A Brief Primer on Commodity Futures

I wanted to share some of the research I have been reading to learn more about investing in commodity futures.  This post is based on the Yale University Study “Facts and Fantasies about Commodity Futures”, by G. Gorton (U Penn), G. Rouwenhorst (Yale), and is a mix of direct and unmarked quotes, alongside edits and original content.  This study is mentioned by most people seeking to explain why we should care about commodities as an investment class.  Certainly, the study authors could not have picked a better time for their research, published in June 2004.

For those of you that prefer reading original source material, the full report is here: Link

For those of you that prefer Cliff Notes, read on:

Commodity futures are still a relatively unknown asset class, despite having been traded in the US for over 100 years and elsewhere for even longer.  This is probably due to the fact that commodity futures are very different from stocks, bonds, and other conventional asset classes. Key differences are:

1. Futures are Derivatives - they are not claims on long-lived corporations
2. Short Lived - futures are short maturity claims on real assets
3. Seasonality - unlike financial assets, commodities can experience pronounced seasonality in price and volatility
4. Less Transparency - there is significantly less information available about commodity prices and performance

Let's try and understand this by first thinking theoretically about the purpose of stocks and bonds.  Both raise cash for a business, and as a result, represent obligations to businesses: for stocks, to maximize the shareholder's return, and for bonds, to ensure timely payment of interest and principal.  Once the cash has been handed over, investors and lenders now carry the risk that the performance of the business may be weak for a variety of reasons. The risk is borne out in the value of these claims, which changes according to the value of the business (which is the present value of its expected future cash flows.)

Commodity futures are different. They do not involve raising cash for a business' operations; rather, commodity futures are like insurance for a business for the future value of their inputs/outputs. Hence, the role of investors is that instead of receiving compensation for providing capital to a business whose value may change, investors receive compensation from companies consuming commodities for bearing the risk of short-term changes in price.

What is a commodity future?

Purchasers of commodities – airlines, food producers, etc. – consume raw materials as a regular part of their business.  As such, these users have an ongoing need to purchase commodity products.  Their business demands materials today, but a business with experience knows it needs to plan ahead for its future consumption. 

Buying commodities for immediate consumption involves purchases in what is known as the “spot” market, and the price paid for commodities to be consumed immediately is the “spot price”.

Commodity futures do not represent direct exposure to actual commodities. A futures contract is a contractual agreement to purchase a given product for delivery at a given point in time, the price of which represents a bet on anticipated future spot price. In order to initiate a contract, a buyer and a seller have to agree to the terms, and no money is exchanged at the initiation of the contract. 

The buyer/seller make or lose money depending on the spot price of the commodity at maturity.  If the spot price at maturity is higher than the futures price at inception of the contract, the futures buyer makes money (future contract allows them to buy the commodity at a price lower than prevailing prices); if the spot price is lower, the futures buyer loses money (because they bought the commodity at a price higher than prevailing prices).

A futures contract is therefore a bet on the future spot price, and by entering into a futures contract an investor assumes the risk of unexpected movements in the future spot price.

So Why Would Futures Be a Good Investment?

Keynes developed a theory in 1930, called the "theory of normal backwardation".  Backwardation is the term used to describe market conditions where the futures price is less than the spot price.  This is considered the normal state of prices in a commodity market, and Keynes' theory sought to explain why this was.

Keynes' theory was based on an assumed world where producers of commodities would seek to hedge the price risk of their output. For example, a producer of grain would sell grain futures to lock in the future price of his crops and obtain insurance against the price risk of grain at harvest time.  Speculators would provide this insurance and buy futures, but they would demand a futures price which was below the spot price that was expected at the maturity of contract.  By “backwardating” the futures price relative to the expected future spot price, speculators would receive a risk premium from producers for assuming the risk of future price fluctuations.

So, we have defined the risk premium (see graph below) is the difference between the price of the futures contract, and the expected futures spot price, and this is the amount of money that an investor would make for buying futures contracts over time and holding them to maturity.

Does this mean that speculators have to hold the futures contract until expiration to earn the risk premium? The answer is no. Over time, as the maturity of the contract draws close, the futures price will start to approach the spot price of the commodity. At maturity, the futures contract will become equivalent to a spot contract, and the futures price will equal the spot price. If futures prices were initially set below the expected future spot price, the futures price will gradually increase over time, rewarding the long position, and speculators could sell prior to maturity.

Futures vs. Spot Prices

The next graph below takes a look at Keynes' theory of normal backwardation in practice to show what the reward would be over time to a speculator in commodity futures, compared with the change in the underlying spot price over time. What is clear from the graph below is that investors are indeed rewarded over time for bearing the risk of price fluctuations through futures contracts. 

The chart below shows returns over a 40+ year time period.  Now, it is important to note that the comparison of “returns” is more illustrative than indicative of real opportunities, for one cannot “invest” in spot prices.  The chart below simply shows how spot prices changed over time, and how an investor could earn a return by buying short-dated (one month out) futures contracts and holding them to maturity.  While spot prices increased 5x over the sample period, the futures index increased 15x.

Investing in Futures vs. Equities and Bonds

Ok, so commodity futures perform better than spot prices, but everyone knows equities outperform other asset classes over longer time periods, right?

Well, not really.  Turns out that fully-collateralized commodity futures have historically offered the same return and Sharpe ratio (risk-adjusted return, correlates return with volatility) as equities. 

Note: “Fully-collateralized” means that the futures were not purchased on margin.  This is important, because there is no margin requirements for commodities purchases, whereas equities requires 50% of the transaction value held as collateral (this is due to the evolution of equity markets and the timing of the creation of the Federal Reserve.)

Correlation of Commodities with Equities and Bonds

Now here’s where things get interesting for investors seeking diversification: while the risk/reward trade off for commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns.

The negative correlation between commodity futures and the other asset classes is due, in significant part, to different behavior over the business cycle. In addition, commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation.

Conclusion

Commodity futures are a misunderstood asset class that offers comparable returns with a similar risk profile as equities.  Commodity futures offer a significantly greater return to an investor/speculator over time than simple changes in spot prices, as the "risk premium" identified in Keynes' theory of normal backwardation accrues to the speculator/investor.  Finally, for truly diversified portfolio construction, commodity futures offer returns that are negatively correlated with equity and bond returns.  - Ed

Comments

[mike bertelsen]

Very good. Gives me a better understanding.

[Jeo]

Great primer

[Rick]

I will never understand why people who do not produce, process, consume or in any way add value to a product are allowed to legally "bet" on it's future price. I cannot "bet" on the future value of my poker hand, legally in most localities. Why is this practice allowed?

[Hayek]

Rick: The "betting" lets farmers get rid of the price risk when they grow crops (and same for mine and oil well owners). You cannot run a business for long if you are exposed to one bad storm meaning the difference between solvency and bankruptcy. You'd just go do something else to ensure you could eat and keep your home.

Without these markets, less farmers farm, less mines produce, and less oil gets pumped. Lower supply means higher and more volatile prices -- which are passed on to consumers.

With these markets, other people (speculators) take these risks and earn money to compensate for the possibility they go bankrupt. This is the idea of risk transfer: People who are unwilling to take these risk can move them to somebody who is willing. That makes farmers able to produce more reliably and makes prices you pay lower and less volatile.

That is why this practice is allowed.

P.S. Sometimes you can bet on the future value of your hand. Or a future roll of the dice (e.g. a come bet).