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Commodity Indices and the Curve

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Commodity Indices and the Curve Not for further distribution b For Professional Clients and a Eligible Counterparties only The curve Commodity Indices and the curve To better understand the impact of changing curve shapes on commodity index investments, we have closely examined the performance of commodity indices under different curve conditions. This report was produced by UBS Investment Bank and UBS Asset Management Authors: Adam Glen-Bott Portfolio Manager, UBS Asset Management Ray Fuller, CFA Senior Portfolio Manager, UBS Asset Management Bahaa Mounzer Quantitative Trading Strategist, UBS Investment Bank Virat Agarwal Head of Commodities Structuring, UBS Investment Bank 2 Introduction Backwardation Roll yield is positive when the price of the expiring future is Against the backdrop of rising inflation risks and widespread higher than the price of the far-dated futures. This can occur supply threats, we think the case for investing in commodities when participants prefer to hold a physical commodity rather has rarely been stronger. Investors seem to agree and have than a future, perhaps due to short-term supply disruptions. increased their broad commodity exposure so far in 2018. The premium for short-term delivery is often referred to as the "convenience yield". Global inflows into broad commodity ETFs exceeded 4.8bn US dollars by the end of May 2018. This is more than double the For example, Aluminium markets temporarily entered a period of full-year 2017 inflows of 1.8bn USD1. backwardation in April 2018, when the USA imposed sanctions on Rusal, one of the largest aluminium producers in the world. Strong economic growth and above-trend inflation have historically been good indicators of strong commodities In these conditions, the market is "backwardated" and the performance. In this paper, we take a closer look at another positive roll yield makes a positive contribution to commodity important commodity performance driver – curve shapes and index investment returns the impact of roll yield. Exhibit 2 Backwardation curve – illustrative example Oil's recent transition into a period of sustained backwardation, where longer dated oil futures are cheaper than near-dated futures, is the first such period since 2014. Clients have asked us what sort of implications this situation might have on their commodity index performance. To help address this, we have examined our flagship UBS Bloomberg Constant Maturity Commodity Index (CMCI) to analyse its performance under different curve shapes over its 11-year history. Exhibit 1 CMCI outperformance under different market conditions, 31 January 2007 – 30 June 2018 Note: For illustrative purposes only 12 10 Contango Roll yield is negative when the prices of far-dated futures are 8 higher than the price of the expiring future. Markets are said 6 to be in "contango". The price difference is largely driven by a commodity's "cost of carry" – i.e. storage, transportation % 4 and any other costs associated with physically holding the 2 commodity. Note how costs of carry are still there in a backwardated market, but the convenience yield for holding 0 the physical asset outweighs its cost of carry at the time. -2 Negative roll yields are a drag on commodity index investment 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 returns and a number of different strategies exist to try and CMCI outperformance (1Y rolling) Market backwardated mitigate these adverse costs. Source: UBS, Bloomberg, as of 30 June 2018. CMCI outperformance is the outper- formance of the UBS Bloomberg BCOM Constant Maturity Index ER against the Exhibit 3 Contango curve – illustrative example Bloomberg Commodity Index ER. Past performance is not a reliable indicator of future returns Roll yield Commodity indices typically represent a diversified, long-only basket of exchange-traded commodity futures. To provide continuous exposure, index investments have to sell out of their expiring futures and roll into futures with a longer-dated maturity. The difference in price between the near-dated future and the far-dated future is called the "roll yield". It plays a large part in driving the overall performance of a commodity index investment alongside commodity spot performance. 1 Source: UBS, Morningstar, as of 31 May 2018 Note: For illustrative purposes only 1 Rolling methodologies Exhibit 5 Curve shape summary statistics First generation indices, such as the Bloomberg Commodity (January 2001 – June 2018) Index (BCOM), are a common investment choice. They typically Backwardation Contango implement a simple "front-month" rolling methodology – this means they hold a single future until it approaches expiry, Number of observations 957 5,423 then roll into a new future slightly further along the curve, and % of observations 15% 85% repeat. By contrast, the UBS Bloomberg Constant Maturity Average curve shape (implied 1-month roll yield) +0.4% -0.8% Commodity Index (CMCI) aims to mitigate the cost of carry Average period length (days) 23 132 by simultaneously investing at multiple points along the Maximal period length (days) 137 1,372 curve and rolling a small portion of its investment every day, thus maintaining a constant maturity. This is an example of a Source: UBS, Bloomberg, as of 30 June 2018 second generation commodity index. It is immediately apparent that the natural state of broad We are going to see whether the CMCI rolling methodology commodity markets is in contango. In fact, since 2001, historically outperforms a first generation rolling methodology markets have been in contango 85% of the time and the under different market conditions. average length of a period of contango is 132 days. This For more information on the CMCI rolling methodology, compares to states of backwardation which are far less please click here. persistent at an average of 23 days. Curve shape analysis Exhibit 6 CMCI outperformance in sustained backwardation To begin our comparison, we construct a curve shape time or sustained contango (January 2001 – June 2018) series for each commodity in our reference index by measuring Markets in Markets in the slope of the curve around the expiring futures. An sustained backwardation sustained contango upward slope implies negative roll yield, while a downward Annualised outperformance of 0.2% 3.0% slope implies positive roll yield. The curve shape time series CMCI rolling methodology is presented as a commodity's roll yield on a given day Number of days 452 (11%) 3706 (89%) and provides an indication of whether a commodity is in "backwardation" or "contango". Source: UBS, Bloomberg, as of 30 June 2018. CMCI outperformance is the outperformance of the UBS Bloomberg BCOM Constant Maturity Index ER against the Bloomberg Commodity Index ER. Past performance is not a reliable indicator of future returns Curve shapes are not consistent across all commodities or through time. Indeed, commodity returns are known to exhibit To see whether curve shape can affect the rolling performance low intra-asset-class correlations and we see a similar picture of our broad commodity indices, we measure the relative for intra-asset-class curve shapes. To combine individual performance of the CMCI rolling methodology versus the commodity curve shapes, we use the prevailing target weights BCOM rolling methodology in each period of contango and for the Bloomberg Commodity Index (BCOM) to construct backwardation. In sustained contango markets the average a composite curve shape based on the weighted average of annualised outperformance of CMCI is 3.0%, and the average each commodity. annualised outperformance in sustained backwardation is 0.2%. It is important to note that the backwardation data set Exhibit 4 shows our BCOM curve shape time series: this is is much smaller than the contango data set, so the average what we use to indicate whether markets are generally in outperformance is calculated based on a smaller number of backwardation or contango. observations. Our curve shape analysis shows markets have generally Exhibit 4 BCOM curve shape, monthly average per calendar month exhibited long periods of contango punctuated by short (January 2001 – June 2018) periods of backwardation. Further, our performance analysis 0.02 supports the merits of the second-generation CMCI rolling methodology in all market curve shapes and especially when 0.01 markets are in contango. 0.00 -0.01 As contango is the long-term natural state of commodity markets, we can speculate that any outperformance foregone -0.02 during short periods of backwardation are recovered during -0.03 the subsequent periods of contango. To investigate this further, we extend our analysis to look at each day in our -0.04 time series and calculate the relative performance of the -0.05 CMCI rolling methodology over the subsequent twelve 2001 2003 2005 2007 2009 2011 2013 2015 2017 months (imagine looking at the curve shape today, and asking Contango Backwardation whether the rolling methodology should outperform over the next twelve months, or not). Source: UBS, Bloomberg, as of 30 June 2018 2 The results reveal the CMCI rolling methodology consistently outperforms the BCOM rolling methodology (in over 89% of our observations), regardless of curve shape. This seems to support our claim. Exhibit 7 plots CMCI returns against BCOM returns – points above the straight line indicate CMCI outperformance and the intensity of the colour indicates the strength of backwardation / contango at the start of the twelve month period. Exhibit 7 Relative performance in backwardation / contango Periods starting
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