Beware! Contango and Commodity Investing
In my role as risk manager for my clients I try to envision what macro economic changes could happen and determine whether my portfolios are situated to weather that change. I was looking at various hyper inflation scenarios (for when the economy gains traction again) and reexamined whether commodities would be a viable tool.
From 2000 to 2003 a number of academic papers were published that showed over the previous 30 to 40 years that adding commodities to a portfolio would have significantly improved the risk/return of the portfolio. This led to a frenzy of activity in creating investment vehicles to make it easier for people to gain exposure to commodities. It also led many endowments and other institutional funds to allocation a portion of their investments to commodities. I also bought into the story and incorporated commodities into my clients’ portfolios.
As this research was disseminated it fundamentally changed the commodities market. By 2005, I had traders in the oil industry tell me they were seeing more money coming in that year than they had seen in the previous 20 years combined. In my view, history was no longer a useful guide on what to expect in the commodities market and I removed commodity exposure in my portfolios by the end of 2005.
Fast forward to today and commodities have crashed right along with the stock market, failing in their promise of downside diversification. With many commodity prices down so much from their highs, you might believe that once the economic recovery gets underway commodity prices could potentially rise quite quickly. And this might lead you to allocate a portion of your portfolios in commodities.
Beware! If you use a commodity vehicle that is based on futures or their derivatives, besides anticipating where commodity prices are going, you also need to understand how commodity futures work.
Most commodity funds invest in two month commodity future contracts and then when one month has passed they sell that position and buy a new two month future contract. When the spot price (i.e., the current price) is higher than the future price this is called backwardation. Historically commodity futures have spent the majority of their time in backwardation (e.g., think of a farmer wanting to guarantee a profit for his/her crops and willing to sell at a discount for that guarantee). For the futures investor this has an advantage that even if prices stay the same you will make money as the future price converges to the spot price.
Sometimes however the spot price is lower than the future price and this is called contango. And when commodities are in contango, a futures investor has the problem that if prices stay the same, they are losing money as the contract price comes down to the spot price. Luckily for the futures investor, contango typically doesn’t get very large because people start buying the commodity and storing it to make a guaranteed profit if the contango gets larger than the storage and interest costs.
What does all this mean for today? Right now oil is in super contango (i.e., the future price is higher than it what it would cost you to buy and store it today). A future contract one month out is more than 16% higher than the current spot price and the two month contract is 26% higher than the current spot price. So an oil futures commodity investor is currently looking at a huge headwind (i.e., spot prices need to go up these amount just to break even). This means there are lots of people right now going around storing oil to lock in the arbitrage profit. And a lot of oil in storage means that spot prices are less likely to rise quickly.
I will end with this observation. If you choose to use commodities as an inflation hedge, it is not a set and forget component. You need to pay attention to the levels of backwardation and contango in the various components and decide whether your forecasts make the inherent risks worthwhile. As a relatively new addition to many portfolios, I anticipate a lot of extra volatility as investors reasses their commitment to commodities.