By Abraham Bailin
Following the financial crisis of late 2008, commodities were driven ever higher by bouts of substantial monetary debasement, a consistently uncertain global macroeconomic outlook, and the market's search for diversification. Through 2011, however, the asset class hasn't been nearly so flush. Since late April, GreenHaven Continuous Commodity Index (GCC), an equal-weight broad-basket commodity futures offering, lost just less than 18%. This places annual performance for 2011 at negative 9.2%, which approximates the return of its competing broad-basket commodity offerings. Here we highlight the most noteworthy moves within the commodity asset class during 2011.
Top-Performing Energy Commodities Keep Broad-Basket Offerings Afloat
Whereas GCC maintains an equal-weight to each of its 17 constituent commodities, the most popular products in the space lean far more heavily toward energy exposure. Contrast GCC's 18% energy allocation with that of the largest broad-basket commodity ETF, PowerShares DB Commodity (DBC), which allocates 55% of its portfolio to energy. IShares S&P GSCI Commodity-Indexed Trust (GSG) holds an even-larger 71% energy exposure. As it turns out, an energy-heavy weighting paid off in 2011. DBC and GSG fell just 2.6% and 3.3% for the year, respectively.
The best individual performer in the commodity asset class during 2011 was United States Brent Oil (BNO), which tracks a basket of front-month Brent futures, with a 19.5% return in 2011. BNO was closely tailed by its sister offering, United States Gasoline (UGA), which rose 14.8% over the same period.
Brent and WTI Break Stride
West Texas Intermediate is a U.S.-based crude oil whose pricing is heavily tied to the supply and demand construct around the major Cushing, Oklahoma oil hub. Brent is a European crude that comes from the North Sea and is distributed across the globe. In 2011, WTI inventories at Cushing climbed to record levels, while at the same time, WTI consumption had been steadily decreasing for half of a decade. The two forces worked in tandem to place downward price pressure on the WTI.
Overseas, Brent prices have been bolstered by decreased North Sea crude production and the Arab Spring which took a swath of crude production offline, namely from Libya. While the crude markets are truly global, given the geographic proximity of Europe to Libya, it's only intuitive that the loss of Libyan production would place larger strain on Brent supplies than WTI.
Prior to 2011, the price of WTI crude oil had routinely ranged between $1 and $2 higher than its European counterpart, Brent crude. The reason that WTI had historically garnered a premium is that it is lighter and sweeter than Brent. Because of this, it can produce a higher percentage of refined products and is easier to refine. Earlier this year, however, the spread reversed. At the time of this writing, front month Brent is trading at an $8 premium to WTI.
Not only were spot prices impacted, but so, too, were the futures forward curves of the two crude oil markets. Academic literature published by Yale University's Professor K. Geert Rowenhorst indicates that the yield produced by rolling from a near to expiration contract into the next one out has a very strong inverse relationship to inventory levels. Given the surging inventories at Cushing, United States Oil (USO), which tracks front month WTI futures, has been subject to a negative roll yield for quite some time, a situation we refer to as contango. On the other hand, the futures forward curve of Brent crude has gone into backwardation. That is to say that the prices of contracts progressively further from expiration become less expensive. For BNO, rolling into new contracts allowed the fund to effectively sell high and buy low, producing a positive roll yield. It comes as no surprise, then, that while BNO rose 19.5% in 2011, USO was down 2.3%.
Natural Gas Offerings: Laggards of the Lot
While swelling inventories at Cushing worked to depress WTI prices relative to Brent, the supply situation for natural gas is far more bearish. Both proven reserves and storage of natural gas sit at or near all-time highs; circumstances that have made for severely depressed prices. As was the case for WTI, this naturally leads to a persistent state of contango.
At the time of this writing, the annualized cost of rolling a natural gas futures position forward was nearly 30%. That means that an investor holding a year-out futures contract would need to see spot natural gas increase by 30% just to break even. It should come as no shock then, that in 2011, United States Natural Gas (UNG) and iPath DJ-UBS Natural Gas ETN (GAZ), both of which track front month natural gas futures, were down 46.1% and 53.2%, respectively.
A Cautionary Note
Let us be very clear. Exchange-traded products that track commodities using only front-month futures are best left to those inclined to speculate over the very short term. Holding these products over longer periods, perhaps with the intent of bolstering exposure to a particular commodity, leaves the investor vulnerable to taking losses even when the spot commodity appreciates. Again, this comes on the basis of negative roll yield.
The problems that arise under the guise of contango can be mitigated to a large degree by the use of a dynamic contract selection methodology. PowerShares DB Oil (DBO), for instance, uses the DB 'Optimum Yield' strategy to select non-front-month WTI crude contracts. In doing so, they avoid the largest contango related drawdown. This nearly always occurs at the very front of the futures curve, while remaining close enough to expiration to realize a high degree of sensitivity to spot price fluctuations. That said, we would always recommend that long-term passive investors use broad-basket exposure to fulfill a commodity allocation within their portfolio.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.