Commodities Market Commentary, Investment Process, and the Passage of Time

Commodities Market Summary

  • Energy: As measured by the S&P GSCI indices, energy lost 1.9% in May, natural gas lost 9.4%. WTI crude oil and brent crude oil markets continued to exhibit an undertone, due to a market of surplus, which was over 2 million barrels per day. Relative to volume, the open interest (total number of options/future contracts that are not delivered on a particular day) increases on a price advances is generally below average, indicating that market participants are not willing to make a strong commitments at the upper end of the trading range.
  • Agriculture: Agriculture declined by 61 bps. Delayed plantings, which were caused by the wet weather, were the main driver of performance in grains; corn market rebounded over concerns on both the size of the U.S. planting area and the yields; soybeans rose as the purchase from China increased, as well as low inventories; softs fell 7.2% during the period; other U.S. agriculture sub-sectors, cotton, sugar, cocoa, and coffee were pressured by higher-than-anticipated U.S. inventories, reduced buying from China, the rainfall in West Africa, and the healthy Brazilian supply; oil seeds market rallied on severe planning delays of soybean in the U.S., and a slow export pace of soybean from Argentina; there are also large palm oil inventories.
  • Livestock: The S&P GSCI Live Cattle and the S&P GSCI Feeder Cattle Indices were down 1.3%, and 3.1%, respectively, while the lean hogs returned 1.1% during the month on a rising demand as the seasonal peak approaches.
  • Precious Metals: Precious metals remained weak. The net-long position by gold speculators was the smallest since 2005. U.S. silver data is showing six-year high in consumer sentiment; forecasts in the silver market also remain overoptimistic given the current spot price (June 28th 2013 Last $19.66).
  • Base Metals: Base metals market was one of the few that delivered a positive return, with the exception of nickel. Lead posted a strong 9.0%, primarily driven by its declining inventories; nickel, on the other hand, whose inventories were high, resulted in  pressure on the prices, which fell 3.8%; copper production in Chile dropped due to strikes, production line problems, and lower ore grades in some deposits. Beyond that, some of China’s largest copper smelters have stalled due to shortages of scrap, which reduced copper output in the region. According to the China’s National Bureau of Statistics, Chinese Purchasing Managers’ Index (PMI) were up 20 bps, meaning that demand remained positive. The fact that overall base metals market outperformed the precious metals market may indicate optimism about global economic growth.
  • Equities: On the equities side, there was wide divergence between the performance of commodity equities and commodity prices overall year to date. Gold mining shares, as measured by the NYSE Arca Gold Miners Index (GDM), outperformed underlying gold commodity.

Hard assets are defined and categorized as the foundation of industrial economies. The typical investment vehicles to obtain the market exposures are:

  • Equities – generally offer good liquidity, but subject to broad stock market risk
  • Index futures/index total return swaps/money market instruments – usually over-concentrate in credit; they have reasonable liquidity but are generally expensive
  • Futures/hedge funds/leveraged – not liquid, and the risks vary
  • ETFs/ETNs – may invest in single commodity and hold it in physical storage, or may invest in futures contracts. Since leverage is used through derivatives purchase, they may have large portions of cash.

Investment Process Outline

1. Global Market View:

  • Macroeconomic indicators, global infrastructure builds, resource nationalization (macro)
  • New Technology, substitution, structural changes in end-user markets (micro)

2.1 Commodity Analysis (bottom up)

a) Fundamental Analysis – demand/supply balances, market forecasts, and production trends

  • Supply analysis in commodity investing typically considers current productions capacity and expectations, greenfield projects and brownfield projects (for environmental impact study), resource nationalization (capital budgeting purpose), supply constraints (labor, equipment, power shortages, grade quality, infrastructure), and inventory levels.
  • Demand analysis analyzes leading economic indicators (OECD and non-OECD), global infrastructure build, industrialization/urbanization, and speculative money flows.

b) Quantitative Analysis

  • Multi-linear regression models for each individual commodity, with parameters of total supply, stock to use, world ending stock, total world consumption, inventories, trend, and percentage of global consumption by producing domiciles.

c) Technical/Chart Analysis

  • (I will expand this section later as there are many different perspectives to discuss technical analysis in general and in commodities investing particularly) To summarize, we capture price support, moving average, parabolic indicator, trend reversal, widening bands, new trend is commenced or not.

d) Sentiment Analysis/Consensus

2.2 Commodity Company Analysis (Equity Valuation)

a) Asset-based valuation for asset-intensive resource companies, such as mining, oil/gas exploration, and production

  • Domicile and quality of resource base, grade, cost structure, reserve life, probable increase/decrease in reserve base, hedging programs, balance sheet factors, and capital spending programs.

b) Earnings- and cash-flow-based valuation for processing-oriented companies, e.g., integrated oil and aluminum

  • Analysis of trough, peak, and normalized commodity pricing environments, consequent impact of pricing on margins, and profits and return on capital employed.

c) Screen for value

  • Adjusted value per ounce of reserves and net asset value, for instance.

d) Potential catalysts to unlock value

  • Recapitalization, restructuring, consolidation, new resource discoveries, management changes.

3. Portfolio Construction

  • Upside/downside outlook
  • Country allocation
  • Sector exposure
  • Commodity selection and positions
  • Cash strategy determination

4. Risk Control

  • Total positions (maximum and minimum of longs)
  • Diversification limits by sector, by commodity, by asset
  • Concentration of top positions

5. Trade Evaluation

  • Types of trades: equity, commodity futures, linked notes, etc.
  • Position size: volatility of position, liquidity, degree of conviction
  • Technical analysis helps with entry/exit

6. Asset Allocation

Commodity Indices Selection

Benchmarking the appropriate index is essential in assessing a commodity fund’s performance. The key difference in commodity indices is the “rolling,” since these indices are composed of futures on physical commodities, which normally specify a certain date for the delivery of the underlying physical commodity. In order to avoid the delivery process and maintain a long futures position, nearby contracts must be sold and contracts that have not yet reached the delivery period must be purchased.

1) The Dow Jones –UBS Commodity Index (DJ-UBSCI) currently has 19 commodity futures in seven sectors. No one commodity can compose less than 2% or more than 15%, and no sector can represent more than 33% of the index. The DJ-UBSCI is rebalanced annually.

2) The S&P GSCI (Goldman Sachs Commodity Index) is a tradable index available to market participants of the Chicago Mercantile Exchange. The index was developed by Goldman Sachs, and in 2007, the ownership transferred to Standard & Poors. Futures of the S&P GSCI use a multiple of 250. The S&P GSCI is a world-production weighted index that is based on the average quantity of production of each commodity index over the last five years of data, which allows the S&P GSCI to be measure of investment performance as well as a better economic indicator. It is important to note that the index contains a much higher exposure to energy than the DJ-UBSCI.

3) The Thomson Reuters/Jefferies CRB Index (TR/J CRB) was first calculated by Commodity Research Bureau, Inc. in 1957. The index was originally composed of 28 commodities, 26 of which were traded on exchanges in the U.S. and Canada, and two cash markets. In addition to the 26 markets, the index also included the spot New Orleans cotton and Minneapolis wheat markets which were added to balance some commodities repeated in the index as by-products of other commodities.

4) The Rogers International Commodity Index (RICI) was designed by Jim Rogers in 1996. It tracks 38 commodity futures contracts from 13 international exchanges. The index is rolled at the end of each month to contracts that are expected to be most active during the next month. Generally, if the next calendar month of a futures contract includes a first notice day, a delivery day or historical evidence that liquidity migrates to a next contract month during this period, then the next contract month is intended to be applied to calculate the index, taking legal constraints into account. Each commodity is rebalanced on the start of each month, determined annually by the RICI Committee.

5) The Deutsche Bank Liquid Commodity Index (DBLCI) was launched in February 2003. It tracks only six commodities: WTI crude oil, heating oil, aluminum, gold, corn, and wheat. It is market value weighted, with energy at 55 percent and precious metals at 10 percent. Since there is not much diversification in the index, the volatility can be high, but costs are lower.

The Impact of Time in Commodities Investing

In addition to demand/supply, time is also a powerful fundamental. Time enters explicitly into formulas that are used to price options (theta), and it features in all elements of futures pricing, i.e., the cost of financing, cost of storage, and convenience yield.

In many instances, cost of storage is absent from commodity market analysis. The passage of time is misapplied in the investment process. Investors express a long-term view on supply and demand trends, but they adopt short- to- medium-dated instruments to achieve the exposure. In fact, costs of rolling are fairly high, and the returns on short-term instruments do not track long-term investment closely.

Some argue that commodity-indexed strategies can minimize the drag on returns; however, due to carrying costs, investment in commodity indices often has a fundamental error. Investors of commodity futures suffer from “contango;” the carrying costs embedded in futures prices offset almost all the returns from rising spot commodity prices. Furthermore, commodity futures are considered as instruments for risk management, and speculation over the short-to-medium term, and therefore, there lies open interest in the commodity futures markets.


4 comments on “Commodities Market Commentary, Investment Process, and the Passage of Time

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