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Transcript of 2. Commodity Markets_final
8/10/2019 2. Commodity Markets_final
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Dr. Denis Schweizer Associate Professor of Finance John Molson School of Business, Concordia UniversityMailing address: 1455 de Maisonneuve Boulevard West, Montreal, Quebec H3G 1M8Office: MB 11.305Phone: +1(514)-848-2424, ext. 2926Fax: +1(514)-848-4500E-Mail: [email protected]
2. Commodity Markets
Investment Analysis
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Page 2Investment AnalysisDenis Schweizer
Learning Outcome Statement
Characterization of commodities as an independent asset class
Exploration of various possibilities to invest in commodity markets
Knowledge of return drivers of investments in commodity futures
Consideration of the diversification effects from integrating commodity futures intotraditional portfolios
Learning about the interdependencies between commodity prices and fundamentalmacroeconomic data
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Page 3Investment AnalysisDenis Schweizer
Agenda
I. Current trends
II. Characteristics of commodity markets
III. Commodities as an independent asset class?
IV. Opportunities to participate in commodity markets
V. Sources of returns of commodity futures indices
VI. Commodities and macroeconomics
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Page 4Investment AnalysisDenis Schweizer
Discussions about Gas Supply in Europe
Gas pipelines and dynamics through LNG
By cooling natural gas to about -165°C, it canbecome a so called “Liquefied Natural Gas“
(LNG)
With its volume being 1/600 of that of the gasform, LNG can be much easier transported on
roads, rails and water
This could considerably reduce Europe’s heavily
discussed dependence upon Russian gas pipelines
Currently, the transportation of gas is cheaperthrough existing pipelines
Due to current developments, new pipeline
projects are discussed, which would reduce the
dependence on Russia and Ukraine (see map onthe right)
Instead of bigger investments in pipeline projects
(e.g. like currently in the Ukraine) other means of
transportation could establish themselves
Russia warns Germany of a long gas dispute
“Record-low temperatures in Germany - and the gas dispute between
Russia and Ukraine escalates right at this time. Medwedew, the vice
CEO of Gazprom, explained in Berlin that the conflict will not be
solved soon: He advised the Germans to build more reservoirs to
ensure supply if necessary.“
Der Spiegel, 06.01.2009
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Page 5Investment AnalysisDenis Schweizer
Current Trends: Fears of Export Stoppage on Rare
Earth Metals from China
“Rare Earth” Rare Earth Metals – Overview
Forward-looking technologies like hybriddrives, solar plants, flat screens and mobilephones require for their production so called“rare earth” metals
Currently 93% of the total world market forthese metals (137.000 t p.a.) are mined in China
Due to an increased demand for the metals, theChinese government considers an exportstoppage for rare earth metals. This would putespecially Western industries in a difficultsituation threatening their future
That is why a worldwide footrace begins for thesearch for sources of those metals in other
regions Besides the small sources in Zambia and Sierra
Leone for example, the hope of the worldeconomy lies in significant sources like thosefound in Afghanistan
Worldwide mining (in t)
Country 2006 2011 2012 Reserves
Australia Na 2,200 4,000 1.6 Mio
China 119,000 105,000 95,000 55 Mio
India 2,700 2,800 2,800 3.1 Mio
US - - 7,000 13 Mio
Other 1,300 1,000 1,200 ~41 Mio
Total ~123,000 ~111,000 ~110,000 ~114 Mio
Scandium Yttrium
Lanthan
Cer
Praseodym
Neodym
Promethium
Samarium Europium
Gadolinium Terbium
Dysprosium
Holmium
Erbium
Thulium
Ytterbium
Lutetium
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Page 6Investment AnalysisDenis Schweizer
Global Rare-earth-oxide Production Trends
Source: USGS. Note, The Mountain Pass deposit is in California, U.S.A. Graph from D.J. Cordier (U.S. GeologicalSurvey, 2011) and was updated from Haxel and others
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China’s Appetite for Resources as the Driving
Force for Growth
Chinese raw material imports increased twentyfold to about 200 billion USD in the last 20 years
Currently, China mainly imports crude oil and ore, most of them coming from South America and Africa
The increasing income and the decreasing agricultural area will increase the demand for agricultural
products
Resource Unit Demand p.a. Change 2006-2010
Curr. 2020 total p.a.
Iron Ore m t 148 710 380% 10%
Oil m t 91 1.860 1,940% 20%
Soy m t 26 50 80% 4%
Coal m t 11 810 7,400% 20%
Copper m t 3 20 600% 10%
Manganese m t 3 13 360% 10%
Meat m t 0.3 4 1,260% 20%
Timber m m³ 34 150 330% 10%
Metals
Oil
Cotton
Soya
Source: Deutsche Bank Research
Projection for China’s demand for
imported raw materials
China’s main suppliers of resources in
Africa and South America
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Page 8Investment AnalysisDenis Schweizer
Agenda
I. Current trends
II. Characteristics of commodity markets
III. Commodities as an independent asset class?
IV. Opportunities to participate in commodity markets
V. Sources of returns of commodity futures indices
VI. Commodities and macroeconomics
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Page 9Investment AnalysisDenis Schweizer
Characteristics of Commodity Markets
Commodities – in comparison to financial assets – are real assets and primarilyconsumption goods (electricity, gas, coffee etc.), and not durable goods
Commodities have an intrinsic value and provide a utility through usage, if they areneeded for example in industrial production, or through consumption
The demand for commodities does not only depend on the price, but also oneconomic growth or the demand of other assets (opportunity costs)
The supply of commodities is limited and can be scarce in the short term, as for agiven time period only a certain amount of commodities is available (see „commodities
and macroeconomics“)
The supply of some commodities is also characterized by seasonality (i.e. harvestingcycle, gas, live cattle)
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Characteristics of Commodity Markets
Commodities are not standardized regarding their nature, and every class ofcommodities features specific properties, so commodities as such are very
heterogeneous
On the contrary, traded commodity futures are standardized contracts
“When a bushel of soybeans weighing 60 pounds is crushed, the typical result is 11 pounds ofsoybean oil, 44 pounds of 48% protein soybean meal, 4 pounds of hulls, and 1 pound of waste. If
the hulls are retained, the result is 48 pounds of 44% protein soybean meal. In October 1992, the
Chicago Board of Trade revised the soybean meal futures contract specifications from a 44% protein
standard to 48% protein soybean meal.” (Chicago Board of Trade)
The cycles of different commodities also behave differently: the development inagricultural commodities and energy commodities is driven by the weather, whileindustrial metals are driven by business cycles
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Classification of Commodities
Commodities
Energy Foodstuffs, drinks and tobacco - Metals Indust. - agricultural Live cattle
Fossile energy - Crude oil- Heating oil- Gasoline- Natural gas- CoalNuclear energy - Uranium
Renewables - Solar energy- Wind energy- Water energy- Biomass energy
D & T Crop and Oilseeds Industrial metals
Precious metals
CoffeeSugar TeaCocoaOrange juice Tobacco
Crop - Barley- Oat- Corn- Rice- Wheat
Oils and Oilseeds - Soy beans- Soy bean oil- Coco oil- Palm oil- Canola oil
AluminumCopperZincLeadNickel Tin
GoldSilverPalladiumPlatinum
Live cattleFeeder cattleLive hogs
CottonSilk WoodNatural rubberPulp
Hard Commodities Soft Commodities
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Page 12Investment AnalysisDenis Schweizer
Why Investing in Commodities?
Commodities as an asset class have historically gained positive returns in long-termperiods, which are uncorrelated to stock and bond returns
Commodities therefore reduce the portfolio risk and enhance the risk-and-return tradeoff(diversification of market price risks)
Participants in commodity markets:
Hedgers
Speculators (Traders)
Arbitrageurs
→ Why do we need arbitrageurs in the market?
Strategic advantages:
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Why Investing in Commodities?
The demand for commodities:
Industrialization and economic growth in the BRIC states (Brazil, Russia, India,China) drive the demand for commodities ( → see current financial crisis )
Urbanization of the population leads to industrialization of agricultural economies Industrialized and prospering economies demand more commodities due to a
higher demand in consumption goods and investments in infrastructure (e.g. China)
The supply of commodities:
Shortage of commodities due to lacking capital investments and productioncapacities → Cyclical investments in infrastructure!
Tactical Advantages:
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Page 14Investment AnalysisDenis Schweizer
Agenda
I. Current trends
II. Characteristics of commodity markets
III. Commodities as an independent asset class?
IV. Opportunities to participate in commodity markets
V. Sources of returns of commodity futures indices
VI. Commodities and macroeconomics
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Page 15Investment AnalysisDenis Schweizer
Categorization in “Super classes” (Greer 1997)
(1/2)
1. Capital Assets
Have a continuous value development
2. Store of Value
Assets
Assets for the conservation
of values
Super classes
3. Consumable and
transformable assets – C/T-assets
to which an economic value is assigned
Especially the 3. property makes commodities an independent asset class.
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Categorization in “Super classes” (Greer 1997)
(2/2)
Important:
Commodity prices cannot be determined by a Discounted Cash Flow (DCF)approach, but they result from supply and demand on specific markets
The borders between the super classes are floating, e.g. gold is a commodity (used in
electronic circuits in airplanes and computers), an asset for value storage (analogous tocurrencies), but also a capital asset, as it can be leased
Gold served as the security for the “Bretton- Woods” central banking system in the U.S.
from 1944-71
Commodity prices are globally denominated in U.S.-Dollars. In fact, the value of a certain
commodity is determined by global rather than regional imbalances of supply anddemand. In comparison, stock markets often reflect the economic development withina country or a region
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Page 17Investment AnalysisDenis Schweizer
Agenda
I. Current trends
II. Characteristics of commodity markets
III. Commodities as an independent asset class?
IV. Opportunities to participate in commodity markets
V. Sources of returns of commodity futures indices
VI. Commodities and macroeconomics
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Page 18Investment AnalysisDenis Schweizer
How Should You Invest in Commodities?
= Buying the physical good on the spot market (direct real investment)
Disadvantage:
Immediate delivery of the commodities (or within 2 days) is not tractable in mostcases, regarding specific requirements for storage and logistics and due to high ongoingcosts (e.g. feeding costs for live cattle)
(exception: precious metals, e.g. gold, platinum, silver) Current example:
“ Whenever the forward curve of these commodity futures is backwardated (inverted) asin the case for crude oil at present, cash-and-carry storage is unprofitable and we shouldexpect inventories to decline. The opposite held true between 2009 and 2011 when aglut of supply at Cushing Oklahoma, pulled the forward curve into a contango thatmade storage profitable” (Nasdaq, September 30th, 2013).→ Why?
In order to invest in commodities financial assets are needed in most cases …
Purchase of the physical assets
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How Should You Invest in Commodities?
= Investments in commodity stocks (natural resource companies)
Yield major returns through trading of physical commodities (i.e. exploration, mining orharvesting, refining, processing, selling and delivering commodities)
Disadvantage:
Indirect, securitized investment in commodities (e.g. investment in petrochemicalstocks) is an insufficient substitute for direct investments, i.e. the investor does not gainan immediate exposure in commodities
Reason:
Stock markets and listed companies possess different value driving factors and inherent
risks (e.g. strategic company positioning, quality of the management, capital structure,expectations in profitability, transparency of information, market instabilities,operational risks, smoothing of company profits etc.)
Commodity stocks
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How Should You Invest in Commodities?
= Long-Only-Commodity funds
Differentiation by management style, composition, geographical and temporal investmenthorizon, currency, investment behavior and conducted strategy (active or passive funds)
Commodity Trading Advisors (CTAs) with active management
Hedge Funds with trading strategies in energy or commodities
Advantage:
Appropriate potential for diversification and moderate transaction costs
Disadvantage:
Low liquidity
Intransparent investment strategies for investors
Commodity funds
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Page 21Investment AnalysisDenis Schweizer
How Should You Invest in Commodities?
Advantages:
Investors gain from price movements of the underlying commodities without specificrequirements in storage and logistics
High flexibility, i.e. roll-over of existing futures positions is possible on short notice(long and short positions)
High degree of liquidity and low transaction costs
Disadvantages:
Low amount of futures in highly volatile commodities
Long-term exposure in commodity price risk requires proactive roll-over of contracts
(might be very costly, depending on the market structure)
Permanent margin calls if value depreciates
Management of futures positions requires higher effort
Risk of a physical settlement / delivery
Commodities Futures = active engagement in futures-market
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Page 22Investment AnalysisDenis Schweizer
How Should You Invest in Commodities?
= tradable passive commodity indices (keep in mind that most alternative asset classesdo not have “appropriate” tradable indices)
Index-oriented investments are cost efficient alternatives to gain exposure to singlecommodities or segments of the commodities market
Listed commodity index funds or index trackers (Exchange Traded Funds (ETF)):
Advantage: relatively easy and cheap to trade, no solvency risk of the issuer, sinceETFs are guaranteed deposits
Commodity indices, like the commodities themselves, are denominated in U.S.-Dollars,i.e. investors are exposed to exchange rate risk
Some ETFs or investment certificates provide a currency insurance and are called “Quanto”
Disadvantage: Prices of the index or ETF can decline even if the spot price of theunderlying commodities increase, which is caused by the structure of the Futures-curve
Commodity-indices
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Page 23Investment AnalysisDenis Schweizer
How Should You Invest in Commodities?
Commodity indices due to their construction only incorporate futures contracts with shortdurations (→ why ?)
„ The ETF “United States Oil Fund (USO)” lost 22 percent of its value only in December
– significantly more than the oil price has lost in this very period: WTI only lost 9.5percent. The stock price of the ETF shrunk by 80 percent since July 2008.“ (Financial Times, September 2nd, 2008)
Commodity indices do not incorporate short-positions Commodity funds, such as CTAs — not ETFs! — which are independent from an index can
freely determine optimal durations by directly engaging in commodity futures contracts (seeCTA/Managed Futures)
Disadvantages of index-based commodity investments
Based on monthly dataOct. 2003 to Oct. 2013 CISDM CTA S&P GSCI TR
Annual ROR 3.28% 1.75%
Volatility 5.84% 25.42%
Max DD -7.74% -69.95%
Sharpe Ratio( = .%)
0.30 0.01
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Page 24Investment AnalysisDenis Schweizer
Correlations in Up- and Down-Markets
S&P GSCI Agricultural Sub-Index
Passive portfolios show positivecorrelations in up-markets as well asdown-markets → on average investors
suffer losses in down-markets
Barclays Agricultural Trader Index
Active portfolios show negativecorrelations in down-markets and positivecorrelations in up-markets → on average
investors can gain profits in up-marketsand down-markets
Source: DataStream (Monthly Returns from January 1990 – October 2013)
I t t C dit I di (P i L
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Important Commodity Indices (Passive, Long-
only)
Reuters/Jeffries
Commodity Research
Bureau (RJ/CRB)
S&P Goldman Sachs
Commodity Index
(S&P GSCI)
Dow Jones/AIG
Commodity Index
(DJ-AIGCI)
Introduction to
Market 2005 1991 1998
Historical data since 1957 1970 1991
# of commodities 19 24 19
Computation of
index weights
System of 4 subgroups,differentiated by liquidity
& economics importance
Rolling 5-years-average of total
world production
Liquidity data in combination with Dollar-weighted pro-
duction of the last 5 years
Rebalancing monthly annually annually
Limitations in
diversification
none none 33% max. per sector; 2%
minimum per commodity
Futures price for
index calculation futures contract with next
maturity date Next month with
sufficient liquidity futures contract with next
maturity date
Roll-Over period 4 days 5 days 5 days
Calculation arithmetically arithmetically arithmetically
I t t C dit I di (P i L
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Important Commodity Indices (Passive, Long-
only)
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Price Formation on Commodity Futures Markets
Investigation of risk premia in commodity markets
Framework:
CAPM , insurance perspective, hedging pressure, storage cost theory
If the no-arbitrage condition holds for the spot and futures prices of assets, and if we
assume that no storage cost occurs, the futures price in t of commodity , with duration
T is equal to the compounded (with risk-free continuous interest rate r ) spot price . For = 0 (today) we conclude that:
, = ∙
If c are storage costs that accrue during the holding period and which are assumed to be
proportional with the commodity price, then the futures price , in = 0 of the
commodity will be calculated as follows:
, = ∙ +
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Theory of Storage Cost and Convenience Yield
In addition to the no-arbitrage condition, the direct utility that can be provided by thepossession of the physical commodity (e.g. if there are temporary shortages in the market),has to be calculated as follows:
, = ∙ +−
According to the theory of storage (Kaldor, 1939), the convenience yield y reflects theutility implied by the physical holding of a commodity, compared to a purely contractualagreement on its delivery in the future
Market participants are willing to pay a premium (the convenience yield) for theimmediate availability (access) of (to) the commodities
The utility results from the avoidance of costs that arise from interruptions in theproduction process or from complications in storage (e.g. oil refineries)
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Theory of Storage Costs and Convenience Yield
Buyers are willing to pay a higher price for immediate delivery
= Backwardation
= markup for immediately available goods over the 3-months futures price(spot price over futures-price)
The availability-premium varies over time, if unexpected inclines or declines in theavailable commodity stock occur
Commodities which are highly exposed to abrupt changes in stock show changes in theirforward curve in a particularly high degree. This can even lead to a total inversion of the
forward curve
Slope of the forward curve as an indicator for the stored amount of a commodityand the market’s expectations on its future availability
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Patterns of the Futures Curve
Considering the futures curve for a commodity, that depicts the futures-prices for
different durations of futures contracts, one observes two typical patterns:
Contango , the futures price is above the spot price, thus, the futures curve has a positiveslope
Backwardation , the futures curve shows a negative movement, i.e. the futures-prices(today) are lower than the current spot price
➔ In a Backwardation situation the investor can gain profits by engaging in long positionsin the respective futures contracts even if the spot price of the underlying commodity isnot changing at all
➔ If there is a significant premium in futures contracts (Contango) and the spot price doesnot move at all, the futures contract will suffer a loss equal to the “forward premium”
Net Gas Futures Prices in January 2011
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Contango versus Backwardation
January 2007Source: Bloomberg (taken from Engelke and Yuen, 2008)
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Forward Curve vs. Spot Curve
Weekly price of Nov 2011 Natural Gas Spot price chart of Natural Gas
Source: NAS Trading
The futures contract ′11,′11 starts in
January 2011 at $5.185 and is in November
2011 (expiry date) at about $ 3.681, this is
equal to a loss of $1.504 per contract
Reason for the difference is the decline in the
“forward premium” as the contract
approaches its expiration date
Natural Gas spot price (quoted in British thermal
units (Btu)) started the year at $4.54, and iscurrently at expiry date $3.68, this is equal to a
loss of $.86, or $860 per volume equivalent of
one futures contract
Notice, futures price converges with the spot
price at expiry date
January 2011 November 2011
Dynamics of Shortage Exemplified by Oil
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Dynamics of Shortage Exemplified by Oil
Returns
If storage is low compared to demand, the market is not protected against temporaryshort-term futures- as well as spot-price jumps
The oil market frequently experiences unexpected rises in demand (due to cold weather,rising demand for transportation etc.) or disruptions in supply (due to weather, politicalarousal, technical errors)
If the buffer (= oil in stock) is insufficient, short-term future prices may rise sharply
O i l p r i c e ( $ b a r r e l s )
$100
$102
August September October
$100 $100
How Do Commodity Futures Returns Work in a
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Example (Contango): Initial investment amount K = 100
Margin account M = 10 for 1 Futures-Contract
For simplicity no interest rate payments are made
Time t Commodity
Price
Futures-Price with
Maturity in t+1
Futures-
Payoff
Margin-Account
(w/o Interest)
0 100 105
1 103 107
2 110 117
3 112
How Do Commodity Futures Returns Work in a
Contango Situation?
How Do Commodity Futures Returns Work in a
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Example (Backwardation):
Initial investment amount K = 100
Margin account M = 10 for 1 Futures-Contract
For simplicity no interest rate payments are made
Time t Commodity
Price
Futures-Price with
Maturity in t+1
Futures-
Payoff
Margin-Account
(w/o Interest)
0 100 96
1 97 92
2 90 85
3 88
How Do Commodity Futures Returns Work in a
Backwardation Situation?
Generating Returns Through the Shape of the
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Generating Returns Through the Shape of the
Forward Curve
Example: An investor holds
short-term futures.Shortly before maturity,he has to roll themover into the next
contract, as he wouldget a physical deliveryotherwise!
He sells the currentfutures and invests theproceeds in futures with the next maturitydate
→ Is the profit riskless? Next future Second-nextfuture
$62
$60
1. Selling the long position in short-term futures10 barrels x $62 = $620
2. Invest proceeds in the futures contract with second-next maturity at a lower price.$620 / $60 = 10.33 barrels
3. Rolling up the curve: sell 10.33barrels at $ 62 = $640.46= 3.3% return
Contango and Backwardation May Change Over
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Contango and Backwardation May Change Over
Time
Roll-Returns (YoY)
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
1 9 7 1
1 9 7 3
1 9 7 5
1 9 7 7
1 9 7 9
1 9 8 1
1 9 8 3
1 9 8 5
1 9 8 7
1 9 8 9
1 9 9 1
1 9 9 3
1 9 9 5
1 9 9 7
1 9 9 9
2 0 0 1
2 0 0 3
2 0 0 5
2 0 0 7
Industrial Metals
Livestock
Precious Metals
Energy
Agriculture
Contango vs. Backwardation: Example from the
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Contango vs. Backwardation: Example from the
Current Market Environment
Different situation for cereals Contango for precious metals
Contango for nearly all energy goods Industry metals: Contango & Backwardation
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Backwardation is not a temporary phenomenon, but also not a guarantee! Energy and livestock sector are mostly in backwardation, as the majority of non-
storable commodities belongs to these sectors
Precious metals with neglect able storage costs are always (???) in contango
Sector #days % Backwardation
Crude oil 5953 61%
Unleaded fuel / RBOB(1) 5530 62%
Live hogs 5993 51%
Live cattle 5993 51%
Copper 5987 42%
Aluminum(2) 4928 21%
Wheat 5990 28%
Corn 5990 17%
Soy beans 5991 15%
Gold 5963 0%
Backwardation in Commodities
(1) Data for the fuel futures
begins on Dec 4, 1984
(2) Data for the aluminum
futures begins on July 11, 1987
Source: Goldman Sachs (March
1983 – December 2006)
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Page 45Investment AnalysisDenis Schweizer
Seasonality Patterns for Pork Belly
CME Outside Chicago 12-28 lbs Pork Belly Stocks, Source: Bloomberg, LP
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Page 46Investment AnalysisDenis Schweizer
Agenda
I. Current trends
II. Characteristics of commodity markets
III. Commodities as an independent asset class?
IV. Opportunities to participate in commodity markets
V. Sources of returns of commodity futures indices
VI. Commodities and macroeconomics
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Page 47Investment AnalysisDenis Schweizer
Components of Commodity Futures’ Returns
spot price
actualfutures price
backwardation
cost of carry
10
20
30
40
}}
collateral return
roll return
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Page 48Investment AnalysisDenis Schweizer
Where do Futures-Returns Come From?
Commodity-Futures
= Derivatives, futures contracts on physical commodities
Price formation of these assets depends on far more factors than just the commodityprices on the spot market. It is more complex:
Excess Return = Spot Return + Roll Return
Total Return = Spot Return + Roll Return + Collateral Return
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Page 49Investment AnalysisDenis Schweizer
Returns Components of Commodity Indices
Collateral return
Roll return
Spot return
Returns Components of Commodity Indices – A
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Page 50Investment AnalysisDenis Schweizer
p y
Closer Look after its Introduction
Collateral return
Roll return
Spot return
Sample Exam Question: Charts of Spot- and
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Page 51Investment AnalysisDenis Schweizer
Sample Exam Question: Charts of Spot andExcess-Return Indices for Heating Oil and Gold
Source: GSCI sub-indices for gold and heating oil, excess return and spot return, courtesy of Erb, Claude
B. and Harvey, Campbell R, "The Tactical and Strategic Value of Commodity Futures" (January 12, 2006), available atSSRN: http://ssrn.com/abstract=650923. (taken from: Engelke und Yuen, 2008).
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Page 52Investment AnalysisDenis Schweizer
Agenda
I. Current trends
II. Characteristics of commodity markets
III. Commodities as an independent asset class?
IV. Opportunities to participate in commodity markets
V. Sources of returns of commodity futures indices
VI. Commodities and macroeconomics
Price Development Depending on
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Page 53Investment AnalysisDenis Schweizer
Higher demand fully translates into higher prices (this effect is partly weakened forstorable commodities)
Only in the long term, new investments in commodity infrastructure lead to higher supplyor more intensive processes (→ oil slate )
D'
D
Ss(ns)
S
s
(s)
P
Q
●
●
Sl
Qs Ql
●
p p g
Supply and Demand
Prices Go Up in the Investment Phase, But Go
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p
Down in the Exploitation Phase
log of real prices in $/barrel