Commodity Investing
CFA Alternative Investments
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Commodities Subjects
Learning objectives (LOS from CFA Curriculum)
a. describe types of market participants in commodity futures markets;
b. explain storability and renewability in the context of commodities and determine whether a
commodity is storable and/or renewable;
c. explain the convenience yield and how it relates to the stock (inventory level) of a commodity;
d. distinguish among capital assets, store-of-value assets, and consumable or transferable assets and
explain implications for valuation;
e. compare ways of participating in commodity markets, including advantages and disadvantages of
each;
f. explain backwardation and contango in terms of spot and futures prices;
g. describe the components of return to a commodity futures and a portfolio of commodity futures;
h. explain how the sign of the roll return depends on the term structure of futures prices;
i. compare the insurance perspective, the hedging pressure hypothesis, and the theory of storage and
their implications for futures prices and expected future spot prices.
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Differences
How are stocks and bonds different from
commodities in terms of financial assets?
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Questions
• What do stocks and bonds represent?
• What are commodities?
• What kind of commodities (classes) can you
mention?
• What are some ‘weird’ commodities classes?
• Are bitcoins commodities? Why or why not?
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Types of commodities
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Why the interest in commodities
• In the old days, commodities were boring
investments
• Then China and India started growing quickly
as of about 2000 and they started buying
commodities massively
• And then people started talking about
commodity super-cycles
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Why the interest in commodities
Copper price as of 4 January 2019 ($2.65 per pound)
Copper price (USD/lb)
Volume
https://www.macrotrends.net/1476/copper-prices-historical-chart-data 7
Facts and Fantasies about
Commodities
• Your turn
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Why invest in commodities
• Efficient portfolio through diversification
– Returns similar to equities
– Lower volatility than equities
– Low correlation with stocks and bonds
• Inflation hedging (e.g., Gorton and
Rouwenhorst 2006)
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Spot and futures markets
• Commodities trade in spot and futures
markets
• Spot markets involve the physical transfer of
goods between buyers and sellers so prices
reflect current supply and demand conditions
• Futures represent financial exchanges of
standardized futures contracts with the price
established today for a sale at a future date
• Execution can be physical or cash settlement
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Long and short - definition
• What does going long a stock mean?
• What does going short a stock mean?
• Is a bakery a natural long or short due to the
nature of its business?
• A natural short because it is a buyer
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Market participants
Hedgers
• Farmers, who produce wheat want protection
from price swings, have a natural long so they
go short to lock in prices
• Do airlines who want protection from fuel
costs go short or long to hedge?
• Bread factories (what position)?
• De Beers diamonds?
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Market participants
Hedgers
• Cotton farmer wants to hedge 200,000 lbs in
October. Currently 1 April. Future contract in
October at 85c, a good price, and versus 95c
currently. Contracts are for 50,000 lbs each.
• He locks in this price for three contracts and not
four. Why?
• At the end, two scenarios, final price at 95c or
final price at 75c. What is the overall outcome for
the farmer under the two scenarios?
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Market participants - Speculators
Speculators
• Speculators assume the risk of commodity
hedgers
• In exchange they demand a premium
• They provide liquidity to markets
• What are the negative effects of speculators?
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Market participants
Arbitrageurs
• The goal of arbitrage is riskless profits
• They look for differences between futures and spot
prices
• When price differences grow too high given factors
such as insurance premiums, shipping costs and
interest rates, they step in, as per the law of one price
• They regulate the difference between spot and futures
prices
• The cash-and-carry strategy is a good example of
arbitrage
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Price determinants-
Fundamental approach
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Storability vs renewability
• If a commodity does not degrade over time and
the cost of storing is low compared to its value,
then the commodity is storable
• Gold is highly storable. Cattle are not storable
(really?)
• Wheat is renewable because unlimited quantities
are possible over multiple seasons
• The biggest factor influencing renewable
commodity prices is current investor demand
• What are nonrenewable commodities?
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Convenience yield
• When it is better to keep commodities on hand, this
creates a cost for the holder
• For example, a gasoline refinery may prefer to have
crude oil in stock to ensure sufficient inventories to
continue operating in case of supply disruptions
• What is the risk of holding stock for the gasoline
refinery?
• The cost is a monetary benefit because firms prefer
holding the physical commodity rather than being long
the equivalent futures contract
• So the convenience yield indicates market expectations
of future availability of a nonrenewable resource
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Convenience yield vs inventory
• Differences between futures and spot prices are driven by
storage costs and convenience yield
Futuret – spott-1 = spott-1 + storage costt-1 - convenience yieldt-1
• The theory of storage sets out an inverse relationship
between inventory levels and commodity futures prices
• The higher the inventories, the lower the convenience yield
• In general, storable=higher inventories=lower convenience
yield compared to nonstorable commodities
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Convenience yield
• Each firm's convenience yield is unique because each
will experience different economic impacts from a
commodity shortage
• The market’s convenience yield is the sum of each
firm’s convenience yield
• If inventories fall dramatically, the convenience yield
will rise, and futures price will fall relative to the spot
• The theory of storage has been shown to have weak
validity and it does not allow for easy prediction of
the convenience yield
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Types of assets - capital assets
• Expected to provide continuous cash flows in
the future, such as stocks and bonds
• Capital assets can be valued by discounting
the expected future cash flows (PV(CFn))
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Types of assets- store of value assets
• Do not generate income and cannot be
consumed
• Artwork and currencies
• How do you value artwork?
• Is artwork part of an efficient portfolio?
• Is real estate a store of value or capital asset?
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Types of assets-
consumable/transferable assets
• Commodities have value but no stream of
cash flows, so cannot use DCF to value them
• Prices driven by supply/demand
• Is gold a consumable, store of value or capital
asset?
• Does anyone know about the leasability of
gold? What effect does this have on the type
of asset that gold represents?
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Commodity Life Cycle
• The commodity life cycle varies depending on the
economic, technical and structural (i.e., industry,
value chain) profile of each commodity
• The length of the life cycle amplifies or diminishes
the adjustment time to outside events
• Natural gas can be consumed almost
immediately, whereas crude oil needs to be
transformed into something else
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The oil life cycle
Title Timing Description
Extraction 50-100 days to begin Survey and dig well
Transportation 1-10 days Pipeline, oil, truck
Storage Days to a few months Seasonal impact
Trading N/A
Refining 3-5 days
Transportation and Trading 5-20 days
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Oil life cycle
• Many kinds of crude oil
• Shale oil changed many factors in oil pricing and made the
US a net oil exporter
• Refineries themselves use 20% of crude oil refined for the
refining process
• Lots of sensitivity to political and economic factors
• Oil is produced year round whereas other commodities
have seasons
• Refineries cost several billion US dollars to build and
construction lasts for several years
• Pipelines costs billions to build and also take several years
to build and can be incredibly contentious issues (e.g.,
Keystone XL)
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How to gain exposure to commodities
1. Direct purchase of a physical commodity
2. Commodity stocks (Total)
3. Commodity mutual funds
4. Commodity futures
5. Structured products based on commodity
futures indices
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How to gain exposure to commodities
1. Direct purchase of a physical commodity
2. Commodity stocks (Total)
3. Commodity mutual funds
4. Commodity futures
5. Structured products based on commodity
futures indices
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How to gain exposure to commodities
1. Direct purchase of a physical commodity
2. Commodity stocks (Total)
3. Commodity mutual funds
4. Commodity futures
5. Structured products based on commodity
futures indices
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Oil price and Total revenues
Source: https://www.xtb.com/int/market-analysis/news-and-research/stock-of-the-week-total
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How to gain exposure to commodities
1. Direct purchase of a physical commodity
2. Commodity stocks (Total)
3. Commodity mutual funds
4. Commodity futures
5. Structured products based on commodity
futures indices
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How to gain exposure to commodities
1. Direct purchase of a physical commodity
2. Commodity stocks (Total)
3. Commodity mutual funds
4. Commodity futures
5. Structured products based on commodity
futures indices
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Futures contract terms
The following are typical contract specifications for futures exchanges:
1. The type and quality of the futures underlying. The type of commodity,
abbreviation, and futures exchange.
2. The contract size. The amount and units of the underlying asset per
futures contract.
3. Price determination. The formal notation of futures prices at the futures
exchange.
4. Trading hours.
5. The tick. The minimum permissible price fluctuation.
6. The currency in which the futures contract is quoted.
7. The daily price limit.
8. The last trading date.
9. Delivery regulations (e.g., delivery month, type of settlement)
Example of LME Copper : https://www.lme.com/Metals/Non-ferrous/Copper/Futures
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Why futures and not forwards
• Futures are OTC agreements between two parties
• Early commodity exchanges operated as forward markets
• But too often participants would go bankrupt when
unrealized losses became realized at the end of the
contract
• There were many bubbles that led to bankruptcy such as
the Dutch tulip bubble
• The futures process minimizes the risk because the
exchange acts as guarantor of payments
• The first modern exchange was the Dojima Rice Exchange in
Osaka founded in 1710
• In the US, the first futures exchange was in Chicago, for
hogs
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Futures
• Longs and shorts need to operate on an equal
basis
• Futures markets are zero-sum games
• Margin and margin calls are the mechanism
to guarantee payment alongside price stops
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Commodity exchanges worldwide
• CME and ICE in the US
• LME in the UK
• BM&FBOVESPA (grain and livestock in Brazil)
• China and Japan
• Indonesia (palm oil)
• Singapore (rubber)
• Australia (energy, grains, wool)
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Hedging with Futures Contracts
• Futures Contract
– An agreement to trade an asset on some future date, at
a price that is locked in today
• Futures contracts are traded anonymously on an
exchange at a publicly observed market price and
are generally very liquid.
• Both the buyer and the seller can get out of the contract at any
time by selling it to a third party at the current market price.
• Futures contracts eliminate credit risk (unlike forwards or
contracts).
• For each long contract, there is a short contract so the total is
zero (zero-sum game)
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Futures Prices for Light, Sweet Crude Oil, September
2012
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Hedging with Futures Contracts
• Futures prices are not prices that are paid
today.
– Rather, they are prices agreed to today, to be paid
in the future.
• The futures prices are based on the supply and demand
for each delivery date.
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Hedging with Futures Contracts
(cont'd)
• Eliminating Credit Risk
– Futures exchanges use two mechanisms to
prevent buyers or sellers from defaulting.
• Traders are required to post collateral when buying or
selling commodities using futures contracts.
– This collateral serves as a guarantee that traders will meet
their obligations.
– Margin
• Collateral that investors are required to post when
buying or selling futures contracts
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Hedging with Futures Contracts
(cont'd)
• Eliminating Credit Risk
– Marking to Market
• Computing gain and losses each day based on the
change in the market price of a futures contract
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Hedging with Futures Contracts
(cont'd)
• Marking to Market: An Example
– Suppose a buyer who enters into the contract has
committed to pay the futures price of $87 per
barrel for oil.
• If the next day the futures price is only $85 per barrel,
the buyer has a loss of $2 per barrel on her position.
– This loss is settled immediately by deducting $2 from the
buyer’s margin account.
• If the price rises to $86 per barrel on the following day,
the gain of $1 is added to the buyer’s margin account.
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Hedging with Futures Contracts
(cont'd)
• Marking to Market: An Example
– The buyer’s cumulative loss is the sum of these
daily amounts and always equals the difference
between the original contract price of $87 per
barrel and the current contract price.
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Hedging with Futures Contracts
(cont'd)
• Marking to Market: An Example
– If the price of oil is ultimately $65 per barrel, the
buyer will have lost $22 per barrel in her margin
account.
• Thus her total cost is $65 + $22 = $87 per barrel, the
price for oil she originally committed to.
– Through this daily marking to market, buyers and sellers pay
for any losses as they occur, rather than waiting until the final
delivery date. In this way, the firm avoids the risk of default.
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Example of Marking to Market and Daily Settlement for the
November 2015 Light, Sweet Crude Oil Futures Contract ($/bbl)
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How to gain exposure to commodities
1. Direct purchase of a physical commodity
2. Commodity stocks (Total)
3. Commodity mutual funds
4. Commodity futures
5. Structured products based on commodity
futures indices
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Commodity indices
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Backwardation and contango
Figure 1: Backwardation Market
Backwardated Market for Crude Oil Futures, April 2008
In backwardation, the term structure will have a negative trend. Futures prices will be
lower than the current spot price as shown in Figure 1. An investor can profit from
taking long positions in successive futures contracts and holding them until maturity
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Backwardation and contango
In contango, the term structure has a positive slope, and the futures price is
above the spot price as shown in Figure 2. Contangoed markets may arise
when buyers dominate the futures market.
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Backwardation in commodities
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Futures prices without storage
• F0=S0erT
• T = time remaining to expiration of futures
contract
• S0 = current spot price of the commodity
• F0 = current futures price of the commodity
contract
• r = continuously compounded risk-free
interest rate
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Futures prices with storage
• F0=S0e(r+U)T
• U=cost of storage as a percentage of the
commodities’ price
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Futures prices with storage and
convenience yield
• F0=S0e(r+U-Y)T
• Y=the benefit of holding the physical commodity
rather than a contract for future delivery
• Convenience yield depends on the current levels
of a commodity’s inventory and on the market’s
expectations of the commodity’s availability in
the future.
• If the value of Y is large enough to exceed the
risk-free rate and storage cost, the futures market
for that commodity will be in a backwardation
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Return Components of Commodity
Futures
Cost of carry - costs incurred due to holding a position such as interest on loans used to
purchase a position, storage costs and spoilage costs
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Return Components of the Goldman
Sachs Sub-Indexes
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Theories about why contango and
backwardation come to be
1. Global supply and demand
• Backwardation should dominate if there are many
producers (e.g., farmers, oil producing countries) that
wish to use a short hedge to fix the net price that they
will receive for their product in the future. Contango
should dominate if there is an excess of commodity
users (commodity consumers) that wish to hedge the
future price of their commodity inputs. Speculators will
step in to collect a risk premium arising from the
mismatch between long hedgers and short hedgers.
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Theories about why contango and
backwardation come to be
2. Theory of storage
• The theory of storage contends that there is a
relationship between storability and the
slope of the term structure curve. Relatively
nonstorable commodities (such as oil and
livestock) are most frequently in backwardation
and thus have the best potential for
investment. Highly storable commodities like
gold, on the other hand, are almost always
in contango
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Theories about why contango and
backwardation come to be
3. Convenience yield
• Demand/supply shocks and changes in the
market’s expectation of a commodity’s future
availability will change the value of
convenience yield and in turn affect the
shape/slope of the term structure
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Returns from commodities futures
total return = spot return + roll return + collateral
return + rebalancing return
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Returns from commodities futures
total return = spot return + roll return + collateral return + rebalancing
return
1. Spot return simply refers to the percentage change in a commodity’s
spot price. The global balance between supply and demand is the main
driver of spot return, and the majority of commodity futures’ return
variation can be traced back to spot price volatility. Spot return is also
highly correlated with unexpected inflation.
2. Different commodities are impacted by different market factors.
Industrial metals like copper are used in manufacturing many products,
so prices are strongly correlated with global economic development.
3. The spot prices of agricultural products, on the other hand, are driven by
seasonal factors (as crops are harvested at specific times of year), while
natural forces such as weather can also have an effect.
4. Finally, political factors such as trade barriers or political instability can
lead to commodity price volatility.
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Returns from commodities futures
total return = spot return + roll return +
collateral return + rebalancing return
Roll return is the income(loss) generated as
traders close out maturing futures contracts and
replace them with newer futures contracts
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Returns from commodities futures
total return = spot return + roll return + collateral return +
rebalancing return
Collateral return corresponds to the interest received on a cash
investment. Taking a position in a commodities futures
contract normally requires an up-front payment only of a small
margin amount, rather than the total value of the contract.
Collateral return is the return associated with the entire
amount of underlying capital being collateralized by the
investor and invested in government securities; collateral
return thus reflects the U.S. Treasury bill rate.
Collateral return is responsible for the generally higher return
of the total return indices versus excess return indices.
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Returns from commodities futures
total return = spot return + roll return + collateral return + rebalancing
return
When we consider a portfolio of commodities futures rather than an
individual futures contract, one additional source of return is the
rebalancing return (a.k.a. diversification return).
In a value-weighted commodity index, the proportion of the portfolio
value devoted to each commodity sector is rebalanced to a fixed
percentage periodically. Futures contracts that have increased in value
are sold, and futures contracts that have decreased in value are
purchased.
Because the correlation between different commodities is usually low
and prices are generally mean-reverting to production cost, an
additional profit will be generated by this rebalancing process in
trendless but volatile markets.
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Excess return and total return indices
• An excess return index reflects an uncollateralized futures
investment. The return of an excess return index consists of the
spot return and roll return, but no collateral return:
• excess return index = spot return + roll return
= futures return
• A total return index, on the other hand, represents a fully cash-
collateralized commodity investment and thus has collateral return
as one of its components:
total return index = collateral return + futures return
= collateral return + spot return + roll return
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Comparing commodity performances
with other asset classes
• The performance of a total return commodity
index should be representative of a passive
long-only investment in commodity futures
where the futures position has been fully
collateralized with cash (i.e., invested at the
risk-free rate). A total return commodity
index is appropriate for comparing the return
performance of commodities with the
returns of other asset classes.
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Definition of roll return
• Roll return (or roll yield) represents the profit
(or loss) that results from the continuous
convergence of futures prices towards spot
prices as a futures contract approaches
maturity. Roll return is the result of the rolling
over of expiring futures contracts into
the next-nearest-month’s futures contracts.
The difference in purchase and sale prices
results in a return.
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Definition of roll return
• Roll return is equal to the difference between the
price of a new futures contract Ft,T (futures price at
time ‘t’ for a contract with a maturity of ‘T’) and the
price of the near month futures contract Ft-1,t.
Because the futures price Ft – 1,t and the spot price St
must be equal at the maturity of the contract, we
can write the formula for roll return at time t as
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Example of roll return
• Imagine a contangoed market where today’s spot price for a
barrel of crude oil is $100, the expected spot price 12 months
from now is $103, and the forward oil contract for 12 months
in the future is selling for $105 today.
• An oil refiner (consumer of crude oil) may still wish to lock in
the $105 future price to reduce uncertainty, even though the
$103 spot price to which these futures contracts are expected
to converge is lower than the $105 price of the new futures
contract.
• As the refiner rolls this contract, it is likely to require cash, as
the new contracts will continue to be more expensive than
the maturing contracts: the roll return will be negative.
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Roll returns in general by type of
commodity
• In line with the theory of storage, nonstorable
commodities like energy and livestock exhibit
positive roll returns, while highly storable
commodities like industrial and precious
metals and agricultural commodities generally
have negative roll returns.
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Predicting future returns
Models to predict expected return of
commodity futures:
1. The Capital Asset Pricing Model (CAPM).
2. The Insurance Perspective.
3. The Hedging Pressure Hypothesis.
4. The Theory of Storage.
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Predicting future returns
1. The Capital Asset Pricing Model (CAPM)
The CAPM framework is an appropriate model to use to
derive the theoretically appropriate required rate of return
for a capital asset, based on that asset’s beta. However,
because commodities are not capital assets, the use of
CAPM to derive a commodity’s expected return is not
appropriate
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Predicting future returns
2. The Insurance Perspective
The insurance perspective focuses on the desire by commodity producers to
hedge commodity price risk. A commodity producer such as a farmer has a
natural long position in that commodity and will seek to hedge this position
by taking an offsetting short position in commodity futures (i.e., sell his crop
forward). To entice a sufficient number of speculators to take the opposite
side of these positions, hedgers will need to offer speculators a risk premium.
This creates a normal backwardation situation: the futures price will be lower
than the expected spot price in the future. This assumption of a
preponderance of commodity producer hedging suggests that a long position
in commodity futures should have a positive expected return.
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Predicting future returns
3. The Hedging Pressure Hypothesis
The hedging pressure hypothesis expands on the insurance
perspective to include the idea that not only do commodity
producers wish to hedge their natural long positions, but
commodity consumers seek to hedge their natural short
positions.
A speculator that takes the opposite side of this trade (i.e., a
speculator that shorts the commodity future) should earn an
insurance premium as a result. The hedging pressure hypothesis
suggests that the risk premium can be earned on either long or
short positions, depending on the balance of hedgers in the
market.
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Predicting future returns
3. The Hedging Pressure Hypothesis
For example, a manufacturer of copper fittings for the
plumbing industry is naturally short copper and may
want to reduce the risk of rising copper prices by taking
a long position in copper futures. This demand for long
futures will cause the futures prices to rise, leading to a
normal contangoed situation where the futures price is
higher than the expected spot price in the future.
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Predicting future returns
4. The Theory of Storage
The theory of storage considers the impact of inventory levels on
commodity futures prices and states that the difference between
futures prices and spot prices is caused by the convenience yield
and storage costs.
The theory suggests that the higher the levels of current
inventories of a particular commodity, the lower the
convenience yield. Commodities that are more difficult to store,
such as livestock, will generally have lower inventory levels and
thus a higher convenience yield.
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Correlation matrix
76
The efficient frontier and commodities based
on monthly returns
This slide shows how portfolio efficiency can be improved by including commodities in a
traditional portfolio. The upward shift of the efficient frontier also provides higher risk-adjusted
returns.
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