What is commodity investing all about:
1. The curves and carry – backwardation/contango (inventory). Given the cash market for commodities is often not available for investing, the primary market for investors in commodities is the futures. Consequently, the shape and dynamics of the futures curve is a dominant factor for longer-term investing. Investors cannot think of commodity prices in isolation, no different than investors can think about bonds without looking at the current yield or equities without dividends. Carry in commodities is as important as any other asset class. This is the cash return on the investment and the premium from the roll of the futures to expiration. We can describe part of this carry as convenience yield or a risk premium, but the result or impact is similar to other carry markets. The holding of the future as it moves to expiration will have a major impact on return for both long and short investors.
Simply put, if the markets are in backwardation, the roll will work in favor of the investor like a tailwind. If the market is in contango, there is a roll or carry headwind. The backwardation story is closely associated with inventories. If there are low inventories, there is a high convenience yield. There is also a premium for compensating speculators, but the economics of inventory convenience yield seems to have a strong economic rationale. Show me whether markets are in backwardation, and I can tell you whether long-only commodity investing will be profitable.
2. The cycle – The long-term cycle in commodities is driven by technology, production, and investment. In the long-run, technology will place downward pressure on real prices. A cycle is caused when low prices result in less investment in production, extraction, or infrastructure. A combination of low investment and low inventory makes commodity markets sensitive to any supply or demand shock, which will generate a long-term surge in prices. These cycles will be related but not solely dependent on the business or financial cycle. These unique cycles create asset class diversification that is attractive to investors.
3. The trend – Given inelastic demand and supply, a shock to demand or supply may have longer-term impacts on commodity markets. There are likely to be trends. The lower level of transparency, as well as the non-profit maximizing behavior of hedgers, will often result in commodity prices trending.
4. The shock – Commodity shocks can be looked through the short and long-run. The short-run is dominated by demand shocks and production, weather, or logistic shocks. The longer-term price is affected by expectations on production. The front-end of the futures curve is not closely linked with these longer-term prices. Front-end volatility can be higher because of these short-term shocks.
5. Diversification – The asset class is called commodities as if there is a close relationship between all of the markets in the asset class. This is not the case. A key characteristic is that there is often a low correlation between commodities that are bundled together. For example, even natural gas is not closely correlated with crude oil. Of course, correlations will change based on market shocks, but for most investors, there is little relationship between different commodity groups.
6. The size – Commodity markets relative to other asset classes are small, so the dynamics of hedgers and speculators or market participants matters. These markets are small relative to the market capitalization of many companies. Volume and open interest may be high given the active trading, but the production of many commodities may be low relative to what many investors may expect. Hence, the activities of indexers or specific hedgers and speculators may have a greater impact than what would be expected in other asset classes.
It is not about:
1. The cash price for commodities – Following the cash price as an indication of what may happen to futures can be a loser’s game. The curve dynamics may dominate return, and the cash price is often an elusive concept in commodities. There are cash prices for specific grades and delivery, but that is a far cry from a general price for a market.
2. Inflation hedges – The link between inflation and commodity prices is not always strong. In the current sub-2% inflation world, the correlation between commodities and inflation may not exist.
3. Large amounts of passive capital – The pre-FC period was made by large increases in commodity index activity. A combination of backwardated markets and a super-cycle allowed for a large number of funds to flow into indices. Some called this the financialization of the commodity markets, which may have caused an increase in correlation with other asset classes. Money has flowed out of passive index products, and it is not likely commodity markets will be able to handle this activity.
If you are going to make a long-only commodity investment do it because you have the right tailwinds to ensure that you will be compensated for risk. If you are an active long/short investor, make sure you know where your returns will be coming from.