Tough Outlook for Commodity Indexes

Investors in commodity futures - and that includes all the people who own commodity futures ETFs - are in a world of hurt.

It's bad enough that spot commodity prices are crashing. Oil is down nearly $100 from its highs, and copper and other commodities are down 50% or more.

But commodity investors have lived through falling commodity prices before and come out more or less OK. In the 1980s, for instance, the S&P GSCI Spot Commodity Index delivered -1.37% annualized returns for the entire decade. But investors in the S&P GSCI Total Return Index actually earned 10.67% annualized returns.

How? Because, as we've written before, there are three sources of return on a fully collateralized commodity futures index:

• Spot return: Changes in the spot prices for the underlying commodities.
• Collateral return (cash yield): Interest income on collateral. Futures are inherently leveraged, so a fund only needs to put up 5%-10% margin to gain its commodity exposure, with the remainder invested in safe collateral, typically short-term Treasuries.
• Roll yield: The return (or loss) gained from "rolling over" a futures portfolio, i.e., selling contracts that expire this month and replacing them with contracts that expire next month (or next quarter, depending on the commodity). Contracts may be either more or less expensive, creating either a positive roll yield (a situation called "backwardation") or a negative roll yield (a situation called "contango").

Each of these returns is critical to commodity futures index returns. The table below shows the roll each type of return made to the S&P GSCI Commodity Index over the past few decades. (The data is only through March 31, 2007, as that is the latest data I have available.)

Annualized Returns - S&P GSCI
	1970s	1980s	1990s	2000-March 2007
GSCI Spot Return	9.05%	-1.37%	-0.63%	12.88%
GSCI Cash Yield	6.67%	9.52%	5.11%	3.20%
GSCI Roll Yield	4.24%	2.44%	-0.53%	-4.67%
S&P GSCI TOTAL RETURN INDEX	21.25%	10.67%	3.89%	11.05%

Not surprisingly, the best situation for commodity futures indexes is when all three types of returns are working together, as happened in the 1970s, when the spot return, cash yield and roll yield were all positive. But even when one of the returns falters - as the spot return did in the 1980s and 1990s, and the roll yield did as well in the 1990s - investors still did OK, because the other sources of return provided ballast.

Unfortunately, investors find themselves in exactly the opposite position today: Everything is working against them. In a major way.

Spot prices, as mentioned, have collapsed, and show little sign of a rebound.

The cash yield from collateral is terrible too: Three-month Treasuries were yielding 0.01% at the end of November, according to the Federal Reserve. (No, that is not a misprint.)

And the roll yield? That is awful too.

Consider the DB Commodity Index. It is both the simplest broad-based commodity index - comprising just six commodities, compared with 24 for the S&P GSCI - and the benchmark for the most popular broad-based commodity ETF, the PowerShares DB Commodity Index Fund (NYSEArca: DBC).

If you look at pricing for the six commodities contracts in the DB Commodity Index, you can make a rough calculation of the roll yield by comparing the price of the current contract (which the index tracks today) with the price of the next-month contract (which the index will "roll into" when the current contract expires). Then, you simply annualize the cost or benefit and see what impact that will have on the index as a whole.

The chart below highlights the calculations, and let me tell you: It isn't pretty.

DB Commodity Index Contango: December 2, 2008
	Weight in Index	January Contract (*=December)	February Contract (**=January ***=March)	1-Mo Percentage Change	Weight-Adjusted Drag, Annualized
Light Sweet Crude	35%	46.96	48.43	-3.13%	-13.15%
Heating Oil	20%	1.5935	1.6227	-1.45%	-3.49%
Aluminum	12.5%	0.7885	0.7960	-0.95%	-1.43%
Corn*	11.25%	332.4*	348.2***	-1.58%	-2.14%
Wheat*	11.25%	509.6*	528.4***	-0.89%	-1.20%
Gold	10%	781.30*	782.10**	-0.10%	-0.12%
TOTAL	100%	N/A	N/A	N/A	-21.53%

Source: NYMEX and CBOE. Data as of close, 12/1/08.

Based on current prices, the fund is 21.56% annualized headwind over the next year. That means that, even if commodity prices stabilize, this index will decline by more than 20% over the next year if the contango situation holds.

Remember: There is essentially zero collateral return to cushion this blow. That is a very, very unfriendly outlook.

Where To Turn? Commodity Stocks

Where does that leave investors who want to retain commodity exposure? In my book, it leaves them turning to commodity stocks.

Many of the factors that are working against commodity futures right now are working in favor of commodity equities. Take yield: While Treasury yields have collapsed, yields on stocks are at decade highs. The S&P 500 is currently yielding 3.5%, and ETFs like the iShares S&P North American Natural Resources ETF (NYSEArca: IGE) or the Market Vectors - Hard Assets Producers ETF (NYSEArca: HAP) are yielding between 1.5% and 2.0%.

The fact that the futures markets are in contango doesn't necessarily mean good things for commodity stocks - it generally means there is a surplus of commodities in the marketplace. But there is no direct impact, and generally, the markets should already have priced the impact of that surplus into equity prices.

Conclusion

All this is an important reminder that commodity futures are not like the stocks. There are structural sources of returns in commodity futures that can be looked at, evaluated and predicted (at least over the very short term). Investors who ignore these forces - who figure that concepts like contango and backwardation can't possibly have an impact on their returns - do so at their peril.

There are moments when it makes great sense to be invested in commodity futures, and moments when commodity stocks seem a better bet.

Right now, the choice seems to be simple.

Comments

[letsmakemoney:]

"Based on current prices, the fund is 21.56% annualized headwind over the next year. That means that, even if commodity prices stabilize, this index will decline by more than 20% over the next year if the contango situation holds."


I don't believe you can simply add these up and call it a 21.56% annual headwind. You should calculate a weighted average number for each commodity, based on its % weight in the fund (i.e., 35% x 13.15% +20% x 3.49%..etc). So this 'headwind' would be much lower, somewhere under 6% just eye-balling the math.

Apologize if I'm missing something based on your methodology..thanks for the insightful way of thinking about this extra headwind though..

2008 Dec 03 09:07 PM