The true costs – and opportunities – of running a futures position in commodities...
Most of the time, investing in commodities means investing in futures contracts. That's the accepted wisdom. And trading commodity futures means getting into the mysteries of contango and backwardation.
We cover this all the time here at HardAssetsInvestor.com, and with good reason. Rolling forward a futures contract can be a tremendous source of loss or gain for an investor, often overwhelming the returns that changes in spot price might imply.
Usually, we’re worried about contango – the crippling headwind faced by most commodities these days, where it costs more to buy next month’s contract than it does today’s. This comes about because storing natural resources for future use tends to cost money, and the expense is factored into the shape of the futures market.
The effect of contango on commodity indexes has been so pronounced that many investment firms have started designing portfolios explicitly to maximize positive roll yield or minimize the contango headwind.
Given that so much of the commodity market is in contango, how severely would their roll yields – the cost or gain of holding a futures bet open from one monthly commission to the next – be affected if their contracts were all rolled today?
First, here’s a snapshot of the contango/backwardation picture looking one month out.
The winners and losers here are completely explained by seasonality. We're coming off the peak period for Heating Oil prices (spring 2008), so the price to get more heating oil today is higher than it will be next month – and so backwardation becomes your friend.
Live Hogs, in contrast, are in the opposite situation. March is traditionally the lowest month of the year, and prices rise towards a peak in the fall.
So here's the first problem – annualizing roll yield is tricky, but it's a tool used (not just by us) to get a sense for the market. It makes it easy to see, for instance, the divergence in price expectations for Red Wheat (big backwardation) or Corn (big contango).
Perhaps more interesting is the effect these short-term swings can have on your portfolio – most specifically, your index portfolio.
For the purposes of our exercise, we're going to look at the S&P-Goldman Sachs Commodities Index, the Dow Jones-AIG index, and the Deutsche Bank Liquid Commodities Index.
Each of these baskets of raw materials' futures tracks similar contracts, but they have very different sector weightings. They also have different roll strategies and rules about which contracts they own; we'll deal with those realities later. This is all about the hypothetical right now.
- All contracts move from this month to next month out;
- We are looking at roll yield only, not price fluctuations;
- Roll yield has been annualized.
And we’re basing our back-of-the-envelope analysis on what the indexes currently look like as of March 20, 2008:
We talked about the pros and cons of each index previously at HardAssetsInvestor.com, but based on the raw weights, here are the implications.
- GSCI Positive annualized roll yield (hypothetical) of 3.41%
- DJ-AIG Negative roll yield of 3.28%
- DB LCI Positive roll of 8.34%
Quite a variance! And while these are only the grossest of vectors, they do give a sense of which indices are heading into the wind, or filling their sails for the short term.
Looking at the DJ-AIG Commodity Index first, it is fair to say that diversity is not working when it comes to roll yield and contango. The DJ-AIG is the most evenly balanced across all five sectors (energy, agriculture, precious metals including Gold, base metals and livestock). That means it captures a lot of the contango occurring in Livestock, Agriculture and Precious Metals, but it doesn't have the luxury of a larger presence in the Energy Sector where we find backwardation.
That's not to say that the DJ-AIG is not in the Energy Sector; almost 13% of its holdings are in WTI Crude and Natural Gas, but only a little less than 4% is held in Heating Oil.
At the other end of the spectrum, DJ-AIG has almost 3% of its holdings in Lean Hogs. With an annualized roll cost of 94.52%, that easily outweights any gains Heating Oil was able to contribute.
The S&P GSCI vs. DBLCI
The positive roll yield offered by both the S&P-Goldman Sachs and Deutsche Bank commodity indices is not surprising, given that they both are heavily weighted in the energy sector, which tends to sit in backwardation.
The S&P GSCI holds 74% in energy, and DBLCI is at 53%. But the surprising thing is that the S&P GSCI would seem to be heading for a lower positive roll yield than DBLCI – yet it has much more held in energy, so one could expect a better roll yield.
Here's the difference. DBLCI holds only six commodities in total: Heating Oil, Light Crude Oil, Wheat, Aluminum, Gold and Corn. Its deep exposure to heating oil and wheat, and complete avoidance of livestock mean that this is the season for DBLCI.
Of course, there's no guarantee that when the roll for each of these indices actually happens these kinds of yields are realized. Each index has unique timing, contract and roll mechanisms designed to "accurately" represent a particular approach to indexing the market as a whole.
Still, it's an object lesson in the importance of understanding the non-spot dynamics of the commodity futures market. The costs or yield of rolling forward a position in natural resources can make turning a profit easy or uphill work, depending on your mix of contango and backwardation.