A significant portion of investing wealth has flowed into commodities funds in recent years as investors sought greater and greater returns. Anyone who invested in equities during the recent decade's run up in oil prices had to be coveting the large returns they were seeing over in the commodities space. However, commodities investing is significantly different that investing in equities, and not all investors understand this.
When one invests in an equity, they are taking on a share of a business in return for an ongoing share of profits (dividends) and the potential for growth in the business, to be reflected in future higher stock prices. Everyone within the business is on the same side, with the same goal. A growing economy helps, as well. In essence, the market and company is working for you and your goals and all will be well unless the economy changes or competitors do a better job than your chosen company.
When one invests in a commodity, on the other hand, they are attempting to take control of an inanimate entity and hold it for a period of time in the hopes that the value of the commodity rises faster than the ongoing costs to hold the commodity.
Stop Right There
All potential commodity investors really need to understand the latter key distinction. When you invest in a commodity, you are not simply placing a bet that the commodity will rise in value. Instead you are placing a bet that it will rise in value "faster" that any costs will accumulate to hold the commodity over that period of time.
Consider two examples.
Gold: You buy a bar of gold at today's prices and put it in your safety deposit box. A year from now you sell it. Your profit is the deference in sales price minus the rent for the safety deposit box.
Uranium: You buy a chunk of uranium, hoping that there will be a resurgence of nuclear reactor energy production. But before you take delivery, the seller asks you for location of your secure and radiation safe storage facility. If you don't have one, then you need to rent space from someone who does, and this space is not cheap. It may turn out that the space to store uranium, one aspect of something called commodity "cost of carry", is so expensive that, unless uranium doubles in a very short time, you will lose much of your investment through storage costs.
If you don't intend to take delivery, but rather invest using the futures market, you may wonder how this applies to you or the ETF you are using. That cost of carry we have talking about is always built into the futures pricing. It is the reason farther months out futures pricing is usually higher than near months, because the farther out prices reflect today's prices, plus the cost of carry for someone to agree to sell you the commodity months or years out. Just because you are paying today for a commodity to be delivered in the future does not mean that the seller can pocket your money and wait around until the delivery date, using the money for something else. That is a risk a commodities supplier will not take. In its simplest form, when you buy a futures contract for delivery, the seller makes the commodity purchase immediately and places it in storage until you want it delivered.
Of course, it is not that simple in reality, but it illustrates the key point that cost of carry is always built into the futures curve and that investors are paying cost of carry even though they are not directly paying monthly fees for a safety deposit box themselves. Instead, they are paying them through the higher prices offered further out in the futures curve.
The Key Consideration
When you invest in a commodity, you are betting that price appreciation is greater than cost of carry, which for some of the popular commodities like gold, oil and natural gas, is largely represented by cost of storage. If storage is cheap, your odds of profit are higher than that for that which storage is expensive. How can you tell what storage costs are? Look at the futures curve pricing. If prices a few months out are similar to today, storage is relatively inexpensive. If, on the other hand, prices escalate rapidly on the curve, storage is expensive. In the latter case, the pure long commodity play as an investment is a hard way to profit.
A Poster Child of an Example
If you want to see where cost of carry can be devastating, look no further than UNG. This ETF holds natural gas futures contracts, typically the nearest (or prompt) month contracts. Every month, it trades these contracts if for the following month contracts (prompt + 1). When this transitional trade occurs, or contracts are "rolled", the result is most often that UNG holds a little less natural gas than it did prior to the roll. How much less? That depends on the difference in the contract prices, which as we have discussed, is representative of cost of carry,
At the time of this writing, UNG holds October natural gas contracts. The November contracts are currently priced 28 cents higher than October. Looking out further, December is priced 35 cents higher than November, and finally January is priced 17 cents higher than December. Combined, something referred to as the V/F spread in natural gas trader speak, the price differential is 82 cents. This figure represents the cost of carry over the time period and represents the potential loss of natural gas value for UNG due to the fund absorbing these costs ongoing through time. Now here is the real kicker: natural gas is currently priced in the $3.73 range, so a cost of carry of 82 cents over a few months represents a devastating loss to the fund in terms of net asset value. Put another way, natural gas needs to rise substantially just for the fund to break even by January.
Commodity ETF investors are benefited in such cases by rapid rises in the underlying commodity over short periods of time. Holding such ETFs over any long period of time, however, falls into that "hard way to profit" category.
Consider in contrast USO, the corresponding oil ETF. In this case, cost of carry is appreciable as well, with the similar October to January spread difference at $3.88. But what matters is cost of carry as a percentage of value, not simple cost of carry, suggesting that absorbing that $3.88 in a few months of carry costs for $73.91 oil is not nearly as devastating as absorbing that $0.82 on $3.73 price natural gas.
Finally, the reader could look at gold, only to find that cost of carry there is almost insignificant when measured as a percentage of underlying value, at least when compared to oil or natural gas
The Final Word
Before you invest money in any commodity, look at the corresponding futures curves. If the curves appear steep, where monthly prices vary in large amounts as a percentage of the actual commodity contract prices, consider keeping your investment time line on the shorter side, so as to minimize the decaying affects of cost of carry.
Disclosure: No position in gold or oil. Author is short natural gas through UNG puts.
