Commodity Bull: Death Rumours Greatly Exaggerated

[ostap]

It is a widespread perception that the bull market in commodities has been resting in the past few quarters. Some highly visible commodities, such as crude oil, gold, silver, and copper, have peaked and then dropped sharply in the past 12 months. This perception is underscored by most of the popular commodity price indices: The Goldman Sachs Commodity Index, the Reuters/Jefferies CRB index and the Dow Jones-AIG index are all down year-on-year (-20%, -13%, and -4%, respectively).

However, the perception of a standstill in commodity prices could not be farther from the truth. What has been standing still are the commodity futures indices, which are tracking the performance of an investment in commodity futures. However, spot prices of commodities are soaring. How is that possible?

Returns from investing in commodity futures have two components: the roll yield and the spot yield. Due to the “Onslaught of the Sheeple“, most non-storable commodities are now in strong contango (meaning that their term structure is upward sloping). This has been the source of a significant negative roll yield in recent quarters. Spot prices, by contrast, have steadily advanced, generating a positive spot yield. Commodity futures indices, combining both the negative roll yield and the positive spot yield, therefore show a mixed picture.

For many commodity futures indices, there also exists a “spot” version which excludes the roll yield and thus only tracks the spot yield. The following figure depicts the DJ-AIG commodity futures index in both its (usually quoted) excess return version and the (less known) spot version. While the excess return index has basically been stagnating for the past two years, the spot index is soaring: it is up 15% in 2006 and has been growing at an annualized rate of 26% so far this year.

For investors, the relevant index is indeed a futures based index. However, for unhedged commodity producers selling the real stuff, for unhedged consumers buying the real stuff, and for central banks trying to gauge inflation pressure, a futures based commodity index is currently highly misleading. The commodity bull is alive and kicking, and is currently even accelerating. It is thus probably only a question of time until the relentless rise of commodity prices will spread to consumer prices.

[Graph]

Source: www.economicreason.com

[metalman]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

It is a widespread perception that the bull market in commodities has been resting in the past few quarters. Some highly visible commodities, such as crude oil, gold, silver, and copper, have peaked and then dropped sharply in the past 12 months. This perception is underscored by most of the popular commodity price indices: The Goldman Sachs Commodity Index, the Reuters/Jefferies CRB index and the Dow Jones-AIG index are all down year-on-year (-20%, -13%, and -4%, respectively).

However, the perception of a standstill in commodity prices could not be farther from the truth. What has been standing still are the commodity futures indices, which are tracking the performance of an investment in commodity futures. However, spot prices of commodities are soaring. How is that possible?

Returns from investing in commodity futures have two components: the roll yield and the spot yield. Due to the “Onslaught of the Sheeple“, most non-storable commodities are now in strong contango (meaning that their term structure is upward sloping). This has been the source of a significant negative roll yield in recent quarters. Spot prices, by contrast, have steadily advanced, generating a positive spot yield. Commodity futures indices, combining both the negative roll yield and the positive spot yield, therefore show a mixed picture.

For many commodity futures indices, there also exists a “spot” version which excludes the roll yield and thus only tracks the spot yield. The following figure depicts the DJ-AIG commodity futures index in both its (usually quoted) excess return version and the (less known) spot version. While the excess return index has basically been stagnating for the past two years, the spot index is soaring: it is up 15% in 2006 and has been growing at an annualized rate of 26% so far this year.

For investors, the relevant index is indeed a futures based index. However, for unhedged commodity producers selling the real stuff, for unhedged consumers buying the real stuff, and for central banks trying to gauge inflation pressure, a futures based commodity index is currently highly misleading. The commodity bull is alive and kicking, and is currently even accelerating. It is thus probably only a question of time until the relentless rise of commodity prices will spread to consumer prices.

[Graph]

Source: www.economicreason.com

interesting comments. one point of procedure, tho. bart, finster, et al, often post graphs from their sites on itulip without sending visitors back to their sites to see them. just use the little image icon thingy and enter the url. else we're going to think yer spamming the tulip, and then we are not gonna love ya!

[ostap]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

interesting comments. one point of procedure, tho. bart, finster, et al, often post graphs from their sites on itulip without sending visitors back to their sites to see them. just use the little image icon thingy and enter the url. else we're going to think yer spamming the tulip, and then we are not gonna love ya!

Thanks, here it is:

[Finster]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

It is a widespread perception that the bull market in commodities has been resting in the past few quarters. Some highly visible commodities, such as crude oil, gold, silver, and copper, have peaked and then dropped sharply in the past 12 months. This perception is underscored by most of the popular commodity price indices: The Goldman Sachs Commodity Index, the Reuters/Jefferies CRB index and the Dow Jones-AIG index are all down year-on-year (-20%, -13%, and -4%, respectively)...

...Returns from investing in commodity futures have two components: the roll yield and the spot yield...

...For many commodity futures indices, there also exists a “spot” version which excludes the roll yield and thus only tracks the spot yield. The following figure depicts the DJ-AIG commodity futures index in both its (usually quoted) excess return version and the (less known) spot version. While the excess return index has basically been stagnating for the past two years, the spot index is soaring: it is up 15% in 2006 and has been growing at an annualized rate of 26% so far this year...

There are only two versions of the DJAIG commodity index listed by Dow Jones Indexes (see http://www.djindexes.com/mdsidx/inde...nt=showAigHome): The "Dow Jones-AIG Commodity Index" and the "Dow Jones-AIG Commodity Total Return Index". The total return version is the one tracked by funds like Barclay's iShares DJP, and it was up about 3.8% year over year as of Friday, April 28.

There are no separate "excess return" and "spot" versions listed. Can you please clarify?

[ostap]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

There are only two versions of the DJAIG commodity index listed by Dow Jones Indexes (see http://www.djindexes.com/mdsidx/inde...nt=showAigHome): The "Dow Jones-AIG Commodity Index" and the "Dow Jones-AIG Commodity Total Return Index". The total return version is the one tracked by funds like Barclay's iShares DJP, and it was up about 3.8% year over year as of Friday, April 28.

There are no separate "excess return" and "spot" versions listed. Can you please clarify?

The "Dow Jones-AIG Commodity Index" you mention is the so-called "Excess Return Index". The link you mention lists only "investable indexes". The Spot Index is not an investable index; you cannot invest in it, because it deliberately excludes the roll yield, however, as an investor, you cannot avoid to roll.
The DJ-AIG Spot index is for example listed in that spreadsheet:
http://www.djindexes.com/mdsidx/down..._full_hist.xls

(choose the "Excess Return Sheet", column N).

[Finster]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

The "Dow Jones-AIG Commodity Index" you mention is the so-called "Excess Return Index". The link you mention lists only "investable indexes". The Spot Index is not an investable index; you cannot invest in it, because it deliberately excludes the roll yield, however, as an investor, you cannot avoid to roll.
The DJ-AIG Spot index is for example listed in that spreadsheet:
http://www.djindexes.com/mdsidx/down..._full_hist.xls

(choose the "Excess Return Sheet", column N).

But you characterized "the Dow Jones-AIG index" as being down over the past year -4%. Wouldn't that correspond to the "excess return" index? (I'm seeing it down about -2% y-o-y, but that is as of April 28).

But the "excess return" index is itself not investable, correct? The investable version of the index is the "total return" index, which is up about +4%. This still falls short of the "spot" index (up about 14%), but not exactly as bad as -4%, either. The return from the Barclay's iPath ETN (DJP, which I earlier incorrectly referred to as "iShares") which tracks the DJAIG Total Return index would be about 0.75% less due to expenses.

Similar comments apply to the GSCI index, although it has apparently suffered a more severe negative roll over the past year.

I guess what I am not getting is what, if any, actionable point you are making. Are you saying that investors should avoid these commodity futures based funds? If so, given that investing in the spot index is not practicable, then what alternative would you envision?

[ostap]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

But you characterized "the Dow Jones-AIG index" as being down over the past year -4%. Wouldn't that correspond to the "excess return" index? (I'm seeing it down about -2% y-o-y, but that is as of April 28).

But the "excess return" index is itself not investable, correct? The investable version of the index is the "total return" index, which is up about +4%. This still falls short of the "spot" index (up about 14%), but not exactly as bad as -4%, either. The return from the Barclay's iPath ETN (DJP, which I earlier incorrectly referred to as "iShares") which tracks the DJAIG Total Return index would be about 0.75% less due to expenses.

Similar comments apply to the GSCI index, although it has apparently suffered a more severe negative roll over the past year.

I guess what I am not getting is what, if any, actionable point you are making. Are you saying that investors should avoid these commodity futures based funds? If so, given that investing in the spot index is not practicable, then what alternative would you envision?

I guess I measured the -4% on May 2, not end of April.

Roughly speaking, the excess return index describes the returns from an uncollateralized investment in futures. The total return index adds to that the money market return on the full collateral.

Concerning the GSCI index: there also exists a spot version of that index, which also performed much better than the GSCI (both in its total return and excess return version).

What are the consequences for investors? Concerning this question, read also my previous post:
http://www.economicreason.com/index....f-the-sheeple/

or in other words: concerning non-storable commodities, go short contangoed commodities, go long backwardated commodities.

If you're bullish on commodities, go long storable commodities:
http://www.economicreason.com/index...._expectations/

BTW: The following brochure might also contribute to a better understanding of the roll issue:
http://www.abnamromarkets.com/pdf/CH...=none&zoom=100

[Finster]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

I guess I measured the -4% on May 2, not end of April.

Roughly speaking, the excess return index describes the returns from an uncollateralized investment in futures. The total return index adds to that the money market return on the full collateral.

Concerning the GSCI index: there also exists a spot version of that index, which also performed much better than the GSCI (both in its total return and excess return version).

Indeed, the investable GSCI has dramatically underperformed the spot version. Some 15%-16% over the course of the past year.

What are the consequences for investors? Concerning this question, read also my previous post:
http://www.economicreason.com/index....f-the-sheeple/

or in other words: concerning non-storable commodities, go short contangoed commodities, go long backwardated commodities.

If I understand you correctly, this presumes that commodity prices themselves remain flat. If commodity prices were to rise, for example by a degree greater than the negative roll, then going short contangoed commodity futures would generate a negative return, right?

If so, then would this not be unsuitable for an investor who wants to be long non-storable commodities? Thus, even considering the information you link, there appears to be no way to systematically have both long exposure to spot price trends and the term structure or insurance component of contango-backwardation effects ... or at least have long exposure to spot price trends and avoid term structure effects. Am I correct?

[ostap]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

If commodity prices were to rise, for example by a degree greater than the negative roll, then going short contangoed commodity futures would generate a negative return, right?

If so, then would this not be unsuitable for an investor who wants to be long non-storable commodities? Thus, even considering the information you link, there appears to be no way to systematically have both long exposure to spot price trends and the term structure or insurance component of contango-backwardation effects ... or at least have long exposure to spot price trends and avoid term structure effects. Am I correct?

Yes, that's right, or at least that's what I think.
That's also the reason why the typical commodity investor will probably not be happy about his investment returns (actually, he is already unhappy).

If you are bullish on commodities, there are probably better ways to cash in than investing in commodities futures indexes, namely: investing in storable commodities such as precious metals (via futures, ETFs or physical), or in unhedged producers of non-storable or storable commodities.

[grapejelly]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

Yes, that's right, or at least that's what I think.
That's also the reason why the typical commodity investor will probably not be happy about his investment returns (actually, he is already unhappy).

If you are bullish on commodities, there are probably better ways to cash in than investing in commodities futures indexes, namely: investing in storable commodities such as precious metals (via futures, ETFs or physical), or in unhedged producers of non-storable or storable commodities.

I am a bull on grains and proteins. How do I speculate on those without investing in futures?

[Finster]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

Yes, that's right, or at least that's what I think.
That's also the reason why the typical commodity investor will probably not be happy about his investment returns (actually, he is already unhappy).

If you are bullish on commodities, there are probably better ways to cash in than investing in commodities futures indexes, namely: investing in storable commodities such as precious metals (via futures, ETFs or physical), or in unhedged producers of non-storable or storable commodities.

Very much appreciate the insights, Ostap. I am one of those already-unhappy commodity investors. At least insofar as the negative roll yield has impacted the performance of the commodity-futures-based funds. Fortunately I haven't relied on them extensively, but did notice a few months ago the whopping underperformance of a position in a GSCI-based fund relative to spot prices. I was aware of the potential for negative roll yield, but not its persistent nature. Your comments have been most illuminating.

I still think investments based on commodity futures indices can serve a useful role in an investor's portfolio, particularly in light of efforts by firms such as Deutsche Bank and ABN Amro to account for these term structure effects in their indices. But with a crucial caveat - these issues underscore the importance of a fundamental axiom of investing - know what you're investing in.

[grapejelly]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

Does anyone track the rate of change and direction of the premia between spot and different months of a given commodity?

That would be very interesting...

[Finster]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

I am a bull on grains and proteins. How do I speculate on those without investing in futures?

Hopefully Ostap will comment further, but if he's right (and I think he is), it's not easy. The only way to do so without exposure to confounding factors would seem to be buying physical and storing them. This could mean truckloads and a farm.

Crude alternatives might be buying other (storable) commodities as a proxy, e.g. precious metals. Of course, the correlation could be pretty loose. There would also be investing in stocks of companies whose assets include investories of those commodities and/or production capacity for them. But there you also gain exposure to stock market risk. One such stock (which I have a position in) is CRESY, an Argentinian ranchland owner and ag producer. If you include for consideration ETFs that invest in futures, you could look at the PowerShares DB Agriculture Fund (DBA) (http://www.dbfunds.db.com/). This would expose you, however, to potential term structure effects as Ostap has noted, although the index it tracks does make an effort to account for them.

As a practical matter, you could use some combination of the above on the premise that the common element would be reinforced while the differing extraneous factors would be mitigated. That is, own some physical storable commodities like metals, buy some stocks in commodity producers (you could use the IGE exchange-tradable-fund for this purpose as an alternative to individual stocks) and for more ag focus, the DBA exchange-tradable-fund.

[Finster]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

Here's a chart to follow up on this topic. It shows the aggregate yield on long-only, fully collateralized, commodity futures. The net yield (both roll yield and collateral yield) has been profoundly negative, making it so that a portfolio of such futures has fallen far behind the price performance of commodities themselves.

[bart]

Re: Commodity Bull: Death Rumours Greatly Exaggerated

I am a bull on grains and proteins. How do I speculate on those without investing in futures?

Are you distingushing between leveraged futures and unleveraged futures?
My point is that it's very easy to invest in grains and proteins via an unleveraged futures position.