Have all the “Supercycle” Gains been Wiped Out?
We have frequently come across articles lately that are purporting to show that commodity prices have in the meantime declined below the lows that obtained at the start of the last bull market. Yesterday Zerohedge e.g. posted a chart from Sean Corrigan’s True Sinews Report, which depicts the GSCI Excess Return Index. The following remark accompanied the chart:
“Returns from being long the commodity super-cycle have evaporated in the last 18 months – to 42 year lows.”
So are commodities as a group really at 42 year lows? Here is a little test: can you name even a single listed commodity that currently trades at a lower price than at any time since January 1974?
Image credit: Ian Berry / CNN
There is actually no need to check, because there isn’t one. So how can an entire commodity index, which presumably includes a whole range of commodities, have fallen to a 42 year low? Below is a chart that provides us with a hint. It shows the performance of the crude oil ETF USO since its introduction and compares it to the performance of WTIC crude.
Performance of WTIC (red line) vs. the crude oil ETF USO (black line) since mid 2006. USO has declined by nearly 31% more than the commodity the price of which it purports to reflect – click to enlarge.
In one sense, the remark accompanying the GSCI excess return index chart is entirely correct: Had one invested in commodities via this index, the nominal value of the investment would now be at a 42 year low. However, the same is not true of the commodities the index is composed of (although buying them directly wouldn’t have helped much, as we will explain below). The cause of the GSCI’s dismal performance is also the reason why USO has so vastly underperformed crude oil.
Futures Contracts vs. Spot Price
With a hat tip to commodities and seasonality expert Dimitri Speck, who first pointed this problem out to us, we will briefly explain what is going on here. Note that many popular commodity indexes in fact do not reflect actual underlying commodity prices.
This is due to the so-called “roll-over effect”. Normally, futures markets are in contango – this means that later delivery months will trade at a premium over nearer delivery months. The reason for this is that the futures market prices in storage and insurance costs, as well as opportunity costs (in terms of forgone interest that the money tied up in commodities would normally be expected to generate in alternative investments such as t-bills).
In bull markets the contango will often disappear for considerable stretches of time and turn into its opposite, namely so-called backwardation (i.e., later delivery months will trade at a discount to nearer months). Bull markets in commodities are usually characterized by near term supply tightness, or the perception that a supply shortfall exists or is imminent. Backwardation is the market’s way of “driving commodities out of storage” if you will. Conversely, contango will tend to go hand in hand with rising inventories and the expansion of storage facilities.
Given that most investable products, whether they are indexes referring to a basket of commodities or ETFs, invest in commodity futures rather than physical commodities, they are subject to the above mentioned “roll-over effect”. It is simply not practical for an open-ended ETF or an index fund to buy the underlying physical commodities. Adjustments to ETF holdings as a rule have to be made on a daily basis, whenever investors dissolve ETF units or create new ones.
In most standardized futures contracts, every third delivery month tends to be the “active” month in which most of the trading volume is concentrated. Thus, if e.g. USO currently holds front month WTIC futures, it will roll them to the next active futures contract shortly before expiration. Whenever crude oil is in contango, this will automatically produce a loss – and while this loss may seem fairly small on a single roll, it begins to add up after a while. Only when the market is in backwardation will the ETF gain relative to the spot price of the underlying commodity.
Many people are unaware that a number of popular commodity indexes are reflecting the roll-over effect as well – such as e.g. the well-known and widely quoted CRB Index. Thus, the CRB has recently broken to multi-decade lows:
It is certainly true that commodities remain mired in a sharp downtrend and there is no evidence yet that it is over. However, the next chart shows where the spot prices of commodities really are. It still looks like a severe bear market, but it is a far cry from the devastation suggested by the CRB Index.
A few things need to be kept in mind here. First of all, a “spike low” like the one that occurred on occasion of the 2008 GFC is very rare in commodities. Usually commodities rise very sharply and quickly in bull markets and make spike highs. Once a bear market concludes, they will normally spend a long time trending sideways amid relatively minor fluctuations before they bottom out and reverse course again (this is so because commodity bull markets are driven by fear – namely the fear of shortages).
This means that the times when commodities are in contango will as a rule last much longer than the times when they are in backwardation. A commodity ETF or an investable index investing in futures contracts on the long side can therefore never be expected to be a successful long term investment, as it will almost certainly decline over the long term (absent extreme inflation events, i.e., hyperinflation).
Nor would it make much sense to invest in most commodities in physical form and store them in a warehouse, as the costs expressed by the futures contango, such as storage and insurance costs, would still have to be paid. Moreover, opportunity costs in the form of foregone interest returns would have to be borne as well.
Exceptions to the Rule
There are a few exceptions to the rule. For instance, most precious metals ETFs such as GLD and SLV do invest in physical bullion. However, this is only possible due to the special characteristics of precious metals. If one e.g. looks at gold as a currency rather than a commodity, it is worth noting that it is the 4th most liquid currency in the world. In London alone, some 580 tons of bullion have changed hands every single day in 2015.
Gold is especially suitable for a bullion ETF, as it is in fact mainly used for monetary or investment purposes. A quite sophisticated, efficient and not overly costly storage system exists (gold is also very dense, so it doesn’t take up much space). Ownership changes often merely need to be recorded, without actually having to move bullion physically around. However, even an ETF like GLD comes with costs. It charges very little for administration, storage and insurance (around 20 to 30 basis points p.a.), but this small cost does impact the value per unit year after year as well.
With the exception of monetary commodities such as gold and silver (the prices of which will tend to reflect changes in the fiat money supply over the long term, and which serve as systemic insurance and demonstrably preserve purchasing power much better than fiat money), commodities were never meant to be “investment assets”. They can never be more than a trade, resp. a short to medium term investment.
Moreover, as downtrends in commodities tend to last much longer than rallies and are often of almost similar intensity, anyone trying to make money in commodities should at least be able to go short as well.
Addendum – China’s Growing Woes
The most recent bout of weakness in commodities has apparently been triggered by a still evolving mini-crash in China’s stock market, which has been accompanied by a further noticeable weakening of the yuan. The Shanghai stock market had another bad hair day overnight, once again declining by slightly more than 7%:
The SSEC has been getting hammered since late 2015, losing some 600 points in approximately two weeks. The bulk of the losses has been recorded in just two trading days this year. The yuan has weakened concurrently and all indications are that this will continue – click to enlarge.
The long awaited bust in China finally seems to be well and truly underway (see also: Money and Credit in China for a recent comment on the situation).
Charts by: StockCharts, BarChart, BigCharts
Dear Readers! We are happy to report that we have reached our turn-of-the-year funding goal and want to extend a special thank you to all of you who have chipped in. We are very grateful for your support! As a general remark, according to usually well informed circles, exercising the donation button in between funding drives is definitely legal and highly appreciated as well.
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
One Response to “How Big is the Bust in Commodities Really?”
Most read in the last 20 days:
- Alan “Bubbles” Greenspan Returns to Gold
Faking It Under a gold standard, the amount of credit that an economy can support is determined by the economy’s tangible assets, since every credit instrument is ultimately a claim on some tangible asset. […] The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. — Alan Greenspan, 1961 He was in it for the power and the glory... Alan Greenspan gets presidential bling...
- The Gold Situation
A Growing Bullish Chorus – With Somewhat Muted Enthusiasm A few days ago a well-known mainstream investment house (which shall remain nameless) informed the world that it now expects the gold price to reach “$1,500 by early 2017”. Our first thought was: “Now they tell us!”. You won't be surprised to learn that the same house not too long ago had its eyes firmly fixed in the opposite direction. Da bling be goin' somewhere, fellow rastas and homies! Photo via...
- End of an Era: The Rise and Fall of the Petrodollar System
The Transition “The chaos that one day will ensue from our 35-year experiment with worldwide fiat money will require a return to money of real value. We will know that day is approaching when oil-producing countries demand gold, or its equivalent, for their oil rather than dollars or euros. The sooner the better.” Ron Paul A new oil pipeline is built in the Saudi desert... this one is apparently destined for the Ghawar oil field, one of the oldest fields in Saudi Arabia...
- European Banks and Europe's Never-Ending Crisis
Landfall of a “Told You So” Moment... Late last year and early this year, we wrote extensively about the problems we thought were coming down the pike for European banks. Very little attention was paid to the topic at the time, but we felt it was a typical example of a “gray swan” - a problem everybody knows about on some level, but naively thinks won't erupt if only it is studiously ignored. This actually worked for a while, but as Clouseau would say: “Not...
- Writing on the Wall
Time to Sell... Maybe BALTIMORE – Yesterday, the S&P 500 hit a new all-time high. And the Dow just hit a new record close as well. If you haven’t sold yet, dear reader, this may be one of the best times ever to do so. It's still flying... sorta. Meet Bill Bonner's tattered crash flag Image credit: fmh We welcome new readers with a simple insight: Markets are contrary, pernicious, and downright untrustworthy. Just when the mob begins to bawl most loudly...
- Gold – Eerie Pattern Repetition Revisited
Gold Continues to Mimic the 1970s Ask and ye shall receive... we promised we would update the comparison chart we last showed in late November in an article that kind of insinuated that it might be a good time to buy gold and gold stocks (see: “Gold and Gold Stocks – It Gets Even More Interesting” for the details). We are hereby delivering on that promise. A Lydian gold stater from the time of the famously rich King Croesus, approx. 570 BC. It seems they already had this...
- The Central Planning Virus Mutates
Chopper Pilot Descends on Nippon Readers are probably aware of recent events in Japan, the global laboratory for interventionist experiments. The theories of assorted fiscal and monetary cranks have been implemented in spades for more than a quarter of a century in the country, to appropriately catastrophic effect. Amid stubbornly stagnating economic output, Japan has amassed a debt pile so vast since the bursting of its 1980s asset bubble, it beggars the imagination. A...
- Destination Mars
Asset Price Levitation One of the more preposterous deeds of modern central banking involves creating digital monetary credits from nothing and then using the faux money to purchase stocks. If you’re unfamiliar with this erudite form of monetary policy this may sound rather fantastical. But, in certain economies, this is now standard operating procedure. The “Tokyo Whale” Haruhiko Kuroda explains his asset purchase madness with a few neat little slides. Photo credit:...
- Fat People for Trump!
Alphas and Epsilons BALTIMORE – One of the delights of being an American is that it is so easy to feel superior to your fellow countrymen. All you have to do is stand up straight and smile. Or if you really need an ego boost, just go to a local supermarket. Better yet, go to a supermarket with a Trump poster in the parking lot. The protest vote attractor with the funny hair. Image credit: Liberty Maniacs Trigger warning: In the following ramble, we make fun of...
- America Has Become a “Parasitocracy”
Dread and Denial So, let’s return to the discussion you can’t have with your congressman, your mailman, or your barmaid. It’s the important one. It concerns what the Fed is really up to. Eight years after achieving independence, a State modeled after the British merchant state was established in the US. It took a while for the Deep State to consolidate itself within it, a process that was accelerated greatly in the run-up to and aftermath of WW I. Illustration by Ana...
- Planet Debt
Low Interest Rate Persons She is a low-interest-rate person. She has always been a low-interest-rate person. And I must be honest. I am a low-interest-rate person. If we raise interest rates, and if the dollar starts getting too strong, we’re going to have some very major problems. — Donald Trump Two low interest rate persons! The Trumpsumptive president (Donald the Tremendous) can be seen here indicating the approximate size of the interest rate that will...
- Long Term Market Perspectives
Methuselah Tree When looking for a good theme for this post I pondered for a while and then decided to use a picture of a bristlecone pine, which are widely considered to be the oldest living trees in the world. Ye olde bristlecone Photo credit: Kosta Konstantinidis You can find them near the Nevada/California border and if you wind up traveling in the area then I strongly recommend that head over to Bishop and from there head up high up into the White...