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Commodity markets are a challenging area of finance for investors to navigate. Because of the increased complexity, many investors obtain their desired commodity exposure through publicly traded companies that produce the underlying commodity. However, this ends up diluting the anticipated exposure with company-specific risk. This additional layer of company-specific risk can be an undesirable feature from a risk premia standpoint, as many investors already carry some form of equity risk within their portfolios. For investors that want to obtain the cleanest possible commodity exposure, and not dilute the diversification benefits of this asset class, transacting in the direct commodity is the most desirable path. This means that investors need to get comfortable (or have an investment manager that is comfortable) trading and executing in commodity futures markets, as it is unlikely that many investors would be keen to warehouse 5,000 bushels of corn while they find another counterparty to transact with.
However, participating in futures markets comes with its own intricacies; namely how to navigate the futures “curve” as it relates to the different possible delivery dates for the commodity in question. For example, in the throes of the COVID-19 pandemic, when oil traded in negative territory on April 20, 2020, this was only for the “front-month” contract, while the rest of the curve (future delivery dates) remained in positive territory. We don’t need to get into the nuances of what caused oil for immediate delivery to trade in negative territory, but it is important to understand that when longer-dated futures contracts are priced higher than shorter-dated futures the curve is said to be in “contango” — the opposite is called “backwardation”.
The existence of a futures curve for various commodity contracts might seem too technical for many investors to care at what price a commodity will trade at various delivery dates; however, misinterpreting the shape of the futures curve can have interesting economic implications, as well as creating unintended costs for unaware investors. NPR posted an article a few weeks ago on the state of the oil market, as the increase in crude prices is translating to higher prices at the pump for consumers. The article states that because the oil market is tight (high demand and low supply) prices are expected to rise, and we should see this reflected in the futures curve with long-dated futures contracts priced higher than short-dated contracts (contango). Instead, the oil futures curve is in backwardation (longer-dated futures are cheaper than shorter-dated futures) and this “wrinkle in the oil futures market has clogged America’s oil pump” because producers in America are unwilling to bring production online as the futures curve is forecasting oil prices are likely to fall in the future. Unfortunately, NPRs’ assumption that the futures curve is an indication of where prices will be in the future is fundamentally flawed.
Despite its name, the futures curve is not a forecast of where commodity prices are heading, but instead a snapshot of what the market is willing to pay today for delivery in the future. This might sound overly simplistic, but it is an important distinction. When a market for a commodity is tight (e.g., demand is outstripping supply) the futures curve generally shifts into backwardation because it is more convenient to own the commodity for use today because of the current scarcity, rather than at some point in the future. This results in what is known as a “convenience yield,” which can be positive or negative, depending on the supply and demand dynamics of the specific commodity market. In times when supply is abundant, the futures curve is generally in contango as there are costs associated with storing and financing physical commodities, which the futures curve takes into consideration. When there is no benefit to owning the commodity today versus sometime in the future, longer-dated futures tend to be more expensive than shorter-dated futures due to financing and storage costs.
The mistake that NPR made is quite a common one, and according to this article from Bloomberg, one of the reasons that central banks may have been behind the curve (pun intended) on the persistence of higher than expected inflation. With central banks using the shape of the futures curves to inform their expectations of future inflation (because of the impact commodity prices have on consumer prices), they are getting bamboozled by assuming that a futures curve in backwardation means that commodity prices are expected to fall in the future. All that a futures curve in backwardation means is that at this point in time there is a convenience to having access to the commodity today relative to at some point in the future. For those interested in making forecasts on where prices are expected to be in the future as the Bloomberg article suggests, the options market is likely to provide a better sense of how the market is currently viewing the balance of price risk in the future.
At Viewpoint, we don’t make any discretionary forecasts on where we expect commodity prices for immediate delivery to be in the future, but we do actively manage exposure along the futures curve to reduce the unintended costs that accompany naïve long-only commodity exposure.