Smart Money
The five principles of commodity markets
Investing in oil, gold, or wheat follows different rules than trading stocks or bonds. «Finanz und Wirtschaft» explains the key terms.
Every week, our series “Smart Money” sheds light on a new aspect of personal money.
Marco Tancredi
Amid current turmoil and losses in the stock markets, investors are increasingly seeking alternative investment opportunities. This uncertainty has contributed to gold breaking several price records this year.
But it’s not just precious metals in demand: other commodities also attract interest with their diversification potential. While the prices of industrial metals are closely correlated with the economic cycle, the prices of commodities such as soybeans, coal, and pork bellies often evolve independently of stock prices. However, before blindly investing in a commodity ETF or directly trading futures contracts on oil, it is important to understand some peculiarities of the commodity market.
The origin of commodity exchanges
Commodity markets continue to serve their original purpose: farmers can sell their future harvest at a predetermined date. This allows them to hedge against price fluctuations, receive liquidity early, and gain planning security. Buyers gain price and delivery certainty through such futures contracts.
The future gets rolling
However, today’s trading is standardized and often automated. Besides direct producers and buyers of commodities, there are many market participants who do not aim for physical delivery, for example, 5000 bushels (approximately 136 tons) of wheat, the standard size of a contract.
In addition to this futures trading (also known as forward trading), there is a spot market for some goods, where commodities are delivered within a few days instead of a future date, similar to stock trading where shares quickly change hands. For crude oil, there is both a spot market with a spot price, which is the cost for immediate delivery of a barrel, and a futures market for oil deliveries at a later date. Retail investors usually partake only in the futures market.
As mentioned, investors generally do not seek physical possession of commodities, with exceptions like precious metals such as gold, platinum, or silver. When purchasing a future, investors enter into a standardized contract that precisely sets the delivery date, quantity, price, and quality of the underlying commodity. If investors wish to hold the position beyond the maturity date, they must roll the contract: just before the delivery date, the expiring futures contract is sold and the proceeds are immediately invested in a new contract with a later maturity.
Why the futures curve is central
Rolling contracts involves a complication: the expiring and new contracts rarely have the exact same price, even if they refer to the same quantity of the same commodity. Two pricing scenarios are distinguished: contango and backwardation.
When the futures curve is upward sloping, the commodity contract is in contango. The longer-term future is more expensive than the shorter-term one. This can be due to storage costs required for fulfilling a later delivery. From 2017 to 2020, futures contracts for most commodities were priced above the respective spot prices.
However, this changed in 2021. Since then, the majority of commodities in the spot market are more expensive than in futures contracts for later delivery. The market is thus in backwardation. This may be due to the advantage of having the physical material now, for example, to maintain a production process. Alternatively, investors might be expecting future price declines, or there might be acute shortages in the market, as is currently the case for cocoa and coffee. While this is disadvantageous for commodity processors like Barry Callebaut and Nestlé, investors can benefit from backwardation.
Total return vs. excess return
However, direct investments in the coffee market are mostly reserved for professional investors. More accessible to retail investors are tracker certificates or other financial products that replicate the performance of a commodity index.
There are three types of return curves to differentiate between indices. The spot return represents the pure price movement of contracts, with continuous investment in the next maturing contract. The excess return index also considers the roll gain or loss from regularly reallocating the contracts. If additional interest income from unbound investment amounts is included, it is called a total return index, as in futures markets, only part of the contract size needs to be posted as collateral (margin).
Beware of currency risks!
Almost all commodities are priced in dollars, even for contracts traded on the London commodity exchange. An important exception is the contract for Dutch gas, which serves as a benchmark for the European energy market and is traded in euros.
Commodity certificates for European investors, however, are offered in euros or Swiss francs. If the dollar weakens against the investment currency, the value of the commodity certificate decreases, even if the price of the underlying asset does not change. Conversely, a strong greenback leads to gains.
Therefore, commodity investors need to keep an eye on developments in the foreign exchange market, especially in the current situation where the erratic policies of the US president have weakened the dollar. If one does not wish to engage in currency forecasts, one can opt for currency-hedged quanto certificates on commodities or hedge currency risks using other financial instruments. However, hedging currency risks entails additional costs.
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