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
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