Introduction and Theories of Return

Fundamental Analysis

Supply and demand shocks affect commodity prices. Fundamental analysis seeks to predict these shocks using a variety of inputs/tools such as the following:

Announcements. Government or private agencies produce forecasts, which can be useful for analysts in their models.

Component analysis. Different products that make up the commodity class are the components of that commodity (e.g., jet fuel, diesel, gasoline, and lubricants are components of crude oil). Analysis of demand and supply forecasts of components can fine tune the forecasts for the aggregate.

Timing issues. Incorporating any seasonality and previously observed logistical issues can refine estimates of demand/supply.

Macro. Macroeconomic factors such as inflation may trigger an increase in demand for commodities. Low interest rates may increase capital spending and, therefore, the demand for commodities in the intermediate term.

Commodities can be classified by their characteristics into sectors, including:

Energy, crude oil, natural gas, and refined petroleum products.

Industrial metals, aluminum, nickel, zinc, lead, tin, iron, and copper.

Grains, wheat, corn, soybeans, and rice.

Livestock, hogs, sheep, cattle, and poultry.

Precious metals, gold, silver, and platinum.

Softs (cash crops), coffee, sugar, cocoa, and cotton.

The factors that influence supply and demand and the nature of production differ for these sectors. A summary of these differences can help explain the differences in price dynamics among the sectors.

The energy sector comprises crude oil, natural gas, and refined products. It is the sector with the greatest market value and is a very important source of revenue to many countries and regions.

Crude oil from different regions has different characteristics. Light oil (low viscosity) and sweet oil (low sulfur content) are less costly to refine and, therefore, sell at a premium relative to heavier or higher sulfur crude oils. Crude oil can be stored indefinitely by keeping it in the ground and is also stored in tanks and aboard tanker ships.

Many countries store large amounts of crude oil as strategic reserves.

The supply of crude oil has been augmented by advances in drilling and extraction technology, especially in the 21st century. While global economic growth is an important driver of worldwide demand for oil, other factors have slowed this growth in demand. Improvements in refining technology have tended to increase the output of petroleum distillates from each barrel of crude oil, and improved engines are able to produce more work from each gallon of these distillates.

Economic cycles also affect the demand for oil, which is higher during expansions when credit is widely available and can decrease sharply when contractions lead to reductions in the availability of credit.

Improvements in the efficiency of alternative sources of energy production have also reduced the overall growth in the demand for oil. Increasingly stringent restrictions on oil exploration and production in response to environmental concerns have tended to increase the cost of oil production and decrease supply.

Political risk is an important factor in oil supply. Over half the crude oil supply comes from countries in the Middle East, and conflict there can reduce supply dramatically.

Refined products such as gasoline, heating oil, and jet fuel, are only stored for short periods. Refinery output is the relevant supply consideration. The geographic concentration of refinery capacity means that extreme weather in some coastal regions can significantly affect the supply of refined products.

Seasonal factors affect the demand for refined products in that greater vacation travel in the summer months increases gasoline demand, and colder weather in the winter increases the demand for heating oil.

Unlike crude oil, natural gas can be used just as it comes out of the ground with very little processing. Transportation costs play an important role in energy pricing. Crude oil can be transported at a relatively low cost on ships, while natural gas must be cooled to its liquid state to be transported by ship, significantly increasing the cost of transport.

The supply of associated gas, gas produced in conjunction with the extraction of crude oil, is tied to the production of crude oil. Unassociated gas is produced from formations where oil is not present so that its supply is not tied to the demand for and production of crude oil.

Worldwide demand and supply for gas depends on many of the same factors as supply and demand for crude oil, but seasonality due to weather is more pronounced. Cold winters increase the demand for gas for heating fuel. Hot summers increase the demand for gas as well (for cooling) because gas is a primary source of fuel for electrical power generation.

Demand for industrial metals is primarily tied to GDP growth and business cycles because these metals are used extensively in construction and manufacturing. Storage of metals is not costly.

Political factors, especially union strikes and restrictive environmental regulations, can have a significant effect on the supply of an industrial metal. Industrial metals must be smelted from mined ore. Both mines and smelters are large scale operations with high development costs and high fixed costs.

Grains are grown over an annual cycle and stored, although multiple crops in a single year are possible in some areas. The risks to grain supply are the usual: droughts, hail, floods, pests, diseases, changes in climate, and so on. It would be difficult to overstate the importance of grains in feeding the world’s population, especially given the potential for political instability when grain stocks are insufficient.

Precious metals are used in electronics and for jewelry and can be stored indefinitely. Gold has long been used as a store of value and has provided a hedge against the inflation risk of holding currency. Jewelry demand is high where wealth is being accumulated.

Industrial demand for precious metals is sensitive to business cycles.

Livestock supply depends on the price of grain, which is the primary input in its production. When increasing grain prices increase the cost of feeding livestock, the rate of slaughter also increases, which leads to a decrease in price. Such a drawdown in population can result in subsequent increases in price over time.

Weather can affect the production of some animals. Disease is a source of significant risk to livestock producers, and some diseases have had a large impact on market prices.

Income growth in developing economies is an important source of growth in demand for livestock. Freezing allows the storage of meat products for a limited amount of time.

Softs refers to cotton, coffee, sugar, and cocoa, which are all grown in the warmer climates of the lower latitudes. Just as with grains, weather is the primary factor in determining production and price, but disease is a significant risk as well. Demand increases with increases in incomes in developing economies but is dependent on consumer tastes as well.

The life cycle of crude oil begins with the time it takes to drill a well and extract the crude. After being transported, crude oil is typically stored for no more than a few months. The next step is refining the crude oil into various fuels such as gasoline, heating oil, diesel oil, and jet fuel.

These fuels must then be transported to the consumer.

Natural gas requires minimal processing after it is extracted. While natural gas often reaches the consumer through a pipeline, it can be cooled to liquid form and transported on specially constructed ships. Energy commodities are delivered year round, but demand is seasonal to some extent.

The life cycle of industrial metals is straightforward: the extracted ore is smelted into the quality of metal that end users need. Industrial metals can be stored indefinitely in most cases, and the regular flow of output means that end users can meet their needs with monthly deliverable futures contracts.

A key characteristic of industrial metals production is economies of scale due to large, efficient mining and smelting operations. The large size projects required for efficient operation cost billions of dollars and take significant time to construct. Construction of new capacity or facilities when capacity utilization and earnings are high can result in the additional capacity coming online at or past the peak of the economic cycle.

Mining and smelting operations are most efficient running near their capacity, so individual producers are hesitant to decrease production when prices fall because the peak of the economic cycle has passed or because facilities growth has created excess capacity in the industry.

Livestock production times vary with animal size, with chickens ready for slaughter after only weeks, hogs in about six months, and cattle after a few years. Freezing allows storage for some period after slaughter and allows international trade in livestock products such as frozen beef. Livestock production has a significant seasonal component.

Grain production is seasonal, so deliverable futures contracts are available on dates to coincide with the harvest. Because planting occurs five months or more before harvest, quantities harvested are set largely by expectations for demand when crops are planted. Grains can be stored for significant time periods after harvest.

The six month offset to harvest times in the northern and southern hemispheres brings crops to markets more frequently.

Production cycles and storage options for softs vary by product. Among softs, coffee offers an example of an agricultural commodity that is harvested somewhere around the world in almost every month. Coffee is stored in warehouses after transport by ship.

Local coffee roasters then roast the beans and deliver to end users or to retail sales outlets. Coffee plants can take up to four years to produce the fruit that will become coffee beans, so there is a significant lag between investment in new capacity and increases in supply.

To hedge their price risk, coffee producers can sell in the futures market for delivery to a warehouse, and consumer companies can buy in the futures market and take delivery at the warehouse. Two different types of coffee beans are traded, Robusta and Arabica, with Arabica being the premium product.

Unlike stocks and bonds, commodities are physical assets, have no cash flows, and may incur storage and transportation costs.

Stocks and bonds (financial assets) can be valued by calculating the present value of their expected future cash flows (e.g., dividends, interest, etc.). Commodities produce no earnings or cash flows; however, the current (spot) price of a commodity can be viewed as the discounted value of the expected selling price at some future date. Storage costs for commodities can lead to forward prices that are higher the further the forward settlement date is in the future.

Participants in commodity futures markets can be categorized as hedgers, traders and investors, exchanges, analysts, and regulators.

Traders and investors in the commodities market can be classified as informed investors, those who provide liquidity to the markets, and arbitrageurs. Hedgers are considered informed investors because they either produce or use the commodity. Hedgers reduce their risk by buying (going long) or selling (going short) futures contracts.

A corn farmer can reduce the uncertainty about the price she will receive for her corn by selling corn futures.

A cattle producer, however, would hedge his price risk by buying corn futures to reduce his uncertainty about the cost of feed for the cattle.

Speculators take on commodity risk in futures markets and may act as informed investors, seeking to exploit an information or information processing advantage to profit from trading with hedgers. Speculators can also earn profits by providing liquidity to markets: buying futures when short hedgers (commodity producers) are selling and selling futures when long hedgers (commodity users) are buying.

Arbitrageurs in the commodity markets are often those in the business of buying, selling, and storing the physical commodities when the difference between spot and futures prices is too large or too small based on the actual cost of storing the commodity. When the difference is too large, an arbitrageur can buy and store the commodity and sell it at its (too high) futures price. When the difference is too small, an arbitrageur can effectively “not store” the commodity by selling from his own inventory and going long futures, replacing the inventory at the future date.

Commodity exchanges operate in many of the world’s financial centers to reflect the worldwide production and consumption of commodities as well as the globalization of financial markets in general. Investors can trade commodity futures on a smart phone or via a Bloomberg terminal.

Commodity market analysts, considered non market participants, use market information to perform analytical work for various entities including governments, universities, economic forecasters, and commercial data analysis firms.

Various commodity regulators are responsible for the regulation of commodities markets around the world. In the U.S., the Commodities Futures Trading Commission (CFTC) is responsible for market regulation.

The difference between the spot (cash) market price and the futures price for a date in the future is referred to as the basis of that particular contract. The basis is calculated as the spot price minus the futures price and can be positive or negative. The difference between the futures price of a nearer maturity and the futures price of a more distant maturity is known as the calendar spread.

When futures prices are higher at dates further in the future, the futures market (or futures curve) is said to be in contango. In a contango market, the calendar spread and basis are negative. Conversely, if futures prices are lower at dates further in the future, the market is said to be in backwardation, and the basis and calendar spread are positive.

When a futures market is in backwardation, long futures positions have a positive returns component (the “roll return,” which we will describe later in this topic review). With a futures curve in backwardation, futures prices are lower than spot prices for the commodity. Since futures prices converge to spot prices over the term of a futures contract, there is a positive returns component from the passage of time.

When a futures market is in contango, so that futures prices are greater than spot prices, there is a negative returns component for long futures positions. As time passes, convergence of futures prices to spot prices (or longer dated futures prices to nearer term futures prices) results in a decrease in the value of a long futures position.

Three theories of the determinants of returns on commodities, based on the shape of the futures curve, have been expounded: the Insurance Theory, the Hedging Pressure Hypothesis, and the Theory of Storage.

Economist John Maynard Keynes put forward the Insurance Theory of futures returns, which states that the desire of commodity producers to reduce their price risk drives commodity futures returns. Producers face uncertainty about the price they will receive for their output and reduce this uncertainty by selling futures contracts. This selling drives down futures prices.

The Insurance Theory states that the futures prices will be less than current spot prices to provide a return to those buying futures from producers (i.e., speculators). In this view, the resulting positive return to the buyers of futures contracts is their return for providing insurance against price uncertainty to producers. Keynes contended that this results in backwardation “normally,” and the situation was termed “normal backwardation” based on this theory.

The Insurance Theory was found to be lacking based on two empirical findings. The first finding is that for markets in backwardation, buying futures has not resulted in the extra returns the theory says buyers should receive for providing “insurance.” The second finding is that many markets are not in backwardation but are in contango (future prices higher than spot prices), which would imply a negative return for providing insurance to producers.

The Hedging Pressure Hypothesis added the hedging behavior of commodity consumers to the Insurance Theory in an attempt to better explain observed futures returns. Just as a wheat farmer faces uncertainty about the price at which he will sell his wheat in the future, a baking company faces uncertainty about the price it will pay for flour in the future. To hedge its price risk, the baking company will go long wheat futures.

The more commodity users hedge with long positions (buying futures), the more upward price pressure there is on the futures price. Under the Hedging Pressure Hypothesis, when producers’ hedging behavior dominates, the market will be in backwardation, and when users’ hedging behavior dominates, the market will be in contango.

Despite the intuitive appeal of the Hedging Pressure Hypothesis, it has some shortcomings. Producers typically face more concentrated price risk than consumers. Individual consumers will spend only a small portion of their income on a single commodity, and for commercial users of the commodity, the actual cost of the commodity may represent only a small portion of the total cost of the production.

Additionally, both producers and consumers may be speculators in the market, not just hedgers. Another problem with the Hedging Pressure Hypothesis is that hedging pressure is not observable, so we cannot directly test the hypothesis that relative hedging pressure is the cause of backwardation and contango.

The Theory of Storage is based on the idea that whether a futures market is in backwardation or contango depends on the relationship between the costs of storing the commodity for future use and the benefits of holding physical inventory of the commodity. When the costs of storage outweigh the benefits of holding physical inventory, futures are more attractive than current inventory, futures will trade at a higher price than spot, and the market will be in contango. Conversely, when the benefits of holding physical inventory outweigh the costs of storage, current possession is more attractive than future possession, spot prices are higher than futures prices, and the market will be in backwardation.

The benefits of having physical inventory available are referred to as a commodity’s convenience yield. When physical stocks are low and there is a high probability that the commodity will be in short supply, the benefits of holding physical stock (and the convenience yield) are higher.

The Theory of Storage takes both the costs and benefits of holding a commodity into account in the following relation:

Relative to spot prices, futures prices are higher when storage costs are higher, and futures prices are lower when the convenience yield is higher. Further, we can say that the shape of the futures price curve depends on available supply (i.e., current inventory of the commodity) along with expected future supply and demand.

Even with these three theories, we are left without a complete theory of commodity futures returns. “Hedging pressure” and “convenience yield” are not observable, and storage costs are not readily disclosed by participant firms.