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More Roll-Over Trouble

Betting on food inflation? Not all agricultural ETFs are created equal...

the agricultural sector for any period of time, you will note the outperformance of the equity-based Market Vectors Agribusiness ETF (NYSE Arca: MOO) over the futures-holding PowerShares DB Agriculture Fund (NYSE: DBA), writes Brad Zigler at Hard Assets Investor.

In 2009, MOO's 57.2% appreciation trounced the 1% gain attained by the PowerShares portfolio. The gains have continued into the New Year; last week, MOO racked up a 7.8% gain against DBA's 1.7% increase.

There are a number of reasons for the disparate performance. First of all, you'll find the same kind of leverage in agribusiness stocks as you'll find in Gold Mining shares. Increases in goods' market prices above production costs tend to flow directly to a company's bottom line, regardless of whether it's soybean oil, seed corn or fertilizer.

Futures traders, in contrast, have to rely upon margin to leverage their gains (and thus leverage their losses, too). Then there's the matter of contango, the bugaboo of commodity index investors. Contango is unique to the futures market. It means the nearest-month contract is cheaper than the following month's, which erodes the return of a long position as it is rolled forwards to create a constant position over time. Stocks, as open-ended investments, don't suffer contango.

So even though the Deutsche Bank Liquid Commodity Index-Diversified Agriculture Excess Return – the benchmark tracked by DBA – utilizes an optimized roll methodology to minimize the negative yield in a contango, it can't eliminate it altogether. The index methodology can only make the best of a bad situation.

The DB agricultural index originally provided for expiring long positions to be rolled into a contract for delivery in the subsequent 13 months that would generate the best implied roll yield – the one that's most positive or the least negative.

Recent changes in the index's composition, however, reduced its contango-battling power. In October 2009, DBA's underlying index composition was expanded from six commodities to 11. With that move, DBA took on a sort of split personality. Five commodities – corn, soybeans, sugar, Chicago wheat and Kansas City wheat – were designated to employ the optimized roll strategy, while the other six components – feeder cattle, live cattle, lean hogs, cocoa, coffee and cotton – were designated to use a predefined rolling schedule for contract selection.

When, for example, the March contracts are set to expire, DBA's corn position will be rolled into the lowest-priced futures in the horizon that encompasses the May, July, September and December 2010 contracts, as well as the March 2011 delivery. However, for cotton, there will only be one roll option for the expiring March position – the May 2010 contract.

Under most circumstances, the nearby contract will provide the best roll return – but not always. Each agricultural commodity has a unique crop year, representing its growing cycle from sowing to harvest. Corn's crop year, for example, runs from November through the following September, while Chicago wheat's year starts in July and ends in the following May.

Each crop year has its own supply and demand dynamic too, so prices can vary widely from one year to the next. That can sometimes make the futures term structure (the shape of prices across the different futures contracts) look screwy, as one crop year may be in contango, while another is inverted, known as backwardation, with nearer contracts more expensive than further dates. It may even seem like a cascade of successive backwardated markets, or a stairway of contangoed crop years.

Not surprisingly, this can mess up DBA's roll strategy. For example, DBA will soon be obliged to roll its long cotton position from the March to the May delivery, even though new crop cotton is presently cheaper.

The vast majority of DBA's constituents are currently in contango. More than a few, however, invert in subsequent crop years. Inversions, or backwardations, occur when supplies are deemed tight. Sugar, for example, has been a boon for DBA, as the entire term structure is backwards, meaning forward rolls are positive. What's more, sugar remains an optimized commodity under the new index methodology, allowing some yield shopping.

But the drag of contango in the other commodities, however, has trumped most of sugar's benefit.

Weight In DBA
Market Condition
Feeder Cattle*    
4% Contango thru Sept '10
Live Cattle* 12.5% Contango 'til Jun '10; inversion through Jun '11
Lean Hogs*
8.3% Contango 'til Jun '10; inversion through Feb '11; contango thereafter
12.5% Contango through Jul '11; inversion to Dec '11; contango through Jul '12; inversion for the balance of the '12 and '13 crop years
Chicago Wheat
6.3% Contango through the '12 crop year
Kansas City Wheat
6.3% Contango through the '12 crop year
Soybeans 12.5% Contango through Jun '10; inverted through Nov '10; contango thereafter
12.5% Inversion through Oct '12
11% Contango through Sep '10; inversion through May '11
11% Contango through Dec '12
Cotton* 2.8% Contango through Jul '10; inversion through Dec '10; contango thereafter

*Commodity required to roll expiring futures into matrix-specified contracts

There's good news and bad news in all this. The bad news is that contango has plainly been a wet blanket for holders of futures-based products such as DBA. The good news is that this situation is reversible. That is, many of the markets now flush with enough supply to carry over into subsequent crop years can invert.

Note, however, that's a big can, not a will. Shortage is the quickest route to backwardation. Some commodities, particularly the soft commodities, are closer to that state than others.

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