Opinion

The Great Debate

Short side of commodity market becomes crowded

July 15, 2010

Every successful trade and correlation contains the seeds of its own destruction. Imitators pile in and the trade becomes crowded, competing away the gains.

The first six months of 2010 was a good time to be short of commodity futures as investors were able to take advantage of a prevalent contango structure and little if any increase in outright prices.

But there are signs the short side has become saturated. There are no longer automatic benefits from establishing a short position and rolling it forward.

NARROWING CONTANGO

Contangos for a wide range of commodity markets have been narrowing, or even replaced by backwardations.
In base metals, the contango structures for primary aluminium, copper and alloy have narrowed in recent weeks, as my colleague Andy Home pointed out in a column yesterday.

In energy, the discount for front-month light sweet crude oil futures  has shrunk from $4.50 per barrel in May to 39 cents. Front-month Brent futures even moved into a fleeting backwardation this week.

There are distinctive technical factors in each case behind movements in the curve structure (including a drop in North Sea output owing to planned maintenance, and the non-availability of much of the reported LME warehouse tied up in rent deals).

But there is also a broader trend. Substantial discounts for prompt futures recorded for almost two years are disappearing.

As a result, monthly roll losses for long-only investors in major commodity indices are easing. In some instances, long-only investors are starting to see positive roll yields.
(1) http://graphics.thomsonreuters.com/ce/ROLLS1.pdf (2) http://graphics.thomsonreuters.com/ce/ROLLS2.pdf

Investors with a long position in the Standard and Poor’s Goldman Sachs Commodity Index <.SPGSCI> still incurred losses on the roll this month, but roll losses are on course to be the smallest since October 2008 (Chart 1). The non-energy components of the GSCI are on course to report their first positive roll since May 2007 (Chart 2).

FUTURES LONGS: CUI BONO?
Respected oil expert Philip Verleger argues the influx of investment money into the long side of commodity futures markets since 2004 has encouraged increased output and investment by producers, and incentivised banks and merchants to hold and finance more inventories, by supporting outright prices and forcing derivatives markets into a contango structure.

According to Verleger, the result has been a reduction in short-term volatility. Increased inventories have insulated the market against shocks such as the global recession in 2008-09 and the unusually cold northern hemisphere winter in 2009-10.

Long investments in commodity derivatives through indices such as the GSCI and, exchange-traded products, as well as more speculative plays by hedge funds have all benefited both producers and consumers through the reduction in volatility, in this view.

But what have the longs gained in return? They are not altruists, after all.

During the bull market of 2005-2008, commodity longs benefited from the massive escalation of outright prices, which far offset relatively small monthly losses from rolling positions forward in contango markets. Since then, prices have fallen sharply, then stabilised. With little or no flat price appreciation, long-only futures investors have nursed only the roll losses.

CASH AND CARRY STRATEGY

Banks, swap dealers and merchants have mostly taken the opposite side to investors, buying and storing record quantities of raw materials, and hedging their physical stock with a short position in commodity futures, rolling the short futures position forward each month to obtain the contango.

he strategy (known as cash-and-carry) is profitable because returns available from rolling a short position forward in the contango far exceed the actual costs of storage and borrowing money to finance the physical position.

It has been especially profitable for banks and large oil companies with access to cheap borrowing. Cash-and-carry strategies have essentially depended on the availability of cheap finance from central banks and the money markets.

The system has contributed to record profits for the commodity divisions of major banks, as well as companies specialising in storing petroleum, metals and grains. The rush to secure cheap storage and exploit synergies with trading business has prompted a wave of takeovers of LME warehousing firms by investment banks this year.

ALL WANT TO BE SHORT NOW

It was only a matter of time before the longs (including pension funds) realised their monthly rolls were fattening the profits of the shorts and the warehouses, and either quit the market or decided to join them on the short side, at least for some contracts and some parts of the futures curve.

The major index operators have responded by promoting variants which try to minimise roll losses. They roll less frequently, shift positions further forward along the curve (where contango is smaller), or re-allocate investments towards commodity markets with the smallest contango or biggest backwardation.

SummerHaven Investment Management last year launched a fund that employs a more active approach to allocation. Ironically, the fund is advised by Geert Rouwenhort and Gary Gorton, whose paper on long-term returns to passive investments in commodity futures helped fuel the upsurge in interest from investors in the first place.
There have been tantalising signs of more investors joining banks and merchants on the short side, at least for some commodities.

Quarterly data on investors’ index positions published by the U.S. Commodity Futures Trading Commission (CFTC) show the ratio of long positions to shorts had fallen to just 3.95:1 at the end of Q1 2010, down from 4.70:1 when the commodity boom was peaking in Q2 2008.

The shift is even more pronounced in energy futures contracts, which have been plagued by the greatest degree of contango, where the ratio of longs to shorts has fallen to just 3.88:1, down from 5.34:1 at the end of Q2 2008 (Chart 3).
The next set of quarterly data, revealing positions at the end of Q2 2010, due later this month, will be scrutinised for signs the drift to the short side has continued.

It is not just index investors that have been shifting to the short side in the quest for better returns. Hedge funds and active money managers also show increasing interest in shorting at least some commodity markets.

Overall, money managers are still running net long in WTI-linked commodity derivatives, according to commitments of traders data. But the net long position has concealed a record number of shorts (not spreads but outright shorts) (Chart 4).

(3) http://graphics.thomsonreuters.com/ce/CFTC-IDX-RATIO.pdf (4) http://graphics.thomsonreuters.com/ce/WTI-COT-MM.pdf

If the first half of 2010 was a good time to be short, the easy gains from the short/contango strategy are disappearing as the trade becomes increasingly crowded.

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