodity forecasts adopting perfect ENSO factors have statistically significant skill out to 2 years. When adopting the GCM-ENSO factors, there is predictive power of the commodity beyond 1 year in the best case, which consistently outperforms commodity forecasts adopting an AR econometric model of ENSO.