The darkest period before dawn?

July 12, 2010


Abandon hope all ye who enter here was the inscription written above the gates of Hell in Dante’s Divine Comedy.

Investors who decided to take a long position in commodity futures at the start of 2010 anticipating a global recovery, tightening supply-demand balances, and rising prices, could be forgiven a sense of despair.

Their risk-taking has been rewarded with range-bound prices and a contango eating deeply into returns. Most longs lost money in H1 2010.

Flagship U.S. oil prices have moved sideways for the last 12 months, while negative contango rolls ensured investors lost around 13 percent since the start of the year.

The problem is not confined to WTI, which has been likened by some analysts to a “chocolate teapot” because of its sensitivity to inventories around the delivery point at Cushing. An investment in Brent futures, which reflects the seaborne international oil market more faithfully, according to analysts, is down just over 9 percent on a total return basis.

Oil is not the only commodity which has underperformed in H1. The Standard and Poor’s Goldman Sachs Non-Energy Index has produced negative returns of 8.5 percent so far this year.

Only seven of the 24 commodities in the GSCI have seen any sort of backwardation, and only two of them consistently, leaving investors dependent on rising spot prices to have any hope of making money. Spot markets have resolutely failed to respond.

It wasn’t meant to be this way. Commodity prices are meant to outperform in the early stages of an expansion, and especially when inflation is driven by raw materials rather than labour costs, according to a report by the California State Teachers Retirement System (CalSTRS), which decided to make an allocation to commodities in June.

While the year began with comfortable supply-demand balances and a stock overhang inherited from the recession, sustained demand in emerging markets, accelerating growth in the advanced economies, and the prospect of supply bottlenecks re-emerging as early as 2011-2012, was meant to ensure strong gains.

Instead, the first half was a good time to be short and pocket the monthly gains from rolling a short position forward in a contango structure. Pension funds and other longs essentially paid merchants, banks and shorts to accumulate and finance large amounts of physical inventory.

So is it time for the longs to abandon hope and join the banks and merchants on the short side to benefit from the contango rolls? Or is this the darkest period before dawn? Should longs keep faith and see this as a period of testing before they are rewarded again? Is this the path through purgatory to eventual paradise?

The future is essentially unknowable and stochastic, as I have observed elsewhere; I am not about to break my own rule by offering a single forecast for commodity returns. But it is worth reviewing the three factors that made longs so miserable in the first six months to ask whether there is any reason to expect them to change in future.

Demand growth has failed to come through for the longs. Not current demand but expectations about the future. As many analysts have observed, commodity prices have become increasingly forward looking, anticipating scarcity two to five years down the road, more than current supply-demand-inventory dynamics. The market has “capitalised” or brought forward future demand growth and reflected it in present prices.

Prices rose as speculators and hedgers anticipated a robust expansion spreading from emerging markets back to the advanced industrial economies of North America and Europe.

In the past, synchronised growth has been good for commodities. At least one major bank predicted a repeat of the acute bottlenecks and sharp price rises experienced in H1 2008.

But the European debt crisis, faltering U.S. growth and housing markets, and renewed global risk aversion have darkened the outlook, with oil and other commodity prices marked down accordingly as some of the froth (capitalised forward demand) dissipates. For commodity longs, the question is whether markets generally have become too pessimistic.

Markets are increasingly valuing assets on the basis of a U-shaped distribution of returns, rather than a bell curve, and may be assigning too much weight to really bad outcomes associated with renewed recession and deflation at the expense of middling outcomes associated with “muddling through”.

If the economy pulls through with continued albeit modest growth, demand will pick up and gradually draw down excess inventories and capacity. It would help steady prices and create potential for some upside movement. It would also provide a rationale for persevering with a long strategy.

The other issue for investors is whether the contango will disappear or at least narrow so that it does less damage. The extreme contango which appeared in oil markets between April and early June has largely evaporated.

But there is no sign oil markets are about to move into a more long-friendly backwardation structure. Backs have become increasingly scarce across the whole commodities complex, and there are indications the huge inflow of investor money concentrated on the long side of the market has permanently changed the forward price structure so that they will be much rarer in future.

Investors need to answer three questions:

(a) How much of the contango is the (exogenous) result of high levels of inventories, which should gradually correct as demand grows and stocks draw down; and how much is it the (endogenous) result of strong long-only investor interest, which could keep the market in contango and stocks high throughout the cycle?

(b) Even if the market is locked in a structural contango, will it narrow enough that the costs of rolling positions forward are offset by price gains?

(c) How long can the market stay in contango with little or no movement in flat prices before the longs give up and either exit the market or join the shorts, bringing the structural contango to an end?

Even investors such as pension funds do not have infinite patience. While their long positions may help dampen volatility by encouraging higher levels of inventories, they are not altruists. For longs to remain long, there must eventually be some reward.

If the market stays in contango with no offsetting price rises, many will eventually give up or try to join the short side, at which point the contango will gradually disappear. Recent quarterly investment data from the Commodity Futures Trading Commission suggests investors are already starting to show increased interest in the short side.

If the lifting of excessive pessimism and a possible reduction in contango give commodity longs reason to hope, the improving supply picture should give them pause.

The interruption of demand growth during the recession and early stages of the recovery has given commodity producers an extra 2-3 years to bring on more capacity and pushed back the timing of any future supply crunch. The International Energy Agency (IEA), for example, believes that the oil market will remain comfortably supplied through 2015.

While prices have pulled back sharply since their peak in summer 2008, they remain high in historical and real terms. Producer cash flow is strong. After a brief pause in late 2008 and early 2009, producers have mostly resumed investment. Stable real oil prices in the range of $70-80 should be sufficient in the coming years. The same is true for many other commodities.

The second half of 2010 may be less painful for longs if demand pessimism dissipates and the extreme contango manifest in H1 does not return. Even so, investors will have to weigh carefully whether this is the right moment for a long strategy, or whether to stay short or out of the market until the expansion matures further and balances start to tighten.

One comment

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So many wasted words for such a simple investing issue: when volatility goes up, one should invest short; when the volatility drops off, then go long. If these ‘investors’ got burned by holding on to beliefs instead of re-examining their holdings as new data came in then they deserve to get burned. Caveat Emptor pal

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