JP Morgan and BNP Paribas' Commodity Indexes: Smart Weapons for the Contango War

Contango presents some interesting challenges in the era of commodity ETFs and ETNs.

A new skirmish has broken out against contango. No, it's not a new dance program to fill in the void left by the writers' strike. Contango is the normal price relationship that exists between the futures delivery months of a storable commodity. Simply put, contango reflects the costs of carrying the commodity (storage, insurance, financing) for future delivery. The gold futures market, for example, is a contango market: nearby deliveries are priced lower than deferred deliveries (See Table 1).

A market that is pervaded by scarcity fears - crude oil comes to mind, no? - can invert such that nearby contracts are priced higher than later deliveries. In essence the front months are bid up because every one wants their oil now (See Table 2).

These price relationships can play havoc with commodity index returns. Commodity indexes are synthetic futures portfolios made up of long positions. As a futures position in portfolio approach their delivery dates, they must be "rolled" forward to a later contract to maintain the exposure mandated by index rules. If the price of the nearby contract being sold is lower than the price of the deferred delivery bought - a contango market - there'll be an expense incurred, reducing the return on that commodity. That's a "negative roll yield" in futures lingo.

Rolling a long position forward in an inverted market, however, produces a gain - a positive roll yield. Think about it: selling January crude at $96.45 and buying February crude at $95.32 should give you a $1.13 per barrel boost in your return, shouldn't it?

When commodity indexes were first cooked up, little thought was given to the effect of contango, largely because the indexes were never thought of as investable. Indexes, in those simpler days, were just indicators. Benchmarks.

Not so now. The advent of commodity-based ETFs and ETNs has made commodity investing more accessible, even to the hoi polloi. That's brought the contango problem into sharp relief. Investors have, for the past year or so, been scratching their heads and wondering: "Why are my commodity index-based returns not reflecting the bullishness of the underlying markets?"

Enter the newest combatants against the ravages of contango. JP Morgan and BNP Paribas have launched two new index suites that allow investors to invest further out - as far as three years - on the futures curve.

The JP Morgan Commodity Curve Index (CCI) invests all along the future curves rather than just the front months, which is typical of most commodity benchmarks. By spreading across delivery months, index developers hoped to reduce the impact of a negative roll yield.

CCI is comprised of 33 futures holding exposure along the curve in proportion to the open interest of each contract. Open interest, in case you didn't know, reflects the number of contracts awaiting liquidation. It is, in essence, potential volume. The commodities mix includes contracts not found in many other indexes including NYMEX platinum and palladium, CBOT soybean meal, NYBOT orange juice, LIFFE robusta coffee and white sugar and MGE spring wheat.

BNP Paribas' Commodity Market Representative Index [CMRI], operates on the same principle: an open interest-weight scheme that serves as an analog, say its developers, for the market capitalization-weighting of an equity index. For its part, CMRI is made up of 25 contracts highlighted by ICE WTI crude oil, NYMEX natural gas, ICE Brent crude oil, COMEX gold, LME copper and LME aluminum.

The introduction of these new indexes is the latest salvo from investment banks who are trying to make use of the beach head established by Barclays Global Investors, Barclays Bank and Deutsche Bank in the lucrative commodity space. With these new indexes now launched, how far away can JPMorgan and BNP Paribas ETFs or ETNs be?

Click here for more on New ETFs.

Comments

[Commodity Spotter]

BNP and JP Morgan are not the only players who came up with smart commodity investment vehicles, or second/third generation of indexes.
ABN Amro/Jim Rogers' RICI Enhanced and Bloomberg/UBS CMCI indexes do address the same issues and cover as well a large spectrum of commodities. The RICI Enhanced index for instance comprises 37 commodities and most of the "exotic ones" mentioned in this article.

[~lb]

Why can I not find anything for the symbol CMRI? I was looking to do further research and possibly get in. Am I misunderstanding?

[Brad Zigler]

The reason you can't find anything for the symbol CMRI is because the index hasn't been licensed for an exchange-traded product. There's nothing to "get in" yet.

About research ...

Some index manufacturers don't seem to have a keen understanding of the needs of investors. For the investment banks with cadres of sales/traders, the thinking is "This is a proprietary product. We'll use our people to sell it to our clients."

If the products are licensed for ETFs or ETNs, though, they leave a whole new market untapped: sophsiticated investors and their advisors.

Since the reveal of their new indexes, BNP Paribas and JPMorgan have left the benchmarks to twist in the wind. There is no space devoted on either of the banks' Web sites to explaining the methodology, benefits or components of the indexes.

We're following this on Hard Assets Investor (HardAssetsInvestor.com) starting with an article entitled "New Commodity Indexes: They're Just Teasing Us."

[gammaman]

The concept of backwardation and contango have been simplified in relation to something called the "term structure of the futures price curve." Keynes et al. original concept of "normal backwardation" is based on the relationship of the futures contract to the "expected future spot price." This is a much more difficult concept for most to grasp and so is ignored because it doesn't "market" well. This paper:

"Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures"

raises the spector of something called "roll yield permutations." The paper is available on SSRN's eLibaray at:

papers.ssrn.com/abstra...

[zaconly]

This might explain a few things...
db.riskwaters.com/publ...