Commodities | Apr 20 2006
Interest out of the US in investment in commodity index funds, which in turn invest in commodity futures contracts, has been growing exponentially. Rather than fiddle around with leveraged metal stocks, which might have long-dated hedges in place anyway, investors have looked to the closest thing to buying the metal directly other than storing an inventory in one’s garage.
The rush into commodity index funds has had all the hallmarks of self-fulfilment. Forget surging demand for metals coming out of China for the moment, metal futures prices have been furthermore pushed up by investors who do not wish to miss out on metal prices going up. The more prices rise, the more investors want in, the more prices rise. If it wasn’t for actual lack of metal supply, you’d have to be thinking bubble.
However, investment in futures has its own drawbacks. Bellwether contracts are usually only three months in duration, and so to avoid having, say, a container load of copper land on your doorstep, positions need to be rolled forward quarterly. (Commodity futures contracts are still mainly deliverable, not cash-settled).
Each roll-forward prior to the delivery date implies a shift along the forward curve. Commodity contracts are often in "backwardation" meaning the successive contracts are lower in value. This is because inventories are kept of consumable metals which can be drawn on if spot prices are temporarily high. In other words, you will usually not pay more to buy copper in the future than what you would pay now.
This is little comfort to straight out investors who have no plans to actually start making things with copper. They just want price appreciation. The problem is that when the forward curve is in backwardation each rollover means a step back down the price curve. Sort of a two steps forward one step back.
Prices on commodities such as copper have rocketed recently not just because more investor demand has emerged but also because there are genuine supply shortages stemming from mine strikes and other problems. This has sent spot (today’s) prices way up above later-dated prices as such shortages are always considered to be potentially temporary.
For this reason, commodity index returns have actually been disappointing. Barclays Capital reports first quarter 2006 returns were as bad as minus 20%, and returns have only turned back to positive last week. You just can’t win it would seem.
I wonder what would happen if commodity investors got jack of the situation and decided to sell out?