As we have explained before, one consequence of low interest rates has been savvy traders’ pursuit for yield via the commodity contango trade — first made famous in the oil floating storage trade.
And it is true to say, this has mostly been made possible by the rush of so-called speculators into passive long-only positions along the curve. Although these investors might better be described as ‘wealth preservationists’ rather than evil speculators.
The background here is that the long side of the curve in commodities was traditionally always set in backwardation (the opposite of contango, when futures prices are lower than spot). This was because the curve had developed as a financial method for producers to hedge downside risk — meaning most of the risk befell those going long on the opposite side of the trade.
It consequently also meant that those going long demanded compensation for taking that risk — something which was achieved via the backwardation premium at rollover.
However, with the long side increasingly focused on wealth preservation rather than speculation, the risk along the curve has over the last five years or so shifted to the short side — resulting in a contango structure.
Et voila, the most rewarding ‘have your chocolate cake and eat it’ trade in all of history may have become the consequence. For, if you have the means to go physically long the commodity and short the paper, you can quite literally have it all.
You can gather contango yield (which is attractive in a low interest rate environment), whilst also speculating on the appreciation of the underlying price.
Which is where the efficiency of futures markets may have headed into a brick wall. For even if futures do always converge with the physical, the fact that physical players are keen to exploit the changing dynamics of the futures curve has led to the hoarding of physical commodities and speculation on underlying price.
Of course, efficient markets theory — or more specifically Hotelling’s theory — dictates that eventually the curve should flatten and the hoarded sums be liquidated, bringing prices back into kilter. But, it also says that will happen only if interest rates become high enough to incentivise producers to store their ‘wealth’ in cash rather than commodities.
The fact this has not happened (yet), is therefore more demonstrative of the level of wealth preservation hysteria on the long-side, than any real commodity shortage. It may also be indicating there’s something really wrong with keeping rates as low as they are.
Interestingly, it’s a signal some central bankers were acutely aware of, although chose to ignore, even before the bulk of long-only funds started building up positions on the curve.
Note, the following from a speech by Jean-Claude Trichet back in 2006:
Have financial investors played a stabilising or a destabilizing role at a time of booming commodity prices and heightened uncertainty about their long-term fundamentals? According to a benign view, “financial investors” have expanded liquidity in commodity markets, and have made the market more efficient in processing information, thus improving price discovery at a time of greater uncertainty about fundamentals.
New financial actors such as highly leveraged funds and institutional investors may have contributed to lowering spreads and the associated risk premia in commodity futures markets by spreading their own portfolio risk more widely. In this sense, they may even have strengthened the traditional insurance role of futures markets. In addition, financial investors may have helped bring forward price increases that would have occurred nonetheless. This may have provided a signal to both consumers and producers that they needed to start adjusting their consumption and investment plans before the economy hits the physical constraints of oil supply. In this sense, some volatility today might have been the price to pay to avoid even higher volatility in the future.
But, according to an opposite interpretation, financial investors operating systematically on the futures market might have reduced the risk and the cost faced by sellers who want to accumulate inventories, or possibly delay production to gain from steep anticipated price trends. In this way they might have exacerbated changes in prices and inventories due to predicted changes in fundamentals. They might have sent noisier and potentially distorted signals to producers and consumers.
If this seems to me a reasonable conjecture, I admit, though, that existing evidence does not provide uncontroversial support to the notion that non-commercial investors in futures markets have been systematically playing a significant role in pushing spot prices out of their fundamental equilibrium.
And the following from Philipp Hildebrand, member of the Governing Board of the Swiss National Bank, also in 2006:
The case for diversification with regard to investing in commodities may therefore well remain intact. With regard to returns, however, things appear more complicated, particularly if we base our analysis on the return of commodity futures indices.
In the past, most commodity markets have been in backwardation: futures prices were lower than the spot price. This was beneficial to investors buying commodity futures, because they could profit from a so-called roll-yield. This yield can be interpreted as a risk premium priced into the futures contract to compensate the holder for bearing the commodity price risk.
However, if the number of investors ready to bear this risk increases significantly, the risk premium could disappear or even turn negative. In fact, for some time now, the near-term structure of many commodity prices has experienced a change from backwardation to contango. It seems to me, there may well be a connection between this change from backwardation to contango and the growing trend to invest in commodity futures.
Given all of the above, the key point to consider then is what happens when the contango trade gets too crowded and efficient markets theory prevails?
Of course, if you believe in Hotelling’s theory, there’s no chance of that happening until interest rates begin to rise.
Related links:
Short side of commodity market becomes crowded – John Kemp
Monetary policy and commodity prices – VoxEU.org
The end of diversification? - FT Alphaville