The Hard Facts On Soft Commodities

Includes: DBA, DBC, DJP, GSG
by: Hard Assets Investor

Written by Brad Zigler.

Back in the ... er, ah, "old days," there was a quaint institution known as the Coffee, Cocoa and Sugar Exchange. The bourse was the futures trading home of what has become known as "soft commodities" or "softs."

CSCE was merged out of existence in a 1998 deal that agglomerated the softs markets with the two-trick pony New York Cotton Exchange and created the New York Board of Trade. Besides cotton futures, NYCE also traded contracts on frozen, concentrated orange juice. You know, the stuff highlighted in the 1983 Eddie Murphy film "Trading Places."

NYBOT itself was subsequently merged into the all-electronic InterContinental Exchange, the successor of the International Petroleum Exchange.

So, what's the point of this little historical exercise?

Simply to juxtapose a hard (but, oddly, liquid) asset like oil - a constant on these pages - with soft commodities, something that doesn't get much HAI play.

Okay, that was a bit of a reach. But I got mail last night that got me thinking about softs.

It seems some pundits are decrying the relatively "weak" gains made by softs as other agricultural commodities - that is, grains and oilseeds-soar.

Cotton, in particular, was singled out. Well, it's true that the March cotton contract took a 3% dump yesterday, but that followed a rally that sent prices up more than 48% since last May. That's hardly a weak rally, especially when compared with the contemporaneous 29% rise in corn prices.

It's really a matter of perspective. A trader in futures is just that: a trader. Margined, he lives and dies with a contract's short-term volatility. And volatile cotton can be (see chart below). When you're leveraged, you can't wait out volatility storms.

Weekly NYBOT/ICE Cotton Futures

An index investor, in contrast, is unlevered: The entire contract value is committed up front. There's no worry about margin calls. To boot, positions are rolled forward to maintain constant exposure. An index player would have been able to capture cotton's nine-month rally.

Cotton's a relatively small component of commodity indexes. Among the broad-based benchmarks, the Rogers International Commodity Index has the largest chunk devoted to it: 4.05%. The Dow Jones-AIG Commodity Index comes in second at 3.15%, followed by the S&P/Goldman Sachs Commodity Index at 0.87%. There's no cotton exposure at all in the Deutsche Bank Liquid Commodity Index.

Narrower metrics, the agricultural splits of the Rogers International Commodity Index and the Dow Jones-AIG Commodity Index, offer heavier cotton concentrations: 11.60% and 8.70% respectively.

The cost of playing the index game, though, can be pretty costly. Because the cotton market's in contango (see "The Battle Against Contango"), the negative roll yield now runs about 15% per annum. That pares a 48% gain to 37%.

But when you think about it, how bad is that?