Keith Black of CAIA discusses some of the features and investment considerations with commodity futures.

Date: Nov 2011

Tags: Commodities, Futures, Backwardation, Contango

• When investing in commodity futures, it is important to think about contango and backwardation – the term structure of the futures prices
• A trend is towards a more actively-managed commodity portfolio, to diversify a portfolio across a number of different futures contracts – seeking to reduce the negative roll yield, or to enhance the positive roll yield
• The 10-fold growth in commodity-related assets over the trailing 10 years has raised concerns over how such an increase is affecting the market

When investing in commodity futures, it is important to think about contango and backwardation – the term structure of the futures prices – said Keith Black in an interview.

In contango, there is a negative roll yield, where current prices are below the forward prices, he explained, whereas in backwardation there is a positive roll yield, where current prices are above the forward prices.

When investing in a commodity futures programme, therefore, Black said it is critical to understand the role of contango and backwardation, given that the return can be substantially different relative to the change in spot prices in the underlying market.

Dealing with contango and backwardation

When investing in an index-linked product, Black said investors will find that the index construction methodology requires that the investment be in the front-month futures contract, regardless of what the contango or backwardation might be.

A trend, therefore, is towards a more actively-managed commodity portfolio, or to invest in one of the newer constant maturity indexes to diversify a portfolio across a number of different futures contracts – seeking to reduce the negative roll yield, or to enhance the positive roll yield.

Misconceptions

Typically, Black said that in a backwardated market there will be a short-term shortage of supply, where investors are willing to pay a convenience yield to ensure supply in the short run.

On the flipside, contango might come in a market which has an abundance of short-term supply, but not necessarily the same outlook over the long run, he explained.

Concerns over growth in commodity assets

According to Black, there has been a 10-fold growth in commodity-related assets over the trailing 10 years, raising concerns over how such an increase is affecting the market. Potentially, the increase in contango might be related to this influx of capital, he said.

He said there is also a concern over the impact of this influx of money on the physical market. As a result, governments around the world have begun to question the role of financial market participants in the commodity markets, with the increase in generally passive futures markets investment potentially driving spot prices of commodities higher – in turn leading consumers to pay more for energy, and in Asia for food.