February 12, 2015 2:47 pm
Commodity prices go back to basics
Emiko Terazono
Commodity markets are going back to basics. Instead of moving up (or down) in lockstep with each other, and with other assets, they are beginning to show variation.
The “backwardation” seen in some commodities is an indication of this change. Referring to conditions where it costs more to buy a commodity in the spot market than for future delivery, this is not a term you hear much in the commodities world these days.
Crude oil is in contango, as output from US shale and the absence of a cut by Opec has boosted supplies at a time of weak demand. Good weather around the world has meant ample supplies of grains, of which many have also been in contango.
But a closer look shows there are several raw materials that are in backwardation, including copper, oil products such as heating oil, soyabean meal and cocoa.
After four to five years of rising price correlation between commodities and other financial assets, where markets were influenced by macroeconomic and political factors, raw materials seem to be returning to an era where they are more influenced by individual supply and demand fundamentals.
Between 2008 and 2012, correlations heightened between commodities and other financial markets, such as equities, as well as between individual raw material markets, caused by ultra-loose monetary policy in the US and stimulus in China.
However, this has eased in recent months. For commodities subsectors, “correlations fell in 2014 and have stayed low”, says Kevin Norrish, head of commodities research at Barclays.
This trend may favour traders and investors who understand the minutiae and idiosyncratic drivers of commodity markets.
Indeed, recent trends in commodities markets, particularly the falling oil price, have made the sector an unattractive proposition for long-only investors. But those with models that have selected commodities in backwardation would have made returns.
This is because they can gain on the “roll yield”, where they profit when they roll over their position.
In a backwardated market, they can sell their existing positions at a higher price than it costs to buy the next futures contract.
“Those [active, value-oriented] strategies have performed quite well so far this year,” says Mr Norrish.
So what are some of the commodities in backwardation and what is behind this?
Despite expectations of a small supply surplus in 2014, copper has been in backwardation since last July.
Traders and analysts point to the unquantified amounts of the red metal used in China as collateral for financing deals, which are held in the country’s ports as collateral. Large purchases by a single buyer, thought by traders to be Chinese State Reserve Bureau, also sucked up copper for immediate delivery.
Chinese officials have clamped down on the use of metal as collateral to obtain financing, after an alleged fraud was discovered in the port of Qingdao in May. Seasonally, the physical market is also quieter before the Chinese new year holiday this month.
With inventories at the LME rising, “the backwardation is shallowing”, says Colin Hamilton at Macquarie Securities in London.
Argentina is the largest exporter of soyabean meal, accounting for 40 per cent of world trade. Hoarding by farmers there in the face of high inflation and a falling currency has meant they have held on to their soyabeans, which are traded in dollars, as a means of income security.
After being in backwardation for most of 2014, soyabean meal briefly fell into contango, but the near-term market has once again tightened. “The demand side is very good,” says Steve Nicholson at Rabobank in St Louis, Missouri.
The backwardation could signal that the expansion under way in the poultry and pork sectors in the US “could be bigger than people are forecasting”, he adds.
Crude oil has been in plentiful supply, but some of the oil products have been in backwardation.
Heating oil has been in backwardation since October as users have been buying as prices have fallen.
“Consumers of heating oil have been able to stock up,” says Jodie Gunzberg, global head of commodities at S&P Dow Jones Indices. Winter demand in the northern hemisphere has also meant the commodity for immediate delivery has been tight, although the structure may weaken as the weather warms up, say analysts.
The “backwardation” seen in some commodities is an indication of this change. Referring to conditions where it costs more to buy a commodity in the spot market than for future delivery, this is not a term you hear much in the commodities world these days.
Backwardation usually signals a tight near-term supply and demand situation. When supplies are plentiful and commodity prices are falling, prices tend to be in the opposite condition, known as “contango”.
But a closer look shows there are several raw materials that are in backwardation, including copper, oil products such as heating oil, soyabean meal and cocoa.
After four to five years of rising price correlation between commodities and other financial assets, where markets were influenced by macroeconomic and political factors, raw materials seem to be returning to an era where they are more influenced by individual supply and demand fundamentals.
Between 2008 and 2012, correlations heightened between commodities and other financial markets, such as equities, as well as between individual raw material markets, caused by ultra-loose monetary policy in the US and stimulus in China.
However, this has eased in recent months. For commodities subsectors, “correlations fell in 2014 and have stayed low”, says Kevin Norrish, head of commodities research at Barclays.
This trend may favour traders and investors who understand the minutiae and idiosyncratic drivers of commodity markets.
Indeed, recent trends in commodities markets, particularly the falling oil price, have made the sector an unattractive proposition for long-only investors. But those with models that have selected commodities in backwardation would have made returns.
This is because they can gain on the “roll yield”, where they profit when they roll over their position.
In a backwardated market, they can sell their existing positions at a higher price than it costs to buy the next futures contract.
“Those [active, value-oriented] strategies have performed quite well so far this year,” says Mr Norrish.
So what are some of the commodities in backwardation and what is behind this?
Despite expectations of a small supply surplus in 2014, copper has been in backwardation since last July.
Traders and analysts point to the unquantified amounts of the red metal used in China as collateral for financing deals, which are held in the country’s ports as collateral. Large purchases by a single buyer, thought by traders to be Chinese State Reserve Bureau, also sucked up copper for immediate delivery.
However, analysts expect more supplies to come on to the market this year, easing the backwardation.
With inventories at the LME rising, “the backwardation is shallowing”, says Colin Hamilton at Macquarie Securities in London.
Soyabean meal has remained a tight market due to demand for livestock and poultry feed.
Argentina is the largest exporter of soyabean meal, accounting for 40 per cent of world trade. Hoarding by farmers there in the face of high inflation and a falling currency has meant they have held on to their soyabeans, which are traded in dollars, as a means of income security.
After being in backwardation for most of 2014, soyabean meal briefly fell into contango, but the near-term market has once again tightened. “The demand side is very good,” says Steve Nicholson at Rabobank in St Louis, Missouri.
The backwardation could signal that the expansion under way in the poultry and pork sectors in the US “could be bigger than people are forecasting”, he adds.
Crude oil has been in plentiful supply, but some of the oil products have been in backwardation.
Heating oil has been in backwardation since October as users have been buying as prices have fallen.
“Consumers of heating oil have been able to stock up,” says Jodie Gunzberg, global head of commodities at S&P Dow Jones Indices. Winter demand in the northern hemisphere has also meant the commodity for immediate delivery has been tight, although the structure may weaken as the weather warms up, say analysts.
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