2. Commodity Markets_final

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Dr. Denis Schweizer Associate Professor of Finance John Molson School of Business, Concordia UniversityMailing address: 1455 de Maisonneuve Boulevard West, Montreal, Quebec H3G 1M8Office: MB 11.305Phone: +1(514)-848-2424, ext. 2926Fax: +1(514)-848-4500E-Mail: [email protected]

2. Commodity Markets

Investment Analysis



Investment AnalysisDenis Schweizer

Learning Outcome Statement

Characterization of commodities as an independent asset class

Exploration of various possibilities to invest in commodity markets

Knowledge of return drivers of investments in commodity futures

Consideration of the diversification effects from integrating commodity futures intotraditional portfolios

Learning about the interdependencies between commodity prices and fundamentalmacroeconomic data




Agenda

I. Current trends

II. Characteristics of commodity markets

III. Commodities as an independent asset class?

IV. Opportunities to participate in commodity markets

V. Sources of returns of commodity futures indices

VI. Commodities and macroeconomics




Discussions about Gas Supply in Europe

Gas pipelines and dynamics through LNG

By cooling natural gas to about -165°C, it canbecome a so called “Liquefied Natural Gas“

(LNG)

With its volume being 1/600 of that of the gasform, LNG can be much easier transported on

roads, rails and water

This could considerably reduce Europe’s heavily

discussed dependence upon Russian gas pipelines

Currently, the transportation of gas is cheaperthrough existing pipelines

Due to current developments, new pipeline

projects are discussed, which would reduce the

dependence on Russia and Ukraine (see map onthe right)

Instead of bigger investments in pipeline projects

(e.g. like currently in the Ukraine) other means of

transportation could establish themselves

Russia warns Germany of a long gas dispute

“Record-low temperatures in Germany - and the gas dispute between

Russia and Ukraine escalates right at this time. Medwedew, the vice

CEO of Gazprom, explained in Berlin that the conflict will not be

solved soon: He advised the Germans to build more reservoirs to

ensure supply if necessary.“

Der Spiegel, 06.01.2009




Current Trends: Fears of Export Stoppage on Rare

Earth Metals from China

“Rare Earth” Rare Earth Metals – Overview

Forward-looking technologies like hybriddrives, solar plants, flat screens and mobilephones require for their production so called“rare earth” metals

Currently 93% of the total world market forthese metals (137.000 t p.a.) are mined in China

Due to an increased demand for the metals, theChinese government considers an exportstoppage for rare earth metals. This would putespecially Western industries in a difficultsituation threatening their future

That is why a worldwide footrace begins for thesearch for sources of those metals in other

regions Besides the small sources in Zambia and Sierra

Leone for example, the hope of the worldeconomy lies in significant sources like thosefound in Afghanistan

Worldwide mining (in t)

Country 2006 2011 2012 Reserves

Australia Na 2,200 4,000 1.6 Mio

China 119,000 105,000 95,000 55 Mio

India 2,700 2,800 2,800 3.1 Mio

US - - 7,000 13 Mio

Other 1,300 1,000 1,200 ~41 Mio

Total ~123,000 ~111,000 ~110,000 ~114 Mio

Scandium Yttrium

Lanthan

Cer

Praseodym

Neodym

Promethium

Samarium Europium

Gadolinium Terbium

Dysprosium

Holmium

Erbium

Thulium

Ytterbium

Lutetium




Global Rare-earth-oxide Production Trends

Source: USGS. Note, The Mountain Pass deposit is in California, U.S.A. Graph from D.J. Cordier (U.S. GeologicalSurvey, 2011) and was updated from Haxel and others




China’s Appetite for Resources as the Driving

Force for Growth

Chinese raw material imports increased twentyfold to about 200 billion USD in the last 20 years

Currently, China mainly imports crude oil and ore, most of them coming from South America and Africa

The increasing income and the decreasing agricultural area will increase the demand for agricultural

products

Resource Unit Demand p.a. Change 2006-2010

Curr. 2020 total p.a.

Iron Ore m t 148 710 380% 10%

Oil m t 91 1.860 1,940% 20%

Soy m t 26 50 80% 4%

Coal m t 11 810 7,400% 20%

Copper m t 3 20 600% 10%

Manganese m t 3 13 360% 10%

Meat m t 0.3 4 1,260% 20%

Timber m m³ 34 150 330% 10%

Metals

Oil

Cotton

Soya

Source: Deutsche Bank Research

Projection for China’s demand for

imported raw materials

China’s main suppliers of resources in

Africa and South America




Agenda

I. Current trends









Characteristics of Commodity Markets

Commodities – in comparison to financial assets – are real assets and primarilyconsumption goods (electricity, gas, coffee etc.), and not durable goods

Commodities have an intrinsic value and provide a utility through usage, if they areneeded for example in industrial production, or through consumption

The demand for commodities does not only depend on the price, but also oneconomic growth or the demand of other assets (opportunity costs)

The supply of commodities is limited and can be scarce in the short term, as for agiven time period only a certain amount of commodities is available (see „commodities

and macroeconomics“)

The supply of some commodities is also characterized by seasonality (i.e. harvestingcycle, gas, live cattle)




Characteristics of Commodity Markets

Commodities are not standardized regarding their nature, and every class ofcommodities features specific properties, so commodities as such are very

heterogeneous

On the contrary, traded commodity futures are standardized contracts

“When a bushel of soybeans weighing 60 pounds is crushed, the typical result is 11 pounds ofsoybean oil, 44 pounds of 48% protein soybean meal, 4 pounds of hulls, and 1 pound of waste. If

the hulls are retained, the result is 48 pounds of 44% protein soybean meal. In October 1992, the

Chicago Board of Trade revised the soybean meal futures contract specifications from a 44% protein

standard to 48% protein soybean meal.” (Chicago Board of Trade)

The cycles of different commodities also behave differently: the development inagricultural commodities and energy commodities is driven by the weather, whileindustrial metals are driven by business cycles




Classification of Commodities

Commodities

Energy Foodstuffs, drinks and tobacco - Metals Indust. - agricultural Live cattle

Fossile energy - Crude oil- Heating oil- Gasoline- Natural gas- CoalNuclear energy - Uranium

Renewables - Solar energy- Wind energy- Water energy- Biomass energy

D & T Crop and Oilseeds Industrial metals

Precious metals

CoffeeSugar TeaCocoaOrange juice Tobacco

Crop - Barley- Oat- Corn- Rice- Wheat

Oils and Oilseeds - Soy beans- Soy bean oil- Coco oil- Palm oil- Canola oil

AluminumCopperZincLeadNickel Tin

GoldSilverPalladiumPlatinum

Live cattleFeeder cattleLive hogs

CottonSilk WoodNatural rubberPulp

Hard Commodities Soft Commodities




Why Investing in Commodities?

Commodities as an asset class have historically gained positive returns in long-termperiods, which are uncorrelated to stock and bond returns

Commodities therefore reduce the portfolio risk and enhance the risk-and-return tradeoff(diversification of market price risks)

Participants in commodity markets:

Hedgers

Speculators (Traders)

Arbitrageurs

→ Why do we need arbitrageurs in the market?

Strategic advantages:




Why Investing in Commodities?

The demand for commodities:

Industrialization and economic growth in the BRIC states (Brazil, Russia, India,China) drive the demand for commodities ( → see current financial crisis )

Urbanization of the population leads to industrialization of agricultural economies Industrialized and prospering economies demand more commodities due to a

higher demand in consumption goods and investments in infrastructure (e.g. China)

The supply of commodities:

Shortage of commodities due to lacking capital investments and productioncapacities → Cyclical investments in infrastructure!

Tactical Advantages:




Agenda

I. Current trends









Categorization in “Super classes” (Greer 1997)

(1/2)

1. Capital Assets

Have a continuous value development

2. Store of Value

Assets

Assets for the conservation

of values

Super classes

3. Consumable and

transformable assets – C/T-assets

to which an economic value is assigned

Especially the 3. property makes commodities an independent asset class.




Categorization in “Super classes” (Greer 1997)

(2/2)

Important:

Commodity prices cannot be determined by a Discounted Cash Flow (DCF)approach, but they result from supply and demand on specific markets

The borders between the super classes are floating, e.g. gold is a commodity (used in

electronic circuits in airplanes and computers), an asset for value storage (analogous tocurrencies), but also a capital asset, as it can be leased

Gold served as the security for the “Bretton- Woods” central banking system in the U.S.

from 1944-71

Commodity prices are globally denominated in U.S.-Dollars. In fact, the value of a certain

commodity is determined by global rather than regional imbalances of supply anddemand. In comparison, stock markets often reflect the economic development withina country or a region




Agenda

I. Current trends









How Should You Invest in Commodities?

= Buying the physical good on the spot market (direct real investment)

Disadvantage:

Immediate delivery of the commodities (or within 2 days) is not tractable in mostcases, regarding specific requirements for storage and logistics and due to high ongoingcosts (e.g. feeding costs for live cattle)

(exception: precious metals, e.g. gold, platinum, silver) Current example:

“ Whenever the forward curve of these commodity futures is backwardated (inverted) asin the case for crude oil at present, cash-and-carry storage is unprofitable and we shouldexpect inventories to decline. The opposite held true between 2009 and 2011 when aglut of supply at Cushing Oklahoma, pulled the forward curve into a contango thatmade storage profitable” (Nasdaq, September 30th, 2013).→ Why?

In order to invest in commodities financial assets are needed in most cases …

Purchase of the physical assets





= Investments in commodity stocks (natural resource companies)

Yield major returns through trading of physical commodities (i.e. exploration, mining orharvesting, refining, processing, selling and delivering commodities)

Disadvantage:

Indirect, securitized investment in commodities (e.g. investment in petrochemicalstocks) is an insufficient substitute for direct investments, i.e. the investor does not gainan immediate exposure in commodities

Reason:

Stock markets and listed companies possess different value driving factors and inherent

risks (e.g. strategic company positioning, quality of the management, capital structure,expectations in profitability, transparency of information, market instabilities,operational risks, smoothing of company profits etc.)

Commodity stocks





= Long-Only-Commodity funds

Differentiation by management style, composition, geographical and temporal investmenthorizon, currency, investment behavior and conducted strategy (active or passive funds)

Commodity Trading Advisors (CTAs) with active management

Hedge Funds with trading strategies in energy or commodities

Advantage:

Appropriate potential for diversification and moderate transaction costs

Disadvantage:

Low liquidity

Intransparent investment strategies for investors

Commodity funds





Advantages:

Investors gain from price movements of the underlying commodities without specificrequirements in storage and logistics

High flexibility, i.e. roll-over of existing futures positions is possible on short notice(long and short positions)

High degree of liquidity and low transaction costs

Disadvantages:

Low amount of futures in highly volatile commodities

Long-term exposure in commodity price risk requires proactive roll-over of contracts

(might be very costly, depending on the market structure)

Permanent margin calls if value depreciates

Management of futures positions requires higher effort

Risk of a physical settlement / delivery

Commodities Futures = active engagement in futures-market





= tradable passive commodity indices (keep in mind that most alternative asset classesdo not have “appropriate” tradable indices)

Index-oriented investments are cost efficient alternatives to gain exposure to singlecommodities or segments of the commodities market

Listed commodity index funds or index trackers (Exchange Traded Funds (ETF)):

Advantage: relatively easy and cheap to trade, no solvency risk of the issuer, sinceETFs are guaranteed deposits

Commodity indices, like the commodities themselves, are denominated in U.S.-Dollars,i.e. investors are exposed to exchange rate risk

Some ETFs or investment certificates provide a currency insurance and are called “Quanto”

Disadvantage: Prices of the index or ETF can decline even if the spot price of theunderlying commodities increase, which is caused by the structure of the Futures-curve

Commodity-indices





Commodity indices due to their construction only incorporate futures contracts with shortdurations (→ why ?)

„ The ETF “United States Oil Fund (USO)” lost 22 percent of its value only in December

– significantly more than the oil price has lost in this very period: WTI only lost 9.5percent. The stock price of the ETF shrunk by 80 percent since July 2008.“ (Financial Times, September 2nd, 2008)

Commodity indices do not incorporate short-positions Commodity funds, such as CTAs — not ETFs! — which are independent from an index can

freely determine optimal durations by directly engaging in commodity futures contracts (seeCTA/Managed Futures)

Disadvantages of index-based commodity investments

Based on monthly dataOct. 2003 to Oct. 2013 CISDM CTA S&P GSCI TR

Annual ROR 3.28% 1.75%

Volatility 5.84% 25.42%

Max DD -7.74% -69.95%

Sharpe Ratio( = .%)

0.30 0.01




Correlations in Up- and Down-Markets

S&P GSCI Agricultural Sub-Index

Passive portfolios show positivecorrelations in up-markets as well asdown-markets → on average investors

suffer losses in down-markets

Barclays Agricultural Trader Index

Active portfolios show negativecorrelations in down-markets and positivecorrelations in up-markets → on average

investors can gain profits in up-marketsand down-markets

Source: DataStream (Monthly Returns from January 1990 – October 2013)

I t t C dit I di (P i L




Important Commodity Indices (Passive, Long-

only)

Reuters/Jeffries

Commodity Research

Bureau (RJ/CRB)

S&P Goldman Sachs

Commodity Index

(S&P GSCI)

Dow Jones/AIG

Commodity Index

(DJ-AIGCI)

Introduction to

Market 2005 1991 1998

Historical data since 1957 1970 1991

# of commodities 19 24 19

Computation of

index weights

System of 4 subgroups,differentiated by liquidity

& economics importance

Rolling 5-years-average of total

world production

Liquidity data in combination with Dollar-weighted pro-

duction of the last 5 years

Rebalancing monthly annually annually

Limitations in

diversification

none none 33% max. per sector; 2%

minimum per commodity

Futures price for

index calculation futures contract with next

maturity date Next month with

sufficient liquidity futures contract with next

maturity date

Roll-Over period 4 days 5 days 5 days

Calculation arithmetically arithmetically arithmetically

I t t C dit I di (P i L




Important Commodity Indices (Passive, Long-

only)




Price Formation on Commodity Futures Markets

Investigation of risk premia in commodity markets

Framework:

CAPM , insurance perspective, hedging pressure, storage cost theory

If the no-arbitrage condition holds for the spot and futures prices of assets, and if we

assume that no storage cost occurs, the futures price in t of commodity , with duration

T is equal to the compounded (with risk-free continuous interest rate r ) spot price . For = 0 (today) we conclude that:

, = ∙

If c are storage costs that accrue during the holding period and which are assumed to be

proportional with the commodity price, then the futures price , in = 0 of the

commodity will be calculated as follows:

, = ∙ +




Theory of Storage Cost and Convenience Yield

In addition to the no-arbitrage condition, the direct utility that can be provided by thepossession of the physical commodity (e.g. if there are temporary shortages in the market),has to be calculated as follows:

, = ∙ +−

According to the theory of storage (Kaldor, 1939), the convenience yield y reflects theutility implied by the physical holding of a commodity, compared to a purely contractualagreement on its delivery in the future

Market participants are willing to pay a premium (the convenience yield) for theimmediate availability (access) of (to) the commodities

The utility results from the avoidance of costs that arise from interruptions in theproduction process or from complications in storage (e.g. oil refineries)




Theory of Storage Costs and Convenience Yield

Buyers are willing to pay a higher price for immediate delivery

= Backwardation

= markup for immediately available goods over the 3-months futures price(spot price over futures-price)

The availability-premium varies over time, if unexpected inclines or declines in theavailable commodity stock occur

Commodities which are highly exposed to abrupt changes in stock show changes in theirforward curve in a particularly high degree. This can even lead to a total inversion of the

forward curve

Slope of the forward curve as an indicator for the stored amount of a commodityand the market’s expectations on its future availability




Patterns of the Futures Curve

Considering the futures curve for a commodity, that depicts the futures-prices for

different durations of futures contracts, one observes two typical patterns:

Contango , the futures price is above the spot price, thus, the futures curve has a positiveslope

Backwardation , the futures curve shows a negative movement, i.e. the futures-prices(today) are lower than the current spot price

➔ In a Backwardation situation the investor can gain profits by engaging in long positionsin the respective futures contracts even if the spot price of the underlying commodity isnot changing at all

➔ If there is a significant premium in futures contracts (Contango) and the spot price doesnot move at all, the futures contract will suffer a loss equal to the “forward premium”

Net Gas Futures Prices in January 2011




Contango versus Backwardation

January 2007Source: Bloomberg (taken from Engelke and Yuen, 2008)




Forward Curve vs. Spot Curve

Weekly price of Nov 2011 Natural Gas Spot price chart of Natural Gas

Source: NAS Trading

The futures contract ′11,′11 starts in

January 2011 at $5.185 and is in November

2011 (expiry date) at about $ 3.681, this is

equal to a loss of $1.504 per contract

Reason for the difference is the decline in the

“forward premium” as the contract

approaches its expiration date

Natural Gas spot price (quoted in British thermal

units (Btu)) started the year at $4.54, and iscurrently at expiry date $3.68, this is equal to a

loss of $.86, or $860 per volume equivalent of

one futures contract

Notice, futures price converges with the spot

price at expiry date

January 2011 November 2011

Dynamics of Shortage Exemplified by Oil




Dynamics of Shortage Exemplified by Oil

Returns

If storage is low compared to demand, the market is not protected against temporaryshort-term futures- as well as spot-price jumps

The oil market frequently experiences unexpected rises in demand (due to cold weather,rising demand for transportation etc.) or disruptions in supply (due to weather, politicalarousal, technical errors)

If the buffer (= oil in stock) is insufficient, short-term future prices may rise sharply

O i l p r i c e ( $ b a r r e l s )

$100

$102

August September October

$100 $100

How Do Commodity Futures Returns Work in a




Example (Contango): Initial investment amount K = 100

Margin account M = 10 for 1 Futures-Contract

For simplicity no interest rate payments are made

Time t Commodity

Price

Futures-Price with

Maturity in t+1

Futures-

Payoff

Margin-Account

(w/o Interest)

0 100 105

1 103 107

2 110 117

3 112


Contango Situation?




Page 36Investment AnalysisDenis Schweizer

Example (Backwardation):

Initial investment amount K = 100

Margin account M = 10 for 1 Futures-Contract

For simplicity no interest rate payments are made

Time t Commodity

Price

Futures-Price with

Maturity in t+1

Futures-

Payoff

Margin-Account

(w/o Interest)

0 100 96

1 97 92

2 90 85

3 88


Backwardation Situation?

Generating Returns Through the Shape of the




Generating Returns Through the Shape of the

Forward Curve

Example: An investor holds

short-term futures.Shortly before maturity,he has to roll themover into the next

contract, as he wouldget a physical deliveryotherwise!

He sells the currentfutures and invests theproceeds in futures with the next maturitydate

→ Is the profit riskless? Next future Second-nextfuture

$62

$60

1. Selling the long position in short-term futures10 barrels x $62 = $620

2. Invest proceeds in the futures contract with second-next maturity at a lower price.$620 / $60 = 10.33 barrels

3. Rolling up the curve: sell 10.33barrels at $ 62 = $640.46= 3.3% return

Contango and Backwardation May Change Over




Contango and Backwardation May Change Over

Time

Roll-Returns (YoY)

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

1 9 7 1

1 9 7 3

1 9 7 5

1 9 7 7

1 9 7 9

1 9 8 1

1 9 8 3

1 9 8 5

1 9 8 7

1 9 8 9

1 9 9 1

1 9 9 3

1 9 9 5

1 9 9 7

1 9 9 9

2 0 0 1

2 0 0 3

2 0 0 5

2 0 0 7

Industrial Metals

Livestock

Precious Metals

Energy

Agriculture

Contango vs. Backwardation: Example from the




Contango vs. Backwardation: Example from the

Current Market Environment

Different situation for cereals Contango for precious metals

Contango for nearly all energy goods Industry metals: Contango & Backwardation




Backwardation is not a temporary phenomenon, but also not a guarantee! Energy and livestock sector are mostly in backwardation, as the majority of non-

storable commodities belongs to these sectors

Precious metals with neglect able storage costs are always (???) in contango

Sector #days % Backwardation

Crude oil 5953 61%

Unleaded fuel / RBOB(1) 5530 62%

Live hogs 5993 51%

Live cattle 5993 51%

Copper 5987 42%

Aluminum(2) 4928 21%

Wheat 5990 28%

Corn 5990 17%

Soy beans 5991 15%

Gold 5963 0%

Backwardation in Commodities

(1) Data for the fuel futures

begins on Dec 4, 1984

(2) Data for the aluminum

futures begins on July 11, 1987

Source: Goldman Sachs (March

1983 – December 2006)




Seasonality Patterns for Pork Belly

CME Outside Chicago 12-28 lbs Pork Belly Stocks, Source: Bloomberg, LP




Agenda

I. Current trends









Components of Commodity Futures’ Returns

spot price

actualfutures price

backwardation

cost of carry

10

20

30

40

}}

collateral return

roll return




Where do Futures-Returns Come From?

Commodity-Futures

= Derivatives, futures contracts on physical commodities

Price formation of these assets depends on far more factors than just the commodityprices on the spot market. It is more complex:

Excess Return = Spot Return + Roll Return

Total Return = Spot Return + Roll Return + Collateral Return




Returns Components of Commodity Indices

Collateral return

Roll return

Spot return

Returns Components of Commodity Indices – A




p y

Closer Look after its Introduction

Collateral return

Roll return

Spot return

Sample Exam Question: Charts of Spot- and




Sample Exam Question: Charts of Spot andExcess-Return Indices for Heating Oil and Gold

Source: GSCI sub-indices for gold and heating oil, excess return and spot return, courtesy of Erb, Claude

B. and Harvey, Campbell R, "The Tactical and Strategic Value of Commodity Futures" (January 12, 2006), available atSSRN: http://ssrn.com/abstract=650923. (taken from: Engelke und Yuen, 2008).




Agenda

I. Current trends






Price Development Depending on




Higher demand fully translates into higher prices (this effect is partly weakened forstorable commodities)

Only in the long term, new investments in commodity infrastructure lead to higher supplyor more intensive processes (→ oil slate )

D'

D

Ss(ns)

S

s

(s)

P

Q

●

●

Sl

Qs Ql

●

p p g

Supply and Demand

Prices Go Up in the Investment Phase, But Go



p

Down in the Exploitation Phase

log of real prices in $/barrel

2. Commodity Markets_final

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