LONDON (Reuters) – In their famous 2004 paper “Facts and Fantasies about Commodity Futures” Gary Gorton and Geert Rouwenhorst outlined the case for treating commodity futures as an asset class offering a similar risk premium to equities as well as diversification benefits and protection against inflation.

But is the indexing approach to investing in commodity futures still valid?

Substantial inflows of capital chasing roll returns in commodity markets have eroded the risk premium Gorton and Rouwenhorst found in the years before 2004. Rising investor participation has also tied returns more closely to those in other asset classes.

Index operators have responded by offering second and third-generation products that take a more dynamic or discretionary approach to index weightings and roll procedures in a bid to outrun the contango problem. But new products could soon become afflicted by the same crowded trade problem as their forebears.

In the end, investors may find themselves pushed towards a fully active approach via long-only discretionary funds or long/short hedge funds. There may not be any systematic risk premium to being long a basket of commodity futures, however weighted. It may be that any premiums are a return to investors’ and managers’ skill in understanding fundamentals and timing the market.

For a presentation on “Commodity index performance: the case for active management?” please click on the link here: here

LONDON, June 28 (Reuters) – There is no evidence anyone can successfully predict commodity prices. Most forecasts seem to be adaptive — reacting to past price changes — rather than forward-looking, and therefore miss turning points.

There is no evidence any forecasters consistently get it more right than wrong. Forecasts can never be more than a baseline for planning and investing surrounded by significant uncertainty.

Nonethless, preparing forecasts remains a useful exercise because it forces analysts to identify factors driving prices and how the balance might change in future. It is the process rather than the outcome that is valuable.

While equity investors have embraced this approach – valuing research for the supporting information and analysis of sensitivities as much as the price call — too much research in commodities still emphasises point forecasts . There is little consideration of the distribution of risks or of factors that might drive alternative outcomes.

Enormous resources are now being poured into commodity price forecasting but a thoughtful paper by the New York Fed casts doubt on whether it is likely to be successful.

The challenge is to transform the purpose and presentation of research. Rather than trying to help investors and hedgers predict the future (which is doomed to failure) research should help them accept and manage uncertainty in the most appropriate way .

FORECASTING FUTILITY

LONDON (Reuters) – Coal dominated the energy systems of the 19th century, giving way to petroleum in the first part of the 20th century, but the next few decades could see another huge shift to an era dominated by natural gas.

The International Energy Agency (IEA) recently asked whether the world is entering a “golden age” of gas. Gas has uniquely attractive properties that suggest it will take over from oil as the price-setting form of energy in the next two decades.

ABUNDANT, DISTRIBUTED RESOURCE

Unconventional gas from shale and coal-bed methane has doubled the estimated technically recoverable gas resource in less than a decade, ensuring that gas will remain abundant and relatively low cost.

The IEA now puts technically recoverable resources at 404 trillion cubic metres of conventional gas and another 380 trillion cubic metres from unconventional sources, equivalent to 250 years worth of current production, according to the 2010 World Energy Outlook.

Gas resources, especially shale resources, are much more widely distributed around the world than oil, ensuring the market will be more competitive and suffer less political risk.

In a recent survey, the U.S. Energy Information Administration (EIA) put world shale resources at 6,622 trillion cubic feet (188 trillion cubic metres) distributed across China (20 percent), the United States (13 percent), Argentina (12 percent), Mexico (10 percent), Australia (6 percent) Canada (6 percent) and Europe (10 percent).

LONDON (Reuters) – Forget the spot oil price. The real action Thursday following the International Energy Agency’s decision to order a release of emergency stocks was in the timespreads.

The main effect has been to erase fears about a summer shortage of seaborne light sweet crude, crushing the Brent timespreads and largely eradicating the backwardation in place since the loss of Libyan output in February.

The attached chart shows inter-month timespreads for Brent and U.S. light sweet crude futures for the remainder of 2011. (Graphic: link.reuters.com/mav32s )

While both Brent and WTI spreads tightened significantly following the unrest in Libya in February, they have since diverged sharply. Brent spreads have remained exceptionally tight, while WTI spreads began to soften again starting in late April, shortly before the heavy sell off in oil markets on May 5.

Prices for Brent contracts nearing expiry have commanded a substantial premium over both forward months and WTI amid worries about the shortfall of light sweet oil from Libya compounded by drop in North Sea output during the summer maintenance season and the likely ramp up in European refinery throughput during Q3 and Q4.

The comparative resilience of the Brent timespreads, in contrast to softening WTI spreads, explains the blowout in the spread between Brent and WTI for nearby trading months during June.

Fears about a shortfall of seaborne light sweet crude over the summer have been cited by the major commodity banks to justify forecasts of sharply higher oil prices during the rest of the year. It has also been cited by many market participants as the reason why the market remains in steep backwardation and at a record premium over WTI.

LONDON (Reuters) – The International Energy Agency’s (IEA) decision to release 60 million barrels of crude oil from strategic reserves is intended to drive speculators out of the market and resist the formation of a bubble by breaking expectations about near-term supply shortages, rather than target OPEC.

While the intervention will be intensely controversial, especially in the industry and among hedge funds and others running long positions in crude futures and options, it can be presented as a relatively limited move in response to fears about a shortage of specific grades of crude over a short time window, smoothing the process of adjustment.

It is specifically designed to counter fears about a short-term supply-demand imbalance for light sweet crude oils over the peak refining period. These worries have kept Brent futures in a steep backwardation and policymakers fear they may be contributing to the emergence of a bubble that imperils recovering economies across North America and Europe.

While the IEA’s decision is limited and sensible, it does signal the agency, prodded by the Obama administration, will take a more active approach to managing the market than before, and introduces a new dynamic and source of uncertainty into oil prices.

VOLTE FACE?

This is only the third time in its history the agency has called on member countries to make a coordinated release.

The IEA has traditionally opposed using stocks to blunt price rises. “To use the reserves for price management is dangerous and would fail … a policy of releasing oil to counteract high prices would add an additional source for speculation,” IEA Director for Energy Markets and Security Didier Houssin told the U.S. Senate in May 2009.

LONDON, June 23 (Reuters) – The International Energy Agency’s (IEA) decision to release 60 million barrels of crude oil from strategic reserves is intended to drive speculators out of the market and resist the formation of a bubble by breaking expectations about near-term supply shortages, rather than target OPEC.

While the intervention will be intensely controversial, especially in the industry and among hedge funds and others running long positions in crude futures and options, it can be presented as a relatively limited move in response to fears about a shortage of specific grades of crude over a short time window, smoothing the process of adjustment.

It is specifically designed to counter fears about a short-term supply-demand imbalance for light sweet crude oils over the peak refining period. These worries have kept Brent futures <0#LCO:> in a steep backwardation and policymakers fear they may be contributing to the emergence of a bubble that imperils recovering economies across North America and Europe.

While the IEA’s decision is limited and sensible, it does signal the agency, prodded by the Obama administration, will take a more active approach to managing the market than before, and introduces a new dynamic and source of uncertainty into oil prices.

VOLTE FACE?

This is only the third time in its history the agency has called on member countries to make a coordinated release.

The IEA has traditionally opposed using stocks to blunt price rises. “To use the reserves for price management is dangerous and would fail … a policy of releasing oil to counteract high prices would add an additional source for speculation,” IEA Director for Energy Markets and Security Didier Houssin told the U.S. Senate in May 2009.

LONDON (Reuters) – Hedge funds and other money managers continue to liquidate their net long position in WTI-linked futures and options, but the pace of drawdowns has slowed in recent weeks, and the hedge fund community still holds a bigger net long position than at any time before 2011.

In the week to June 14, hedge funds and other money managers cut their net position in WTI-linked futures and options to just 249 million barrels, from 254 million the previous week, and down from a peak of 365 million on April 26, according to data published by the U.S. Commodity Futures Trading Commission (CFTC).

It was the fifth time in seven weeks that money managers have cut their exposure to WTI. Total exposure has been reduced almost 32 percent in a series of persistent liquidations (Chart 1). But the rate has slowed in recent weeks, and the hedge fund community’s 249 million barrel position is still larger than anything it had recorded prior to December 2010 (Chart 2).

Hedge funds remain overwhelmingly bullish or at worst neutral towards oil. There are few bears. The ratio of long to short positions has fallen from 10.3:1 to 4.3:1, but it is still higher than anything recorded before February 2011 (Chart 3). There are only 75 million barrels of hedge fund short positions in WTI, which is unusually low (Chart 4).

Hedge funds have continued to run long positions in WTI-linked futures and options, even though WTI has underperformed Brent, and the WTI forward curve remains locked in contango, so it has cost them to remain long.

Continued bullishness about the short and medium term outlook seems to have persuaded many to look past the poor performance compared with Brent and the short-term roll cost of running positions.

In addition to the WTI positions, money managers were running net long of 81 million barrels in Brent futures and options. Long positions outnumbered shorts by a ratio of 3.7:1 (112 million barrels to 30 million), according to newly released data from Intercontinental Exchange.

LONDON (Reuters) – Stanford University’s Professor Kenneth Singleton has mounted the most wide-ranging and influential assault so far on the orthodoxy among policymakers and academics that speculation does not affect commodity prices.

Singleton’s paper on “Investor Flows and the 2008 Boom/Bust in Oil Prices” is generating waves across the commodity world because he is a highly respected econometrician whose findings and arguments cannot be easily dismissed as the work of the usual cranks and opponents of free markets (www.stanford.edu/~kenneths/OilPub.pdf).

Singleton argues existing theory fails to acknowledge the effect of market participants trying to anticipate the behaviour of competitors. Once this component of trader behaviour is included, the view that futures prices are determined solely by economic fundamentals is undermined.

But Singleton is just the most prominent of a new wave of economists working on commodities who are modifying long-held views about how physical and derivative markets interact.

Singleton builds on the work of Ke Tang (Renmin University), Wei Xiong (Princeton), Bahattin Buyuksahin (IEA), Michel Robe (American University) and Yiqun Mou (Columbia Business School) who have investigated links between investment and prices and challenged or modified the previous consensus.

Singleton’s findings are consistent with a presentation on “Crude Oil Price Formation” given by EIA Administrator Richard Newell in February 2011, and now showcased in a new section on the agency’s website, which gives financial factors a bigger role explaining commodity price movements.

COMMODITY MARKETS’ CREED

LONDON (Reuters) – Equity investors have long been divided over the comparative merits of active management versus passive approaches to investment — whether portfolio managers can add value beyond the returns on a broad-based equity index in a sustainable way that is not swallowed up by their fees.

“Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds,” wrote Professor Burton Malkiel, whose bestselling “Random Walk Down Wall Street” has sold over a million copies in multiple editions since 1973. It remains the most famous exposition of the merits of the index-based approach to investing.

Malkiel’s index-based approach is not without critics and an entire active management industry is based on the idea it is possible to add value beyond fees through skilful stockpicking and market timing. But it does capture an important point.

PREMIUMS FOR SHOULDERING RISK …

Equity investors should expect a positive return from simply holding a portfolio of shares because they capture an “equity risk premium” either in the form of dividends thrown off by companies or appreciation in the stock price. Malkiel doubted whether an active manager could consistently and predictably outperform the index, hence his advice to buy and hold a broad-based index.

Of course, some managers do outperform the index, occasionally for years a time, but it is almost impossible to know which ones will do so in advance. So Malkiel’s advice boiled down to the idea of buy and hold a broad index and pocket long-term returns from the equity risk premium.

The same terminology of active management versus passive index-based investing has been appropriated by sellers of commodity products — with the implication that investors can reap some sort of long-term return just for buying and holding a broad basket of commodity futures and options.

LONDON (Reuters) – “Follow the money,” FBI Deputy Director Mark Felt (“Deep Throat”) told Washington Post reporters Bob Woodward and Carl Bernstein during their investigation into the Watergate break ins.

It remains good advice for participants in commodity markets. Most of the time the river of money coursing through the market remains hidden, visible only in part to the major dealers, leaving everyone else flailing around trying to understand what is really going on.

The one place where the flow breaks at least temporarily from its hidden culvert is the weekly commitments of traders report collated and published by the U.S. Commodity Futures Trading Commission (CFTC).

And the commitment of traders report shows hedge funds and other money managers becoming less bullish about crude oil in the week to June 7. Many used firmer prices as an opportunity to liquidate more of their holdings of WTI-linked futures and options, continuing a trend that has been in place for the last six weeks.

Comment from the main commodity banks has been almost uniformly and strongly bullish — with warnings about the potential for a sharp market tightening in the second half of the year and explosive price increases. The International Energy Agency (IEA) last month also warned producers of the “urgent need for additional supplies” to prevent a further tightening of the supply-demand balance.

Prices have responded to all this insistent bullishness by firming from the lows hit in early and mid-May. But hedge funds and other money managers have used the rally to scale back their exposure and trim their record long position following the upsurge in volatility and amid signs of a faltering economy.

In the seven days ending June 7, hedge funds and other money managers cut their net long position in WTI-linked futures and options another 29 million barrels (10 percent). It was the fourth time in six weeks the macro and commodity hedge funds had cut their long positions. The net long position has been cut almost 111 million barrels (30.3 percent) since peaking on April 26 (Charts 1-2).