The Commodity Market: Victim of its Own Success?

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Includes: DBA, GSG, GSP
by: Hard Assets Investor

Let’s face it, investing in commodities is complex. Unless you’re buying gold or other precious metals, you aren’t actually buying the asset. Instead you are buying a futures contract on the asset. You are buying a promise that at some date in the future you will take delivery of an asset or, more likely, you will end up selling that contract to someone who actually wants that barrel of oil before the contract expires.

The future you hold differs in price from the got-to-have-it-today spot price. The futures price has priced in it a premium for storage or uncertainty or one of a thousand things the market thinks will happen to that commodity – be it good or bad – and so it is either higher or lower than the spot price.

Today the market is flooded with investors “getting into commodities” because of ethanol, oil shocks, China, bio-diesel, and 1,000 headline motivators. Nearly all of these investors are thinking about spot prices, which is what they read about in the newspapers. But the truth is, history shows us that spot prices are just one factor in commodity returns, and often are not even the most important factor.

The Three Sources Of Commodity Returns

There are three sources of commodity returns:

The Spot Price

The spot price is easy to understand. It is just the market price. If the spot price rises between the time you buy a commodity future and the time you sell it, you make money. If not, you lose.

The Cash Yield

The cash yield is also easy to understand. When you buy commodity futures, you only need put up a fraction of what the contract is worth: typically 5-10%. The rest of the purchase price is held as collateral. The commodity index funds and ETFs (and all smart investors) will invest this collateral in a safe asset, like Treasuries, which pay out interest income. That’s the cash yield.

The Roll Yield

The third factor that affects your commodity return is the roll yield. A futures contract is an agreement to buy the underlying asset at a certain future date: say, to buy 1,000 barrels of oil at such-and-such a date. (NYMEX oil contracts expire on the 3rd business day before the 25th calendar day of the month.) There are oil contracts available for every month of the year, but typically, the “front month” (or next month) contract is the most heavily traded.

Of course, most investors don’t want to actually take possession of a thousand barrels of oil, so they sell their contracts before expiration and buy the next month’s contracts. It’s called “rolling” their position. Since you’re selling one thing and buying something else, you either make or lose money. If the next month contract is more expensive than the one you’re selling (a condition called “contango”), the roll yield is negative and you lose money. If the next month contract is less expensive (a condition called “backwardation”), the roll yield is positive and you make money.

These sources of return are well known and well documented. Companies have spent countless hours developing investment products to mitigate the effect of contango on their returns.

Why? Because it matters.

Let’s look at some historical information on the GSCI. The GSCI is a heavily energy-based commodities index, with 73% of its holdings in the energy sector as of Jan 8, 2008. Of that 73%, 6% is from natural gas and the rest is from petroleum-derived products. In other words, the price of oil tends to move the GSCI significantly.

But as you can see, the source of the GSCI’s total returns varies sharply decade by decade, with each of the three factors contributing at different points in time.

Annualized Returns – GSCI

1970s

1980s

1990s

2000s*

GSCI Spot Return

9.05%

-1.37%

-0.63%

12.88%

GSCI Roll Yield

4.24%

2.44%

-0.53%

-4.67%

GSCI Cash Yield

6.67%

9.52%

5.11%

3.20%

GSCI Excess Return

13.67%

1.04%

-1.16%

7.60%

GSCI Total Return

21.25%

10.67%

3.89%

11.05%

*January 1, 2000 through March 31, 2007.

In the 1970s, commodity prices were rising - especially oil prices - and the spot return reflects that growth. The market was in backwardation and the roll yield was positive. Interest rates were high which meant that the cash yield was healthy. All in all the GSCI showed a total return of 21.25%.

This pattern – three positive sources of return – is the perfect positive storm for commodity investors, and frankly, it’s not all that unlikely. After all, interest rates always stay at least somewhat positive, commodities in general rise over the long term, and backwardation is the “normal” expectation for many futures markets (and particularly oil).

But it’s not always like that. In the 1980s, for instance, we weren’t so lucky. After hitting record highs in 1979, oil prices started sliding down as production increased and oil was plentiful. Oil markets continued to be in backwardation, so the roll yield remained positive, although only half what it had been the previous decade. Interest rates were high, however, and it was the cash yield that carried the GSCI Total return to a respectable 10.67% for the decade.

As we entered the Kurt Cobain years of the 1990s, oil prices were basically flat to slightly depressed. By the end of the decade, the roll yield had also dropped to -0.53%. Once again, interest rates came to the rescue and the GSCI total return managed a 3.89% gain - not great, but still in positive territory.

The most interesting comparison is between the 1970s and the current decade. Once again we are seeing commodity prices rise, especially oil, and the GSCI reflects that. As of March 31, 2007, the GSCI Spot Return averaged 12.88% - a higher level than in the 1970s. But counteracting that has been a crippling contango, with the roll yield taking -4.67% off of annual returns. Combined with a low-interest-rate environment (and thus a low cash yield), the annualized return for GSCI so far this decade is “just” 11.05% - half of what was seen in the 1970s, despite the fact that spot prices are rising faster than ever.

What’s Changed In The Market?

As investors move into the New Year, the tenor of the decade has shifted. The good news is that backwardation is back in Oil, and since the GSCI is so heavily weighted in oil, those roll yield numbers have nowhere to go but up – as long as backwardation stays around. This is particularly important for investors sticking toes into the water of a GSCI ETF like the iPath GSCI Total Return Index Fund (NYSEARCA:GSP) or iShares GSCI ETF (NYSEARCA:GSG).

Backwardation is such a friend to investors that it’s possible for investors to make money even in a down market – the roll yield can overwhelm changes to spot prices.

But will that trend remain, or is the current backwardated market just a short-term blip on a contango-ed decade. Some people think it is.

Remember, futures investors aren’t just investing in “stuff,” they are investing in a financial system itself. And because speculators buy and sell on the possibility of future happenings with no interest in the underlying asset (except as an investment vehicle), they impact the system. When there are a lot of speculators, it tends to muddy the waters a bit as futures prices (and spot prices) can move on what the speculators think is going to happen next.

Many people think that the huge number of speculators moving into the market recently has shifted the balance, making it less likely that the oil market will be in backwardation.

This article in MoneyWeek says it best:

The key issue is the disappearance of ‘backwardation’ in the futures market and its replacement by the equally intriguing condition known as ‘contango’. Backwardation is a downward slope in futures price, as in the chart on the left, below. Economic theory tells us that backwardation is the normal state for many commodities markets, since their purpose is to enable producers to hedge by selling their future output in advance. Consequently, there will be more sellers than buyers for longer-dated contracts and thus lower prices. But with the flood of investors entering the futures market, the “previous shortage of natural long investors has been removed”, says economist Simon Hayley of Capital Economics. “Thus it should come as no surprise that the previous backwardation has now disappeared” in favor of an upward sloping curve – ‘contango’.

In effect, the commodity market has become a victim of its own success – by attracting many new investors, the specter of contango hovers that much closer.

It is ever the same – the more the market ‘knows’ something, the harder it is to make money at it.

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