TOPICS OF INTEREST Institutional Investing in Long Commodities Strategies By Eyal Bilgrai, CFA, CAIA Senior Research Associate MARCH 2013 Executive Summary ▪ Historically low correlation between commodities and financial assets, such as stocks and bonds, means that commodities should help institutional portfolios generate better risk-adjusted returns by contributing to the diversification in the investment portfolio. ▪ Commodities tend to perform better than most financial assets during periods of inflation because commodity prices reflect a trend in rising prices of essential goods. ▪ The major commodities indices have inherent drawbacks, which may provide opportunities for active management to add value. Introduction Commodities are defined as raw materials that can be bought or sold; e.g., oil, copper, coffee, corn and gold. Most institutional investors consider commodity futures as a separate asset class due to differentiated exposures to economic drivers and unique return characteristics. The main reasons for investing in commodities includes diversification benefits, overall portfolio risk reduction, and inflation protection. This paper will discuss the attributes of long-only commodities investing and will also address the benefits of active management in the asset class.1 Commodity markets While stocks and bonds provide legal claims on cash flows, commodities provide a legal claim on raw material goods. Valued as a consumable or a transformable asset,2 commodities do not conform to traditional asset pricing models (such as the capital asset pricing model)3 and they cannot be priced by traditional accounting metrics (such as net present value). Commodity prices depend on global supply and demand dynamics, not what market participants perceive to be the acceptable risk premium. The major commodities sectors are: agricultural, energy, industrial metal, livestock, and precious metals. Gaining exposure to commodities Commodities exposure can be achieved through five ways: purchasing the underlying commodity, commodity future contracts, commodity swap and forward contracts, commodity-linked notes, or equity in natural resources companies: ▪ Commodity futures contracts: This is the most common method of gaining exposure to commodities. Futures contract trading occurs in a central marketplace and has transparent pricing, clearinghouse safety, uniform contract terms, and daily liquidity. Only a small percentage of futures contracts results in delivery of the underlying commodity. ▪ Outright purchase of the underlying commodity: The physical purchase and holding of a commodity entails practical difficulties including transportation, storage, and insurance. This is not prudent for most plan sponsors. With the rise of bullion exchange traded portfolios (ETFs), investors can purchase a share of actual physical commodities, although this method is limited to a small sub-set of commodities, mainly precious metals.4 ▪ Natural resources companies: Owning stock in natural resources companies is not considered a pure commodities play because the pricing tends to follow the general movement of the stock market (equity risk factor) and exposes investors to company specific risk.5 ▪ Commodity swap: Total rate of return swap that delivers the performance on the underlying price basket.6 An example would be agreeing to exchange cash flows linked to prices of oil for a fixed cash flow. There is generally no central exchange for swap transactions and so they tend to be less liquid than commodity futures. Commodity swaps also expose the investor to counterparty risk. ▪ Commodity-linked notes: A commodity-linked note is a structured product that pays a return linked to the performance of a commodity or basket of commodities. On its maturity date, the note pays the initial principal amount plus the return based on the price change of the underlying commodity. These notes expose investors to credit risk of the notes issuers. The difference between commodity swaps and commodity-linked notes is that commodities-linked notes are fully funded, while swaps are mainly unfunded. Commodities Futures A commodity futures contract is a single commitment to buy or sell a commodity at a future date. If the seller or buyer of the futures contract wishes to avoid delivering or accepting delivery of a physical asset, the position must be closed out by selling or buying an offsetting position prior to the contract expiration. An investor who wants to maintain long exposure to commodities over time through buying futures contracts must continuously open and close positions - a process referred to as “rolling the position.” To trade futures contracts, only a small initial margin must be posted as collateral against fulfilling the commodity futures contract commitment. The initial margin for holding a commodity future is typically 2%-10% of the value of the contract. For each commodity, there are several futures contracts with different maturities. The nearest dated contract is often the most liquid. Pricing of Commodity Futures Commodity futures contracts exhibit a term structure similar to interest rates. The commodity futures curve can be downward or upward sloping, and the slope of the curve serves as a market signal to hedgers and speculators. The pricing of a commodity futures contract depends on the commodity spot price (i.e., the price of the physical commodity actively traded in the open market), as well as storage and insurance costs, the risk free rate, and the commercial risk allocation (i.e., who bears the risk of Page 2 commodity price change) between commodity consumers and producers, or hedgers and speculators. Storage and insurance costs tend to inflate the value of a futures contract, while commercial risk allocation can serve to reduce the value of a futures contract, especially when physical availability of a commodity is perceived to be low. Interestingly, though we are using commodities futures as investment instruments, the commodities futures market only exists because of the inherent uncertainty in commodity production and demand. Without this uncertainty, there would be no economic reason to enter such a risk-transfer agreement. Generally, when a commodity futures curve is upward sloping, referred to as contango, the commodity is physically readily available. As a result, the higher price of the futures contract relative to the commodity’s spot price is being derived from the insurance and financing costs associated with holding physical commodities. For example, when oil inventories are high and there is little geopolitical instability, commodity consumers are less concerned about a spike in oil prices and are not rushing to buy oil. The price of the oil futures contract will be derived from the oil spot price plus the storage and financing costs. This was the case in 2009 when oil storage in the United States nearly reached its maximum capacity resulting in moving the curve to its widest contango on record. Contango / Backwardation 120 100 Price 80 60 1 2 3 4 5 6 7 8 9 10 11 Contract Maturity/Expiration (Months) Curve in Backwardation Curve in Contango Conversely, when the commodity futures curve is downward sloping, referred to as backwardation, commodity consumers are willing to pay a premium for accessing the physical commodity. The market is signaling to producers that they can realize a higher price for their commodity today versus in the future, while a consumer who can delay consumption can obtain the commodity for a cheaper price in the future. For example, when oil inventory levels are low and geopolitical tensions are high, commodity consumers become concerned about near term oil supply shortages, and are willing to pay a premium for immediate delivery. In this situation, we would expect the future curve to be in backwardation. This situation existed in early 2004, when the Iraq War caused an oil shortage concern. There is a clear negative correlation between oil inventories and oil prices 200 20 10 100 0 0 -10 change, % performance,% 12 month rolling 12 rolling month -100 -20 12 month rolling invemtory rolling month 12 S&P GSCI Energy U.S. Ending Stocks of Crude Oil and Petroleum Products Source: U.S. Energy Information Administration, Morningstar Indices, Wurts and Associates calculations. Page 3 Speculators play a pivotal role in the commodities market by taking the counterpart position to hedgers in a futures contract. This allows real businesses to hedge their commodity exposure.7 We do not agree with the notion that speculators can significantly distort the price of commodities for an extended period of time. Instead, we believe the long-term price trend is determined by the marginal cost of production, though in the shorter-term, cyclical supply and demand factors will drive price variability around that trend: New sources of supply, geopolitics, weather, natural disasters, income growth, demographics (especially in emerging markets), and productivity all affect the long-term pricing of commodities. Return sources for commodity futures Commodity futures returns are often decomposed into three elements; spot price change, collateral return, and roll return. Spot price change is simply the change in the market price of the commodity, which is driven by supply and demand variables. Collateral return refers to the income earned on the cash collateral underlying the notional value of futures contacts, which typically earn the short-term Treasury rate. Roll return depends on the shape of the futures term structure explained