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Where are Commodities headed?
Commodities have been affected by many headwinds over the past several years. Watch as our experts discuss current market conditions and how they will drive prices.
Jodie Gunzberg - Global Head of Commodity Indices at S&P Dow Jones Indices
Sal Gilbertie - President, Chief Investment Officer & Co-Founder at Teucrium Trading, LLC.
Christopher Burton - Managing Director, Head of Portfolio Management for Commodities at Credit Suisse Asset Management, LLC
John S. Guyer - Porfolio Manager at Arrow Investment Advisors
Listen to the Podcast Here
Take the CE Quiz Here
Duration:
00:50:01
Transcript:
Courtney: Welcome to Asset TV’s Commodity Investing Master Class. Joining us today from our New York Studios are: Jodie Gunzberg, Global Head of Commodities, S&P Dow Jones Indices; Sal Gilbertie, President CIO and Co-founder, Teucrium Trading; Christopher Burton, Managing Director, Head of Portfolio Management for Commodities, Credit Suisse Asset Management; Jonathan Guyer, Assistant Portfolio Manager for Commodities and Managed Futures Markets, Arrow Funds. Everyone, welcome and thanks for joining us for Asset TV’s Commodity Investing Master Class. Christopher, I’d like to start off with you, commodities have really fallen over the past couple of years. Can they still be considered a portfolio diversifier?
Christopher: [0:00:38.4] Definitely. I would say one of the biggest reasons why they’ve underperformed other asset classes such as equities is because inflation is continually becoming below expectations. And in that type of environment you expect equities to go up and commodities to lag. I would say had the opposite happened or if inflation comes in a little bit above expectations you might see the opposite occur. And compared to some other forms of portfolio diversifications such as hedging with options, I think commodities are a relatively cheap way to do that.
Courtney: [0:01:07.1] John, do you still think commodities are a portfolio diversifier?
Jonathan: [0:01:10.4] Absolutely, over time the non-correlation to the other asset classes holds that up. I don’t see a reason that the commodity futures would behave any differently from historical asset class parameters.
Courtney: [0:01:22.9] Jodie, do you still consider commodities a portfolio diversifier?
Jodie: [0:01:26.4] I do, one of the most important reasons that commodities are a portfolio diversifier is because of a source of return called Expectational Variance and in plain English that’s supply shocks. And supply shocks are the component of return that drive the pattern of commodity returns to be different from each other and also different from stocks and bonds. So if there’s something like a pipeline burst or a weather event, that may drive commodities but maybe not so much stocks or bonds.
Courtney: [0:01:59.3] Sal, do you still consider commodities a portfolio diversifier?
Sal: [0:02:01.6] Absolutely. And I think Jodie’s right. The drivers that drive prices affect stocks and commodities differently. So if you own both in your portfolio it’s a very good diversifier because they each react differently to the same inputs.
Courtney: [0:02:14.7] Jodie, what’s the impact of the US dollar on commodities?
Jodie: [0:02:17.4] Generally, as the dollar strengthens it’s bad for commodities. But it’s not equally bad for all commodities. And it’s more sensitive with economically sensitive commodities like oil but not like heating oil or maybe natural gas because of the seasonal patterns. And commodities like agriculture also have much less sensitivity to the dollar. So other factors drive commodities more powerfully than the dollar necessarily does, though since they’re priced in US dollars, as it strengthens it’s a headwind for commodities.
Courtney: [0:02:56.3] Christopher, what’s the impact of the US dollar on commodities?
Christopher: [0:02:59.5] Generally it’s negative, especially as stronger dollar is negative on commodities especially over shorter periods of time because most commodities are priced in US dollars and it damaged the purchasing power of non-US dollar consumers. But it tends to be more over shorter periods of time. So if you get a situation where the dollar strengthens 10% in a month it’s likely commodities have gone down during that time. But over longer periods of time it tends to have less of an impact.
Courtney: [0:03:29.5] And, John, how is the dollar impacting commodities?
Jonathan: [0:03:32.7] I have to agree with Jodie, it’s very granular. Generally speaking a stronger dollar is difficult for commodities. We have had a stronger dollar in the second half of 2014. So that had a downward effect on commodities. But over time it does seem to flatten out and become less of significance.
Courtney: [0:03:59.0] Sal, how do you see the dollar affecting commodities?
Sal: [0:04:01.2] Well, the general perception is that a strong dollar is negative for commodities sometimes, whereas other panelists have said; it’s not always the case. I think investors focusing on commodities that are going to be used regardless of economic conditions, regardless of currency strength; those are the commodities that they probably want to make sure they have in their portfolios.
Courtney: [0:04:21.0] Jodie, how do commodities perform in different environments?
Jodie: [0:04:24.1] It depends on how the commodity indices are weighted or how they determine a contract that they hold. And in times of excess or in contango then the newer strategies that have the ability to change contracts or hold beta dated contracts will outperform the first generation indices. But in times of backwardation the first generation indices that hold them near by explorations tend to outperform.
Courtney: [0:04:55.8] And when you look at this chart we’re going to pull up, what do you see with respect to smart beta?
Jodie: [0:05:01.0] What I see in this chart is that smart beta does better in times of backwardation. So for example you can see most recently in 2013 and 2014 that the smart beta strategies have generally outperformed the first generation indices since that’s the first time we’ve seen backwardation in quite some time. And in this time where it’s flipping between contango and backwardation, the changes and term structure are best captured the flexibility within the strategies.
Courtney: [0:05:35.6] Christopher, when you see this chart, what do you see with respect to smart beta?
Christopher: [0:05:40.5] Sure. Well, the first thing actually I see within the chart is different index weightings are probably the biggest difference in returns. So with the S&P GSCI index very energy heavy it would tend to outperform the other indices during those years in which energy is up significantly and during times when energy’s not as strong then they tend to underperform. Smart beta itself, there are many different types of smart beta. And I would say that there are certain ones that are more geared towards certain environments, either different types of sector movements, some are based more momentum, some are based more in curve shaped. So I’d say in general it also depends on the type of smart beta being used.
Courtney: [0:06:21.4] And Sal, when I pull up this bar chart, commodities are a volatile asset class so why would someone with a long term investment horizon consider sugar or wheat in their portfolio?
Sal: [0:06:31.8] Well, this represents prices over a 20 year time period. And the correlation of these specific commodities to the S&P 500 over very long periods of time, 20 years in this case. And what comes up is that sugar, corn, wheat, soya beans and natural gas are actually less correlated than gold. Most people hold gold in their portfolio as a diversifier, what they don’t realize is that there are other commodities that are very important, that are really critical to the global supply and demand issues of all commodities. And if you don’t have those in your portfolio, your portfolio could be lacking, it could also not be diversified enough if you’re just holding gold as a diversifier. And I think most people find, has a great surprise that the grains in particular are less correlated to the S&P 500 over long periods of time than gold.
Courtney: [0:07:21.6] Jodie, would you like to comment on this chart?
Jodie: [0:07:23.6] I think it’s a myth that commodities are much more volatile than equities. If you look back 40 years, the volatility annualize of equities is about 15% and commodities is only about 19%. So it’s not a huge gap in volatility between the two asset classes. And what people don’t realize is that commodities have very low correlation to each other. So you get a big diversification benefit by holding a basket rather than any single commodity where you might see the volatility.
Courtney: [0:07:55.7] Christopher, did you want to comment on this correlation chart?
Christopher: [0:07:57.9] You can look at some of the commodities that are more correlated with an equity index are generally those that are more affected by the overall economy. So something like energy is often connected to global growth for example. When you look at some of the other commodities, especially those with shorter production and consumption cycles such as sugar at the top, natural gas which has a huge seasonal component, you’ll generally see the correlation go down. So I think that’s part of the reason why the chart is organized that way.
Jonathan: [0:08:29.7] I would agree with what Jodie said, the volatility of commodities to equities is very similar, but also commodities during difficult periods, convergence periods, they’re maximum drawdown attributions, generally have that with equities. So they tend to have a little bit of a floor value better than equities. Also to Sal’s point, he’s right, I mean if you look at the correlation of gold or to US dollar or a basket of dollars or a basket of currencies, you’ll find that a broad basket of commodities has a more robustly negative non-correlation to US dollar or a basket of currencies than do any one particular component and especially gold, over a one year, two year, three year horizon it’s a better currency diversifier.
Courtney: [0:09:25.8] And, John, I want to pull up the next chart and ask you, when you look at these commodities here, and their prices are they still a good value?
Jonathan: [0:09:33.7] Absolutely. I get this question a lot. People look at me and say, “Well, John, I like commodities, I know I need to have them but I don’t know how to overweight them, underweight them and how to utilize them in my asset allocation.” So in response to that I often say, “Well, look at it in terms of fundamental and if you look at the price of the current commodity price versus its cost to production, you know, if you see narrow margins or you see instances of current futures prices being below your cost of production, it’s a good indication of value.” So currently what you see is crude oil for example is trading below what is generally agreed to be its cost to production, which is around 71 to 85 or so. Silver, currently trading around 17, 20, and its cost of production is $18 for 20 ounce. So same thing for corn, are currently trading around 3.70, it’s 4¼ per bushel is the cost. So if you can buy something for less than what it costs to produce it, it’s a pretty good value to investors and it’s indicative of good value. So commodities haven’t been out of favor for the last few years, it’s created that kind of opportunity.
Jodie: [0:10:56.5] What’s interesting about the cost of production and the relationship to the futures market is that the futures market enables the cost of production to change in the sense that the futures act as insurance to the producers. And the way that the producers get this insurance is through the commercial consumer or the long only index investor or commodity investor that’s serving to sell that insurance to the producer where the commercial consumer chooses either to substitute or to pass through the cost.
Courtney: [0:11:34.5] Sal, do all commodity ETPs exhibit the same characteristics?
Sal: [0:11:38.1] They do not. And it’s very critical for an investor to look at the underlying benchmark and design of each ETP that they’re considering buying. It has to match their investment criteria. And so if you have a long term time horizon you may want a second generation type design. If you have a very short term time horizon then you might want a first generation type design. So it’s very important that commodity benchmarks of these ETPs are looked at and matched with your time horizon and with your objectives, that’s critical. And you may have two funds that look the same; their designs are going to be different. And that’s the main driver for performance of all other factors; the benchmark design is what governs performance of the investment.
Courtney: [0:12:21.1] And, John, commodities are considered volatile, so what can investors do to mitigate volatility?
Jonathan: [0:12:26.8] I would agree with what Jodie said earlier, volatility and commodities is very similar to equities which is what most investors are already accustomed to investing in. But that said you can work to manage and mitigate volatility within commodities. Firstly, I would say you have both index or passive long only approaches. And you have long short active management, either tactical trend falling and/or fundamental inputs. The two of those approaches combined serve to diminish volatility because they’re complimentary. The two strategies often have a local relation to one another so they’re complimentary. When used together you can proactively allocate between commodity index versus long short active. The other thing you could do is diversify across the various commodity sectors. So that would assist in diminishing volatility. The other thing you can do is use the longer dated contracts within your commodity index approach. Longer dated contracts tend to be less volatile and by utilizing longer dated contracts you can roll this frequently and be more efficient. So those are the things you can do as an investor to diminish your volatility within specifically to commodities.
Courtney: [0:13:46.2] And we actually have an Asset TV viewer with a question for our panel. We have Greg Makowski, he’s the founding partner of CSF Investment Advisory Services. Greg, you’re on the air.
Greg Makowski: [0:13:57.0] Hi, this is Greg. Where do you see the bottom in oil and why?
Sal: [0:14:01.2] I don’t think anybody can predict that. What I do know is that people are going to continue driving to work. They’re going to continue heating their homes. In general the energy use that is pervasive throughout the economy is going to continue. And if you look at traditional economic theory, lower price will mean an accelerated demand. And so at some point you’re going to see oil bottom historically. I go way back in the oil industry and historically, you know, oil traded for many, many years basically in a band of about 15-35 dollars with 35 being the high. When it broke out of that band it kind of hasn’t looked back. And so you’ve got many technicians saying, you know, to look for some sub $40 level as a bottom. I don’t think anyone can reasonably predict exactly where the bottom may be. I think what investors should be focusing on is people aren’t going to stop using energy. They will likely use more with lower prices. And so be ready to keep it as a very critical component in your investment mix.
Courtney: [0:14:55.2] Christopher, would you like to take this question?
Christopher: [0:14:56.4] Sure. I really think the bottom is going to appear when the supply and demand gets tighter. So if on one side you see producers starting to cut CAPEX estimates that eventually starts to hit on the production side. On the demand side we still continue to see increased oil consumption each year. At some point those have to hit. And I think really when we’re looking at $50 oil, we’re really to the point where you might see the production fall, also I think people may have been … may have become complacent about some of the hotspot productionaries, especially in the Middle East and Africa, there’s always the risk of a disruption there too.
Courtney: [0:15:40.0] And, John, what do you think, can we see the bottom in oil?
Jonathan: [0:15:43.0] It’s tough to call a bottom. But I go back to my, you know, cost of production concept, with cost of production for West, you know, West Texas Intermediate being between that 71 and 85 range, current prices would not be very conducive to further production. So you will begin to see production tight right now. When that occurs your supply bills drawdown and you do find equilibrium. So rather than saying, you know, here’s the bottom or the bottom will be here, I would tend to look a it as a process of lower prices working through and affecting producers and affecting output.
Courtney: [0:16:29.7] And, Jodie, do you think we can see the bottom in oil?
Jodie: [0:16:34.1] Historically we’ve seen drawdowns in oil of about two-thirds. And we’re not quite at that level of drawdown yet. This time doesn’t need to be like other times, for example, in 2008/2009. The drawdown was largely due to the falloff in demand. This time it seems to be more of a supply crisis. And that’s a problem, that generally takes care of itself. As the prices continue to fall, at some point it’s not profitable to produce oil anymore and the suppliers will start dropping off, reducing the supply and bringing the price back up.
Courtney: [0:17:12.4] And Prince Alwaleed of Saudi Arabia said that, “We’ll never see $100 barrel oil again.” Sal, do you agree or disagree?
Sal: [0:17:19.9] Well, there’s an expression, never say never. I don’t think anyone can predict. I do know that oil and grains in particular are very supply driven markets. And so the price is very affected by the amount of supply that is coming to market, because the demand is relatively steady, people will not stop feeding themselves or their animals, they will not stop driving to work or using energy in any way. And so what’s happening there is that demand is building and growing and stable. When there is a supply shock, prices will go up again. What the ceiling is, no one could say.
Courtney: [0:17:55.1] Christopher, would you agree or disagree?
Christopher: [0:17:57.0] I think we will see oil go over $100, a lot of what’s driven oil down to $50 was unexpected. And I think there are certainly some possible unknowns, I would say particularly on the production side that could also be unexpected going forward. And that might be one catalyst and go up over 100. The other side is we’ve seen certain regions coming below expectations for GDP growth, for consumption growth. The demand will keep creeping up. And if the supply can’t keep up with it because of some of the recent cutbacks, I think you could see oil get that high even within the next few years.
Courtney: [0:18:38.9] So what’s it going to take for oil to begin its recovery?
Christopher: [0:18:43.7] I think it goes back to that supply has to meet demand. And supply’s just been too high recently. And one of those has to change.
Courtney: [0:18:58.4] Jodie, one thing that a lot of oil ministers have said is that they’ve blamed some of the decline on speculators. But on the flipside, a lot of politicians blame… Jodie, a lot of oil ministers have said that they blame the decline on speculators, but on the flipside, a lot of politicians have also blamed prices being too high in oil on speculators. So this kind of seems like a conundrum, how do you see this?
Jodie: [0:19:33.8] This was well studied after the 2008/2009 drawdown where the perception or the question might have been, did speculators drive down the price of oil? And what the results of these studies say is that it’s not the speculators that drive the price of oil but in markets where more well developed futures markets are and investors come in to supply this insurance to the producers, there’s a reduction in volatility of price. So the more investment activity there is, the lower the volatility despite the level of the price.
Courtney: [0:20:15.0] So how would you define a speculator?
Jodie: [0:20:17.1] That’s a difficult question and that’s a question that’s been studied since at least the 50s or the 60s. There was a famous paper that came from Paul Kuttner out of MIT in the 50s and another one out of Stanford in the 60s from Holbrook Working and what the conclusion is that everybody’s a speculator. And the futures markets enables specialized risk taking where a commercial producer or consumer is able to manage what we call a basis risk, that’s the difference between the futures price and the cash market, more effectively then they are able to manage the price swings themselves which then enables them to stay in business, shall a price drop occur for a producer or a price rise occur for the consumer.
Courtney: [0:21:13.6] So I want to pivot to the futures curve, on this chart here we can see backwardation in the green and a contango here on the bottom in the orange. Jonathan, what do you see here?
Jonathan: [0:21:23.1] The two lines actually speak a lot. The top line, the green one, is how the commodity futures curve looked for crude oil six months ago. Orange line on the bottom is how the futures curve looks for crude oil today. So you can see immediately, pretty significant price drop. You can also see that the shape of the curve has changed dramatically from backwardation to contango in a six month period. Also if you look further out the end of the curve, you can see the two lines seem to vector in on a price range. You heard me quote it earlier, it was basically 71 to about 83/85, something like that. That range I think is not coincidental, I think that’s what the futures markets are saying is the cost of production, if you will, the break even point for West Texas Intermediate Crude, most of the research that I’ve read and seen tend to concur with that. So again, current futures prices below cost of production, it represents a good value to investors. The question is how do you harvest that? How do you participate in it? The difficulty becomes with the shape of the contangoed curve, each of those dots within that curve represents the next month’s contract. So if you hold and you’re by contract and have to roll it to avoid delivery to keep your long position, you’re selling low, buying high, suffering a negative roll yield. So if you math out the shape of that curve and assume you’re going to hold it for a year, your net roll yield implied by the shape of that curve, holding it constant, it’s about 16% negative.
So in a sense - in a very real sense, you’re saying, “If I take a long position now, the price has to move at least 16% for me to break even because of the negative roll yield.” So a lot of commodity indices hold the nearby contracts and roll frequently, and do suffer that negative roll yield away. To mitigate and minimize that negative roll yield is to use the longer dated contracts, not roll every month, suffering sort of the depth of a 1,000 dives and trying to run up a going down escalator, roll minimally, hold a longer dated contract which is less volatile but participate in the price moves and roll minimally, touching the market less, suffering less negative roll yield and less slippage to the index bid aspirate and things of that nature, conditions [unclear 0:24:01.3] for example.
Christopher [0:24:03.4] I also see opportunities. Investors should be aware when they’re investing into an index or they have a manager that invests in commodities, what part of the curve they’re actually purchasing. If you are purchasing the front, that curve flipping from backwardation to contango can also flip from contango to backwardation, and depending on where you are on the curve you might get very different returns. Crude oil I think is a nice tame curve typically where it’s generally slipped in one direction, sometimes there’ll be one hump on it. But especially when you start to get into the more seasonal commodities where you might have more waves, it’s very important what part of the season you may be positioned in and how that might relate to any sort of supply shocks especially, for example, due to weather. So I see opportunity for people to pick a favorable position on that curve.
Courtney: [0:24:57.2] Sal, when you see this WTI chart, what do you see?
Sal: [0:24:59.5] I think investors should see that if you buy the nearby contracts or a benchmarkholding the nearby contracts, you’re taking an incredible risk because of the amount of volatility, the potential volatility that you’re buying into. So you know, I’m in agreement where an investor, depending upon their criteria, needs to look very hard at the benchmark and buy something, if they want a long term exposure to a commodity that holds further out the curve, because as you can see from this chart, if you held further out the curve would you have suffered losses in a down market? Yes, but they’re not nearly as large as if you held a benchmark that was holding the front of the curve. The same can be said for when the price of this goes up and the curve generally shifts up. You’re still going to participate in the up and down price move in general. It won’t be as great, it won’t be reacting to the headline news. But your long term exposure in your asset allocation model that includes oil or whatever commodity it is, is probably going to be better served if you’re a long term investors in buying a well structured benchmark out the curve.
Courtney: [0:25:58.0] And can you discuss the liquidity and open interest of the contracts out the curve, Jodie?
Jodie: [0:26:03.0] What you see here is an inverse relationship between the liquidity which is the bottom green bars versus the time to maturity, with the exception of a few contracts that do hold liquidity in the mid and end of the years. And there’s generally a tradeoff between performance and liquidity where as you aim to either enhance your performance by sitting out on the curve or reduce your volatility by sitting further out on the curve, you may give up liquidity to do that.
Courtney: [0:26:35.8] And, John, what do you see here?
Jonathan: [0:26:36.9] Earlier you’ve heard me say that I use long dated contracts a lot. And as a result I’ve done a lot of liquidity studies out the curve. Typically you find that the hedgers or producers are most often using the longer dated contracts. They’re doing that by managing or attempting to manage their margins. So that’s really driven by an accounting cycle more than a seasonality cycle of the contracts of the commodity. So you’ll find that out the curve there are increases in liquidity and open interest in the mid year and year end contracts. Notably, that chart you’ll see way out the curve where certain contracts are not even traded or available, once you get further out the curve it’s only the mid year and year end contracts that are actually available to trade.
Courtney: [0:27:26.2] Sal, what do you see when you see the liquidity and the inventory going out the curve?
Sal: [0:27:29.6] I think two things are important from an investor’s perspective. One is they don’t really have to worry about the liquidity. The exchange … the issuer of the … the sponsor of the exchange traded product or of the index provider, they’re going to worry about the liquidity for you. You just invest in their products. So for by and large most investors are not going to move enough money in to influence the curve by themselves, an investor really doesn’t have to worry about it, choose a proper benchmark and you’ll be fine. The second point is that if you are out the curve you note that the volume drops. Why is that? I think John mentioned, it’s because the professionals are out there. They’re the ones are buying and selling out the curve. So if you’re interested in a particular commodity or a basket of commodities you want your money invested with the professionals and that’s literally the way to do it. They’re the people out there by and large out the curve. If you invest your money in a benchmark that holds products, futures contracts that are out the curve you’re putting your money where literally only investment professionals are trading, and that’s a good place to be.
Christopher: [0:28:27.6] I absolutely agree. I think that longer dated contracts actually have a better price discovery, hence the lower volatility. And so in utilizing a long dated contract you are essentially deploying your capital with the producers and the professionals, the hedgers and holding that contract, selling it to the speculative audience when volume and interest is increasing, and since that’s a built in demand for what it is you own. And it’s always nice to buy smartly and sell well.
Courtney: [0:29:03.3] And, Jodie, I want to pivot to this next chart where we see the SMP GSCI annual roll yield, what does this chart tell us?
Jodie: [0:29:11.6] It tells us about the curves that we were just looking at. And when the curve that we saw was in the green line, that backwardation, that’s a time of shortage. And in the bottom line, that contango, then that’s a time of excess. And these times, depending on the supply and the demand and the inventories, switch back and forth and how frequently they switch depends on where we are in the cycle. If you can remember back to the first chart that we had up, in 2005 that was a switching year from backwardation to contango. And that’s when the alternative beta or the more frequent strategy outperformed. And again in 2013 when we see this flip from a long trend of contango to backwardation, we’re seeing that outperform once again. So whether this was a turning point, that’s to be determined, but many times when we see a few years in a row now in a different direction, that could indicate that the shortages are starting to persist and are hard to replenish.
Courtney: [0:30:20.5] And what does the forward curve tell us about the price of oil in the future?
Jodie: [0:30:25.5] The forward curve gives an expected value of the spot price in the future. And in the futures pricing it is the spot plus the cost of storage. Essentially you have a choice, you can either buy the cash commodity and store it or you can choose to buy a futures contract. So as the time towards exploration comes, then the prices of the futures and the expected spot price at the future tend to converge.
Courtney: [0:31:00.7] And how do technology and logistics impact these prices?
Jodie: [0:31:06.0] The technology and the logistics can change futures markets from local to global markets. For example, in the index that’s world production weighted, natural gas is the only commodity that’s not world production weighted because it’s so confined to North America. Yet a good example of a commodity that grew from a local to a global commodity would be Brent Oil. Brent Oil which is produced out of the North Sea is priced off of two to three million barrels a day, that gets priced from the ICE Exchange in London, that has now become the benchmark for about 60% of the world’s oil.
Courtney: [0:31:49.6] Sal, when you see a contango or a backwardation in the market, what are the effects to ETPs?
Sal: [0:31:54.7] Well, they can be quite intense. And so I think what … again, if you’re looking at a benchmark for a short term trade you really don’t mind holding something that is in the front month and going to whip around with headline news or very near term supply & demand fundamentals. I think if you’re an asset allocator or a long term holder of a product what you want to look for is something that tries to mitigate both contango and backwardation through either smart beta or a static benchmark design. And there are many products that do that out there. And that way there are many seasonal products that are both backwardated and contangoed in the same curve at the same time. So there’s no way for an investor to know when contango will occur over time, when backwardation will occur over time. And both can either hurt or help, the contango doesn’t always hurt, backwardation doesn’t always help. And so investors need to mitigate contango and backwardation effects by their choice of product.
Courtney: [0:32:49.9] And I know you touched on this, but how can investors harvest more beta out of their commodities?
Sal: [0:32:56.8] One of the better ways is overweighting I think and underweighting commodities. And so if you’re particularly familiar with a commodity, if you live in the Midwest and you’re a farmer and you have an outlook on grains, you can overweight or underweight your grains. I think most people like to think they have an educated opinion on energies, they can overweight or underweight those products. There are many now single commodity exchange trading products that allow an investor the ability to overweight and underweight their core portfolio holding. thats probably in a multi commodity benchmark index.
Courtney: [0:33:27.6] And, John, would you like to comment on that?
Jonathan: [0:33:29.8] I would actually, thank you, Courtney. Looking at backwardation and contango, we in the industry are intuitively familiar with it, we understand it. But long term investors in the asset class, they don’t, I don’t think, really want to become curve shape experts. They want to have an exposure to commodities and harvest commodity beta as efficiently as possible over a longer period of time and receive asset class performance. I think one of the ways that you achieve that is to mitigate the effects of roll yield, either backwardation or contango. So if you look at a commodity index, there’s only three sources of return there, it’s price return, it’s collateral interest and it’s roll yield. So if you mitigate the effects of roll yield which can be positive or negative and very hard to anticipate, then you’re maximizing the effect of price return. And I think that’s what investors really want. And the way I think to do that is to use longer dated contracts, roll minimally, touch the market as little as possible so that you don’t have, you know, significant slippage and you use longer dated contracts to mitigate your volatilities.
Courtney: [0:34:48.1] And are long only commodity indexes and managed futures compatible?
Jonathan: [0:34:50.9] Absolutely. Long only is exactly that, it’s long only, it’s harvesting beta. It’s a passive index strategy. Managed futures is an active long short strategy and many times they include other things besides tangible commodities, they include interest rates, they include stock indices. But they trade or they’re harvesting in different return streams. You’re going to get a technical return stream or fundamental return stream in managed futures. The two of these things often have inverse correlations, for example, just in the last couple of years here, where you’ve had a, you know, commodity indices strongly down, managed futures has performed very well. So unfortunately my index was down about 15% in 2014, after being up about 8% in the first half. Our managed futures fund is up 8% in the year. So they’re very compatible and they help diminish volatility when combined.
Courtney: [0:35:53.7] Sal, did you want to say something?
Sal: [0:35:55.0] I think I’ll pass on that one.
Courtney: [0:35:56.3] Okay. Christopher, did you want to say something?
Christopher: [0:36:00.6] Yeah. So I definitely agree with the other panelists, that it’s important to understand when something’s in contango or backwardation. It is worth noting that at any given time in any commodity index it’s likely some commodities have been in contango, some in backwardation. It’s very tough to avoid one or the other. If you look historically at returns during periods of sustained contango or sustained backwardation, the results are very clear. There’s backwardated periods did matter. But the trick is to figure out if it will be contango or backwardated in advanced. If it’s contango and flips to backwardation, that’s usually alongside a price move up. The opposite is for a price move down. And so I would say it’s … I would say for a skilled manager or a skilled type of index with a good algorithm, there are ways of taking advantage of those price movements between contango and backwardation.
Courtney: [0:36:56.0] And, Christopher, how do you expect Chinese growth to impact commodity prices going forward?
Christopher: [0:37:00.1] I think China will continue to be the marginal buyer of many of the commodities. They’re currently over one-third of the consumption of many of the industrial metals and soya beans, they’ve doubled … they’ve doubled imports over the past seven years. And so I think they will continue to be a strong force. But I also think that with a more … I’m sorry, I think that with a more global supply network, where it’s easier to ship, easier to … where countries are a bit more interconnected it won’t just be about China, as China moves more towards a consumer driven economy, I would say over the years - the coming years, China will be a force in commodity demand, but not the entire force.
Courtney: [0:37:53.6] And after the ECB and NSMB’s actions, metals have kind of come back into the spotlight, do you think gold can reach its 2013 levels again?
Christopher: [0:38:00.6] I think so, and that depends on monetary policy, in general the more easing there is, the better it is for gold, especially because it may tend to act as a currency as well. Gold has historically also been a safe haven during times of conflict. So that’s another possibility. In terms of hitting the highs, I don’t see that occurring personally in the near term. But especially if the quantitative easing continues globally for a long period, I think it becomes more likely.
Courtney: [0:38:32.3] And recent indicators have signaled a global growth slowdown, how do you think this will affect commodity prices?
Christopher: [0:38:37.8] It depends in what direction it goes from here. Some of those indicators have … some of the indicators that have indicated a slowdown mean that peoples’ expectations are lower, and so I would say there’s a lower hurdle to be able to continue to increase commodity demand than there was a year ago. I would also say just because the economy’s going slower does not mean that the global economy’s still not growing. You have strong economies such as the US, you still see some global growth, you still see strong growth out of China, although below recent years, you’re still seeing more than 5% per year growth. I think that growth engine is still there and it should help the demand side of the equation.
Courtney: [0:39:19.3] Jodie, how does gold’s price indicate whether the drop in oil is supply or demand driven?
Jodie: [0:39:27.3] There’s a historical relationship between oil and gold, and gold and other commodities as well as gold as used as a currency. And what we’ve seen is that the relationship today indicates that gold really isn’t that expensive. And that may change the way that we view whether the economy should be concerned about deflation more or less. And the other thing that this tells us about is that the oil price drop is more supply driven than demand drive.
Courtney: [0:40:05.4] Sal, I want to bring up this pie chart where you can see a domestic portfolio and one with commodities. And you can see when the asset allocation changes, you see a really different risk return profile, can you explain this?
Sal: [0:40:17.3] Sure. This is a 20 year study based upon an old Morning Star study. They put a very significant allocation to commodities. But what’s interesting to note, less the specific allocation of 28% is that the allocation to commodities came out of the risk side of the portfolio. So they’ve left untouched the 40% bonds or your fixed income low risk part of your portfolio. They’ve taken the risks out of your portfolio and split it between stocks and commodities. And to the point we said earlier, different drivers that affect prices, affect commodities differently than they affect stocks. So for instance, if the oil price goes down that could affect an oil company very negatively. So that’s not going to help your correlation at all. But by and large a drop in energy prices is generally associated with a rise in GDP after a certain period of time, rise in GDP, rise in stock prices. So the long oil part of your portfolio may go down but the stock part of your portfolio goes up. They offset one another. So it’s kind of counterintuitive that two very volatile asset classes will offset one another, but it’s very simple, they each react differently. So if the price of corn goes up, the price of, you know, a chicken producer’s stock may go down dramatically, but you own corn so that went up, they offset one another. The most interesting part of this is because of the offset in volatility your risk adjusted returns rise And that’s what’s important about including commodities in a portfolio.
Courtney: [0:41:48.7] And, Sal, we’ve seen a surge in ETP issuances, what are the implications there?
Sal: [0:41:53.6] I think it’s good for investors, ETPs are, you know, collateralized investments, they’re very transparent, they’re easy to trade, they have easy access to everyone. So they’ve in essence commoditized the ability to invest in commodities, whereas only 10 or 15 years ago it was really the purview of institutional traders, professional traders, your ordinary investor couldn’t access commodities easily without opening a futures account, which most people don’t want to do and probably shouldn’t do. So the easy thing now, the convenient thing is to go out, research the proper exchange traded product that’s commodity based and include it in your portfolio.
Courtney: [0:42:31.5] And, Christopher, what are the different ways investors can get access to commodities?
Christopher: [0:42:35.5] Sure, and some of them have been touched here, so there’s ETPs, with ETPs also I’d echo Sal in saying, understand what the structure is, some are commodity pools, some are [unclear 0:42:45.6] funds, some are debt instruments, so to look into that. There are mutual funds that are managed by investment companies, they will also track or try to beat various indices. And of course, you could also buy commodity equities, which have provided fairly good returns over time. But generally have a higher correlation to the equity market than what we typically see here. And then there are also absolute return … there are also absolute return managers or algorithms where there could be some sort of view, maybe long on certain sectors, short on another sector. And while that might not provide as much hedging ability against inflation for example, that could also mitigate upsides and downsides compared to other parts of the allocation. One other … the point to mention also why do people put commodities in a portfolio? It is the risk reduction, it is the ability to hedge against inflation, and if you look at most portfolios, most assets do better in a lower than expected inflation environment. There are very few assets you could put in a portfolio that does better when there is inflation and so I would say that’s the biggest reason why we’re seeing commodities come into … why people have come into commodity funds.
Courtney: [0:44:12.3] Christopher, do you think there’s any avenues for opportunity that investors haven’t thought about yet?
Christopher: [0:44:17.2] Yes, and I think some of it have been touched on by other panelists. Not every part of the curve has the same return. So going further out on the curve and certain commodities will give a slightly different return. There may also be a different liquidity profile further out on the curve. I think there are certain commodities that are not included in the major indices that may represent value once liquidity improves, so lesser known contracts. I think that there are explicit opportunities looking at the forward curve. Some products may actually go low on one part of the forward curve, short another part of the forward curve. And so I think that people really should consider all the new innovations in the commodity market and tailor the investment to whatever meets their needs.
Courtney: [0:45:07.6] And, Christopher, are you seeing growing demand for active strategies?
Christopher: [0:45:10.4] Absolutely. So I would say over the past decade commodities in general have become more accepted, the major benchmarks have been modeled by investors and have shown to produce the hedging benefits they’re looking for. And what I’ve seen is once investors get comfortable with commodities, the next step is to become comfortable with risk around whatever the benchmark is. So I think the first step for most investors is passive or enhanced index investing, the step after that I think they’d become more comfortable with active investing.
Courtney: [0:45:45.4] John, do you agree?
Jonathan: [0:45:46.2] Absolutely. I’ve been an active and indexer for a long time in commodities. So I think once investors become familiar and comfortable with indexing in the passive strategies, then taking complementary positions around those core holdings is appropriate and attractive in many cases. And there are definitely ways to accomplish that very efficiently.
Courtney: [0:45:46.2] And, Jodie, what’s the role of pensions in commodity investing?
Jodie: [0:46:15.9] Can I answer the other question?
Courtney: [0:46:17.2] Sure. Jodie, what are your thoughts on that?
Jodie: [0:46:20.0] It depends what kind of investor. Typically in institutions we do see an initial allocation to a passive index. And as they get more comfortable with the commodities then they may go into some more active strategies. However, on the retail side we see the opposite effect where the first step into commodities might be just gold or just oil. And once they realize how volatile those assets are on a standalone basis, they become interested in more well diversified baskets that can reduce that volatility.
Courtney: [0:46:52.4] Sal, do you agree?
Sal: [0:46:53.4] I agree and I think that investors are more and more turning to agricultural commodities, they’re realizing they have gold, they have oil and we’re missing some Ags. And that’s something that we’re seeing a growing interest in. I think once investors do get comfortable with that then they probably do seek out other strategies as well.
Courtney: [0:47:11.2] And, Jodie, what’s been the role of pensions in commodity investing?
Jodie: [0:47:14.9] The role of pensions in commodities investing is multifaceted. There’s a role that they play for the producers who are seeking insurance again if the price drops to offset that price drop. And when the commercial consumers or the processors choose not to provide that insurance then the producers can come in and earn a risk premium for providing that. And the pensions in turn do get a diversification and inflation benefit. With the oil price drop then we see pensions either rebalancing to their targets, so they’re increasing allocations, as the allocations have gone down from both an increase in the stock market and a decrease in commodities. And some investors who have been waiting on the sidelines may view this as an opportunity to get in.
Courtney: [0:48:08.7] And, Sal, if you’re an investor looking for quality educational material about commodity ETPs, where do you recommend people go?
Sal: [0:48:15.0] I think to the ETP sponsors websites is a very good source. Some of the commodities exchanges themselves have good educational materials. But what we’ve found are sponsors themselves are actually pretty good at putting up some very good educational pieces on their website. So start at the futures exchanges and with the sponsors of the ETPs you’re considering?
Courtney: [0:48:36.4] So this has been such a great discussion on commodities. But we’re getting close to the end of our time and I’d like to get final takeaways. Christopher, I’d like to start with you, what are your final takeaways?
Christopher: [0:48:46.0] I would say going back to earlier comments that I think the most important reason to invest in commodities is for diversification for a broader portfolio and particularly inflation hedging.
Courtney: [0:48:57.6] John, what are your final takeaways?
Jonathan: [0:48:59.2] Diversification, but also money’s been out of favor for some time, so that also creates opportunity. And I think also investors should definitely look at the structure of the vehicles that they’re choosing and the options in front of them and make the right choices based on their needs.
Courtney: [0:49:18.8] And Jodie, what are your final takeaways?
Jodie: [0:49:20.9] There are different strategies for different investors, whether they’re long term investors, short term investors or if they have tactical views on where the commodities market is today. And there’s many different products that investors can choose from in order to meet those goals.
Courtney: [0:49:40.0] Sal, what are your final takeaways?
Sal: [0:49:41.7] Investors are embracing commodities. They understand that commodities do provide a very good diversification aspect to a portfolio. And they’re beginning to understand that just gold and energy in a portfolio isn’t as completely diversified as you can be using commodities.
Courtney: [0:49:57.2] Alright, well, Christopher, John, Jodie and Sal, thanks so much. This has been such a great Master Class. And we’ll be continuing this conversation on social media and on our website. You can find us on Twitter and LinkedIn. If you’d like to pose a question to one of our panelists or ask us any questions about Master Class, please feel free to reach out to us. From Asset TV in New York, I’m Courtney Woodworth.
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http://www.teucriumcornfund.com/pdfs/corn-prospectus.pdf
http://www.teucriumcanefund.com/pdfs/cane-prospectus.pdf
http://www.teucriumsoybfund.com/pdfs/soyb-prospectus.pdf
http://www.teucriumweatfund.com/pdfs/weat-prospectus.pdf
http://www.teucriumtagsfund.com/pdfs/tags-prospectus.pdf
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Please contact Sal Gilbertie (914-414-5319/sal.gilbertie@teucrium.com) or Chris Talbert (802-540-0019/chris.talbert@teucrium.com) with any questions.
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MASTERCLASS: Commodities - February 2015
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