Commodities: Onslaught of the Sheeple

[ostap]

Commodities have become a popular asset class in recent years. However, the average commodity investor will probably not profit much from the ongoing bull market. Let me explain why.

A typical commodity fund holds long positions in commodity futures. Instead of taking delivery, the futures are usually sold before expiration and replaced by longer-dated contracts. Roughly speaking, the return from such a strategy consists of two parts: the roll return and the spot return. The roll return derives from rolling the contracts, the spot return derives from the change in the spot price during the investment period.

Several studies show that over long time frames, the roll return is the main source of commodity investment returns.

A positive roll return can usually only be expected if a commodity is in backwardation, i.e. if the commodity term structure is downward sloping. With approaching maturity, the price of the futures contract will rise towards the spot price and is thus a source of positive yield.

In the 1930's, Keynes proposed the “Theory of Normal Backwardation”, which states, not unexpectedly, that backwardation is the normal state of a commodity term structure. Keynes argued that on futures markets, risk-averse producers wanting to hedge their future production usually outweigh risk-averse consumers wanting to hedge their future consumption of that commodity. In order to close the gap between producers and consumers, speculators must be attracted to that market. In order to attract speculators, there must be a positive risk premium associated with taking a long position. A positive risk premium implies that the term structure must be, on average, backwarded.

The roll yield can therefore be viewed as a risk premium. “Investing” in commodities actually means being rewarded for taking a risk. However, there is no law which says that the risk premium is always on the long side. If there were more consumers wanting to hedge their future consumption than producers wanting to hedge their future production, the market would be in contango, the risk premium would be on the short side and speculators would thus be rewarded for taking the short side, i.e. selling futures.

Most commodity markets are currently in strong contango, meaning that their term structure slopes upward steeply. The reason is the blind onslaught on commodities from so-called “commodity investors”. By being indiscriminately long commodities and expecting to profit from the current commodity bull, these “investors” exhibit a fundamentally flawed understanding of futures markets. The returns in futures markets do not derive from being long, but from being on the side with the positive risk premium. If a commodity is in backwardation, the positive risk premium is most probably on the long side, however, if a commodity is in contango, as most commodities are currently, the positive risk premium is most probably on the short side.

A more promising approach to investing in commodities is therefore going long backwarded commodities and going short contangoed commodities. If, furthermore, an investor wants to profit from the commodity bull, it is probably advisable to go long only storable (or “stock”) commodities, where the term structure is mostly flat, and which will probably outperform non-storable commodities later in the commodity bull cycle (see also my recent post on that topic).

Source: www.economicreason.com

[grapejelly]

Re: Commodities: Onslaught of the Sheeple

Great post. I wish I understood it better. I thought all commodities were normally in contango due to storage costs and inflation, and that backwardation is an exception that occurs only when there is fear of shortages or delivery defaults? Please help me understand. Thanks!

[Finster]

Re: Commodities: Onslaught of the Sheeple

...

Good post, and many excellent points. One factor, however, is not mentioned in commodity fund returns that needs to be accounted for. And that is collateral yield. Commodity index funds such as DBC, DJP, GSP & GSG post collateral sufficient to fully cover the long futures positions. Typically this is TBills. The yield from the TBills needs to be added into the total return equation, and depending on market conditions may anywhere from partially offset a negative roll yield to augment a positive roll yield.

[bart]

Re: Commodities: Onslaught of the Sheeple

Several studies show that over long time frames, the roll return is the main source of commodity investment returns.

I couldn't disagree more, and I question those studies.

When any commodity doubles or more in price during a bull market, the roll costs are such a minor portion of the profits (unless one if really uneducated or inexperienced on rolling) that it's almost not worth mentioning.



And for anyone reading this thread who doesn't know:

Backwardation
A fancy term for the current cash price of something being higher than a future price.

Contango
A fancy term for the current cash price of something being lower than a future price. This is the normal condition of prices.

[ostap]

Re: Commodities: Onslaught of the Sheeple

I highly appreciate your comment. I apologize for not including the links to the mentioned studies, here they are:
http://www.qwafafew.org/?q=filestore/download/392
http://www.aima.org/uploads/PremiaEDHEC73.pdf

The reasoning in the article only applies to non-storable commodities (which includes energy, as well as most agricultural commodities). For storable commodities such as gold, the term structure is obviously determined by interest rates and storage cost, and Keynes "Normal Theory of Backwardation" does not apply.

I disagree that the roll loss is negligible; it has been negligible in the past, but the "Onslaught of the Sheeple" has changed that. On that topic see also my forthcoming post on the difference between futures-based commodity indices and spot-based indices.

[bart]

Re: Commodities: Onslaught of the Sheeple

I highly appreciate your comment. I apologize for not including the links to the mentioned studies, here they are:
http://www.qwafafew.org/?q=filestore/download/392
http://www.aima.org/uploads/PremiaEDHEC73.pdf

The reasoning in the article only applies to non-storable commodities (which includes energy, as well as most agricultural commodities). For storable commodities such as gold, the term structure is obviously determined by interest rates and storage cost, and Keynes "Normal Theory of Backwardation" does not apply.

I disagree that the roll loss is negligible; it has been negligible in the past, but the "Onslaught of the Sheeple" has changed that. On that topic see also my forthcoming post on the difference between futures-based commodity indices and spot-based indices.

I think that any roll loss issues are related to the "sheeple" themselves - most specifically including the studies noted.

I've traded futures for years, both recently and in the late '70s and early '80s, and after I learned about how futures markets work with elements like roll loss or fees or "locals", etc., they haven't been an issue.

If someone trades futures without significant study and "dues paying", etc., then any losses whether roll related are not have more to do with their own lack of understanding than anything else. Virtually any other interpretation or assignment of cause will doom a futures trader to poor returns or losses.

[Finster]

Re: Commodities: Onslaught of the Sheeple

I think that any roll loss issues are related to the "sheeple" themselves - most specifically including the studies noted.

I've traded futures for years, both recently and in the late '70s and early '80s, and after I learned about how futures markets work with elements like roll loss or fees or "locals", etc., they haven't been an issue.

If someone trades futures without significant study and "dues paying", etc., then any losses whether roll related are not have more to do with their own lack of understanding than anything else. Virtually any other interpretation or assignment of cause will doom a futures trader to poor returns or losses.

At least part of the disagreement here stems from there being actually two separate issues. One is the inherent nature of commodity futures and returns available, and the other relates to the construction of the indices commonly used for commodity futures funds. Make that three. Somebody may be getting returns from the former at the expense of investors in the latter.

Some observers said Goldman's recent index sales may be designed to head off any perceived conflicts of interest since the firm is one of the world's largest securities traders. Changes to widely tracked indexes often move the market.

http://www.marketwatch.com/news/stor...4C0FEA9B444%7D

Remember an index like this requires funds using it to follow a narrow prescribed algorithm of purchases and sales. This provides traders with an opportunity to take an opposing position, buying when the funds are required to sell and selling when the funds are required to buy. The GSCI is one of the most popular commodity futures indexes used by insitutional investors like pension funds. It may be no accident that Goldman Sachs itself has been reporting blow-out earnings, largely from its trading operations.

Some index providers have responded with broader or more flexible index rules that either don't leave large loopholes or allow for buying contracts with the highest implied roll yield. The Deutsche Bank Liquid Commodity Futures indices, for eaxmple, explicitly addresses these issues in its construction. http://dbfunds.db.com/

[bart]

Re: Commodities: Onslaught of the Sheeple

At least part of the disagreement here stems from there being actually two separate issues. One is the inherent nature of commodity futures and returns available, and the other relates to the construction of the indices commonly used for commodity futures funds. Make that three. Somebody may be getting returns from the former at the expense of investors in the latter.

Very much so, Fin.
I may not have been totally clear - it certainly won't have been the first time.

Roll is definitely something that one needs to be aware and wary of, and can be a problem for less educated traders, but it's not once one is aware of it and makes trades early or whatever.