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Having recently invested in the PowerShares DB Oil Index ETF (DBO), the following statement caught my interest:

New work published by Gary B. Gorton of Wharton, Fumio Hayashi of the University of Tokyo and K. Geert Rouwenhorst of Yale, shows how investors can win bigger profits with futures-trading strategies based on the amount of a given commodity that is held in storage. Returns -- or "risk premiums" -- are bigger when low inventories make prices more volatile, Gorton and his colleagues conclude.

Clearly, the average investor would find it difficult to know with any accuracy what the inventory levels are for most commodities. Gorton and colleagues have determined that investors can infer inventory levels from futures- and spot-pricing data.Here is the background as Gorton and his associates describe it:

The new work looks at the key role played by inventories -- commodities stored for future sale. Inventories serve as buffers against fluctuations in supply, and the Theory of Storage says that when inventories are low, spot prices are more volatile, since commodity buyers cannot be certain of sufficient supplies.

Futures markets provide insurance against future price volatility. So, when low inventories heighten the risk of price volatility, the cost of this insurance can be expected to rise. That translates into bigger returns for the contract holders who take on these bigger risks.

To investigate the premise, they looked at three types of portfolios comprised of 31 commodities over the time period from 1969 through 2006. One portfolio was based on high-inventories, one was based on low inventories and one was a simple index composed of equal amounts of each commodity. The high-inventory portfolio returned 4.62%, the equal weight portfolio returned 8.98% and the low-inventory portfolio returned 13.34%.

So how to identify those commodities with low inventory? Investors can look at the difference between the spot price today and futures prices. When inventories fall, the spot price rises because supply is low relative to demand. The futures price may rise as well but not so much, because traders believe inventories will gradually be replenished before the contracted delivery dates arrive. As a result, the gap between spot and futures prices widens. The wider the gap, the the higher the potential return.

Gorton and his colleagues looked at holding a basket of the commodities with the best indicated returns based on the difference between spot and futures prices. What if we looked at one commodity, crude oil, example.

As of 11/1, the spot price of crude oil was $93.49. The December contract is the same. But starting with the January contract, the futures prices begin to decline. By April, it's under $90. Futures prices continue to decline for each month's contract by roughly $.60 per month.

So it appears we don't have a major gap between crude oil spot and futures prices but it appears there may be enough of a gap to support prices in the current vicinity. Heating oil and natural gas show very small gaps.

Looking at wheat and corn, the gap is in the opposite direction, indicating high inventories. Similarly, metals are not displaying futures prices that indicate inventories are tight.

Using this approach, it appears that oil is the place to be if you feel the need to invest in the commodity markets.

Source: More Gains In Store For Oil?