Here’s a great chart from Emad Mostaque, a strategist at Ecstrat, a new research company set up by Mostaque and former head of EM strategy at Deutsche Bank John-Paul Smith:
As Mostaque explains, even though commodities are at double the level they were in 2003, any investors who assigned money to commodity GSCI products in that period on a total return basis may be sitting on zero returns.
In fact, the relative return of the S&P GSCI Total Return versus the spot index for the last decade shows an astonishing -12 per cent annualized “cost of ownership” on the roll yield up to the Arab Spring of 2011. This is a level far beyond that which would have been implied by the curve structures, he says.
As Mostaque further notes:
Indeed, even with energy commodities, which make up the bulk of the index in huge and unsustainable levels of backwardation since 2011, the total return index still hasn’t managed to achieve a reasonable roll yield. For investors this has been a painful experience and one would question why anyone would invest in a commodity index even if they believed in the story. This is likely to drive further definancialisation and improve overall market function, even if prices overshoot near term.
What’s worth bearing in mind, of course, is that much of this will have been a zero-sum game, meaning for all those who lost there were others who gained.
If the theory is correct, the sell-off we’re experiencing in commodities now could thus be part of a greater commodity definancialisation effect — the dumb money effectively figuring out just how they’ve been gamed and refusing to carry costs and losses further.
How this process came about, notes Mostaque, was through the well finessed practice of selling products linked to commodity indices to “real money” investors on the basis of three stories:
1. Emerging Markets would buy all the commodities in the world, presumably leading to a Mad Max type scenario eventually but riches for investors in the meantime
2. Commodity returns were uncorrelated with other asset classes, something highly regarded by those that followed the Yale Endowment Model
3. Commodities tended to normal backwardation, where the front end of the curve was above the back end, essential as investors would not own the physical commodities but rather the futures. By selling high and buying low investors would realize a nice gain on their positions even if commodities were flat
Unfortunately, all these stories proved to be inaccurate. The 08/09 crash led to severe downgrades to EM growth; commodities proved to be very correlated with other asset classes and backwardation turned into a horrendous contango.
All that said, now that the financialised component is beginning to be ejected from the market, we could be seeing the return of fundamentally-driven commodity prices. Unfortunately, it is also the case that prices may be inclined to over correct leading to major under-investment in the industry, something that sets us up in the longer run for much higher prices and greater volatility, albeit within a much more diversified market structure.
This demonstrates the irony quite nicely. Namely, just as it’s really needed, the inclination to invest in commodities is falling.
Related links:
Why Saudi Arabia’s best bet may be to increase output – FT Alphaville
When the cartel bursts, Brent edition – FT Alphaville
The North Dakota millionaires rocking oil markets – FT Alphaville
Opec compromised; Saudi Arabia becomes lone player – FT Alphaville (Jun, 2012)
Is Saudi Arabia starting to panic? – FT Alphaville (Jan, 2013)
Saudi Arabia resorts to Jedi mindtricks – FT Alphaville (May, 2012)
