I will be going on vacation starting on the 16th through the end of August. After I return, I will post new material on the state of General Motors and the oil markets. I also have several unique series in the works, so be sure to check back after Labor Day for the latest news!
Saturday, August 16, 2008
Friday, August 15, 2008
Commodity Trading (Part 7): Quantifying Investment and Trading Activity
How much has investment increased?
Trading volumes on exchanges (NYMEX, CBOT, ICE and LME) and over-the-counter (OTC) have grown tremendously over the past four years. Institutional investors are buying commodities directly through commodity indices or by purchasing futures in similar distributions to established indices like the GSCI or DJ-AIG. These investors represent a diverse group of financial institutions like pension funds, sovereign wealth pools, university endowments, and hedge funds.
To quantify the amount of index investment in commodities, I will begin with the Commitments of Traders report from the US Commodity Futures Trading Commission (CFTC). This report shows the total number of long positions for index traders in several major commodities. To figure out the total amount of money invested for all commodities by index traders, we can use the percentage allocations from the GSCI and DJ-AIG indices (see chart to the left).
The CIT data show the total number of long positions for all index investors. I compared these long positions with the percentage distributions for the GSCI and DJ-AIG commodity indices. Institutional index investors will allocate their funds to commodities in percentages similar to these two leading indices. If we assume that all index investment mirrors the distribution of funds in these two indices, we can use commodities unique to each index to find the total amount of money invested in each index pattern using these values. The total investment in the index is equal the number of long positions times the value of the contracts they represent divided by the weight of the commodity in the index.
This calculation method is similar to one used by Michael Masters in his testimony on commodity investment before the US Senate. However, I will use the known distribution for other commodities like corn, sugar and coffee to better estimate the level of investment in the GSCI allocation pattern. The three unique commodities to the GSCI give an average estimate of $238 billion invested. However, there are fewer long index positions in the market than the model estimates with this number (see chart to the right). To better estimate the money in the GSCI pattern, I will reduce the difference between real and estimated open positions to zero.
This method results in an estimate of $208 billion invested in the GSCI pattern and $90 billion in the DJ-AIG pattern (see chart to the left). If we assume that most index investment mirrors one of these two indices, around $300 billion is invested in commodities in index fashion, a stark increase from just a few years ago. When Mr. Masters ran a similar analysis using January 2006 data, he estimated that around $75 billion was committed to index investment. The massive increase to $300 billion reflects the surging prices we have seen since 2006. Additionally, since oil prices move in backwardation, index investments have posted impressive yields. This combination of momentum and yield has created an accelerating bull market.
Further Investigation of Increased Derivative Trading
Although the level of commodity index investment is impressive, it only tells part of the story. Commodities are also traded in options, swaps, and other derivatives. It is important to quantify these investments, too.
The Bank for International Settlements (BIS) tracks derivative activity and publishes its results in Quarterly Reviews. The most recent edition, June 2008, contains data on commodity prices and derivative activity for both OTC and exchange-traded markets. BIS data reveals that the majority of increased commodity derivative trading has come from the agriculture and energy sectors (see chart to the right). Both energy and agriculture have seen trading volumes rise from 20 million derivatives traded on exchanges in 2004 to more than 60 million today. The BIS explains:
In the past several years, the volume of trading activity in derivatives on agricultural and energy products has tended to move with the level of their prices substantially more than has been the case with other commodity derivatives.
Over-the-Counter Derivatives
This growth in activity is especially pronounced in the OTC markets. The BIS tracks OTC derivatives for G10 countries’ major banks and dealers. The notional amounts of outstanding commodity derivatives have increased from less than $2 trillion in 1998 to more than $9 trillion in December 2007 (see chart to the left). Notional amounts are the face value of the forwards, swaps, and options being traded. The biggest surge came in 2005, when notional values jumped from $1.4 to $5.4 trillion in one year. As the chart shows, most of this value came from commodities other than gold and precious metals. Since notional amounts represent the face value of an instrument, this chart reflects the global increase in commodity prices for oil and agricultural products. High prices and soaring levels of investment create more contracts with higher face values.
The gross amounts invested in commodity derivatives are equally impressive (see chart to the right). Gross market values represent the sum (in absolute terms) of the positive market value of all contracts and the negative market value of contracts with non-reporting counter parties. Essentially, it shows the replacement cost (or value) of all outstanding contracts had they been settled in the reporting period. The gross market value of all commodity derivatives jumped from $168 billion at the end of 2004 to $870 billion at the end of 2005. Values dropped in 2006 but rebounded to over $700 billion at the end of 2007. As with notional values, the primary drivers of growth were agriculture and energy prices, not precious metals. Remember, these values reflect only over-the-counter transactions and do not include exchange-traded futures or other contracts.
Exchange-Traded Derivatives
The BIS also reports strong growth in the volume of contracts traded on exchanges. In March of 2008, over 90 billion commodity futures were traded on exchanges around the world (see chart to the left). This represents a three-fold increase from the same month last year. Interestingly, much of this growth has come from futures traded on exchanges outside of the
Growth in options trading was equally impressive (see chart to the right). Fewer than 7 million commodity options were traded in March 1994. In March 2008, over 40 million options were traded. Non-commodity options (interest rate, currency, and equity index) have also increased dramatically since the late 1990’s.
Health of the Market
Robust growth in both OTC and exchange-traded commodity derivatives combined with the capital inflows to index investment has sparked a debate about the health of global commodity markets. Since futures markets are smaller than equities, rapid investment has a greater impact on prices. Increased volatility and rapid advancement have attracted speculative interest and momentum trading that further amplifies volatility. Additionally, index funds’ practice of rolling contracts creates long-term liquidity issues since they are long-only. Essentially, these funds never “sell” their positions and leave the market since they use proceeds from a roll to purchase more futures.
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Friday, August 8, 2008
Commodity Trading (Part 6): Rolling Contracts and Futures Curves
Results of Rolling Contracts: Futures Curves
The process of rolling futures contracts can create profit of loss for the index fund depending on the structure of the futures curve (see chart to the left) for the commodity being traded. Futures curves graphically represent the prices of futures with increasing maturity dates relative to the current spot price.
There are two types of futures curves – normal and inverted. Normal futures curves consist of future prices higher than the current spot price of the commodity. The buyer of a future with a normal curve will pay more for contracts with longer maturity dates. Most commodities feature normal futures curves, for reasons which will be discussed in a moment. A good example of a normal curve is the current market for corn futures (see chart to the right). As of July 29, 2008, the prices for corn futures increased for longer maturity dates. A buyer would pay $5.80 per bushel for corn delivered in September 2008, and the price increases for maturity dates farther in the future. Corn delivered in March, 2009 costs $6.29 per bushel and July, 2009 is over $6.40 per bushel. This pattern of higher prices represents a normal curve.
Oil is a good example of an inverted futures curve (see chart to the left). Oil prices actually decrease as maturities increase. The September 2008 price per barrel is around $123. These prices rise in the short term but then become inverted for oil delivery in 2010. The September 2010 price for oil dips below $123 to $122.50. This pattern continues with longer maturities, reaching a low of $121 per barrel in December, 2010.
Why Futures Curves are Normal or Inverted
As time passes and contracts move toward their expiration dates, futures prices must converge toward the spot price of the underlying commodity. On the day of expiration, the price of a future must equal the spot price – this price movement creates the dynamic that allows the futures market to function.
For a non-perishable commodity’s future to be priced rationally, it must reflect the spot rate for the commodity today, the risk free rate of return, and the cost of storing or transporting the commodity. The logic behind the structure is intuitive, and shows why most commodities have normal price curves. The rational price of a future is simply today’s spot price plus the cost of storage, transport, and the risk-free time value return associated with the commodity’s value. An example should help clarify this dynamic.
If I need 25 tons of copper in six months, I have two choices. I can either buy the copper today and store it at my own expense or purchase it on the futures market and take delivery in six months. If the price of the future exceeded the cost to buy the material today and store it myself, I would choose the latter option. For futures markets to function properly, the two prices must be equal. The cost of the future should equal the cost to buy and store the material today. Price volatility comes from shifts in supply, demand and scarcity. Investors and speculators make money from changes in the spot price of the commodity. It will constantly change, and these changes are reflected in the market value of futures.
In summary, futures are rationally priced. Although the spot price of a commodity will fluctuate, the price of a future must always move toward the spot price. The way the futures price moves can be described in one of two ways: contango and backwardation. These price movements have direct implications for the value of commodity index funds.
Contango and Backwardation
Contango and backwardation describe the movement of futures prices as contracts near maturity. Prices move in contango if the value of the future decreases toward the spot price as a contract reaches expiration. This occurs on a normal futures curve because the futures’ prices are greater than the current spot price. The opposite is true for inverted futures curves: futures prices will increase to meet the spot price as the contract ages. It’s easy to confuse these four terms. Normal and inverted refer to the shape of a futures curve at a point in time. Contango and backwardation describe the movement of futures prices over time.
Index funds will make or lose money depending on whether its futures’ prices move in contango or backwardation. First, we will examine a standard contango price movement. The chart to the left describes this situation fully. A commodity index fund will purchase a future which has a normal curve. The spot price is below the future price. In this case, the fund purchases a six-month future for $11.75 in January (versus the spot price of $10.00). As time passes, the spot price increases slightly based on demand for the commodity. Since the price of the future moves in contango, it must decrease to meet the spot price (see detailed graph to the right). When it is time for the fund to roll its future in June, the spot price is $10.50.
The index fund will close its position and receive $10.50 (the current spot price). In this transaction, the fund paid $11.75 for its future and received $10.50 at closure, representing a loss of $1.25. To maintain its open position in the market, the fund manager will purchase another six-month future. The new futures curve reflects the change in the spot price, so the fund will pay $12.25 for the contract. When it is time to roll the position again in December, the firm will likely incur another loss unless the spot price rises in the meantime. Essentially, the fund is forced to buy the commodity at a high price and sell it at a low one. This results in negative roll yields as the company continually opens and closes positions in commodities with normal futures curves.
The opposite situation occurs with inverted futures curves. When the price of a future moves up to meet the spot price, the movement is said to be in backwardation. Backwardation rarely occurs in money commodities like gold or silver. It is more prevalent in seasonal commodities or with perishable goods. Oil is the most important commodity to feature backwardation movement.
The chart to the left demonstrates how backwardation works. The fund purchases a six-month future in January for $90 (below the spot price of $100). The convenience yield of owning the commodity today must outweigh the time value and storage costs discussed earlier. The spot price declines slightly over time (see detailed graph to the right), and when it’s time to roll the future, the fund will sell it for $95. Despite the drop in the spot price, the fund will still make $5 ($95-$90) and have a positive roll yield. The fund will purchase another six month future and the cycle of gains will continue for the fund.
In strong backwardation, index funds can post impressive gains in value. It is important to note that supply and demand forces will alter the spot price for the commodity through the life of a contract. It is possible to purchase a future which historically moves in contango and post gains when the spot price increases above the price of the future. The opposite can happen in backwardation if spot prices shift unexpectedly.
Active Management
Most funds like the GSCI are managed passively, meaning contracts are simply rolled to keep open positions in the market. However, some funds are designed to actively take advantage of commodity price movements. These funds are more expensive to manage, but offer advantages for investors with more aggressive investment agendas. Hedge funds will buy or sell at any position along the futures curve based on their view of market fundamentals or trading patterns. They will make both short and long-term investments and are especially helpful in creating liquidity for long-term futures shunned by traditional index funds.
Hedge funds are more flexible and change investment strategies when the market changes direction. Additionally, they are often highly levered and emphasize algorithmic trading and other advanced strategies. In some cases, hedge funds are willing to take delivery of a commodity if they have strong beliefs about the future of the market.
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Monday, August 4, 2008
Commodity Trading (Part 5): Index Investment
As we saw in previous entries, the last commodity boom was driven by oil shortages and global tension. Today’s bull market appears to come from growing demand and the market’s inability to support it. Rapidly developing economies like China and India have created fundamental increases in demand that attract long-term investment in the commodities sector. Additionally, financial managers have discovered that commodities can add valuable diversification to their portfolios. Hedge funds and other non-traditional investors play both the long and short side of the market. The combination of fundamental growth and financial interest has caused commodities to emerge as an asset class.
Methods of Investment
The financial community has responded to interest in commodity investment by creating investment vehicles to suit the needs of institutional investors. Commodities require special investment products because they are traded differently than traditional bonds and equities. It’s easy for an individual to buy and hold an equity stake in a company through stock. Commodities are different – an investor can’t employ a buy-and-hold strategy unless she is willing to take possession of the physical commodity and store it. This is an issue for several reasons – storage costs are high (oil), products can be perishable (corn), or receipt is impractical (live cattle). This means that the commodity investor must actively manage her portfolio by continually opening and closing positions. The easiest way to accomplish this is through index investing.
Commodity Index Investing
Commodity index investing allows institutions to add commodities to a portfolio while diversifying the risk between the individual commodities (“buying the market”). The institution or company will allocate money to commodity investment and a fund manager will distribute these funds to a variety of commodities contracts. The fund manager’s job is to research all of the commodities in the index and execute the proper trades to keep the fund’s market exposure at the appropriate level for her client’s needs.
These goals give index funds a specific structure. Funds consist of long-only futures contracts and no physical ownership of the underlying commodity. The fund will purchase a forward position and sell it as it nears maturity. The fund manager will use the proceeds from the sale to buy a new future with a later expiration date. This cycle of selling and buying is called “rolling” contracts and will be discussed in more detail later. Unlike hedge funds, index funds are unlevered and usually collateralized with T-bills. Because large index funds must roll contracts continually, it is important that they invest in highly liquid commodities. This ensures that funds can find counter-parties for their trading activity.
Major Index Funds
Although most index funds have similar structures, their compositions can differ significantly. To illustrate these differences, I will compare five major index funds and examine their component commodities (see chart to the left). The two most influential commodity index funds are the S&P Goldman Sachs Commodity Index (S&P GSCI) and the Dow Jones-AIG Commodity Index (DJ-AIG). Both of these indices focus on purchasing unlevered, long, liquid commodities which represent the overall market. Both indices feature smaller sub-indices for investors who want a more narrow focus on certain categories of commodities. However, each index assigns weights to commodities differently. The GSCI weights its component commodities by their perceived significance in the world economy. Conversely, the DJ-AIG Index limits commodities to between 2%-15% of the fund’s assets. While both indices hold many commodities, the DJ-AIG distributes its funds more evenly while the GSCI tends to be more concentrated.
Other funds offer more strategies for index investment. For investors seeking an alternative to dollar-denominated funds, The Astmax Commodity Index (AMCI) is denominated in the Japanese Yen. The Deutsche Bank Liquid Commodity Index (DBLCI) focuses on a small subset of highly-liquid futures to reduce price volatility in contract rolls. Finally, the Reuter/Jefferies CRB (RJ-CRB) Index employs a unique tiered approach to commodity allocation. The RJ-CRB categorizes commodities in one of four tiers and assigns funds equally to each component within a tier (excluding oil). The first tier contains petroleum products and receives the most investment. The second tier focuses on liquid commodities and assigns a 6% weight to each. The third tier focuses on diversification for the first two tiers with weights of 5%. The final tier draws only 1% of the index’s funds and further diversifies its holdings.
How Funds Allocate Resources
The five index funds all approach commodity investment differently. The GSCI, RJ-CRB and DJ-AIG contain a large number of commodities (24, 19 and 19 respectively) but the DBLCI contains only six. There are three commodities held by each index and comparing their weights within each index helps demonstrate the differences in index funds (see chart to the left). All five funds hold crude oil, but it comprises more than 40% of the GSCI and less than 15% of the DJ-AIG. Gold is one of the largest components of the AMCI (with a greater weight than crude) but comprises less than 2% of the GSCI. Since the DBLCI holds only six components, its weights are distributed more evenly but crude oil still outweighs other commodities. These differences point to the different strategies each fund employs to achieve ample diversification.
For a broader look at how index fund composition differs, we can examine funds’ weights by sector (see chart to the right). As you might expect from its weight of crude oil, the GSCI is 78% energy commodities. Meats, metals, and agriculture make up less than one quarter of the fund’s assets. The other major index (DJ-AIG) is more evenly balanced. Energy, metals, and agriculture all make up around 30% of the fund’s total composition. The DBLCI is narrower in scope and heavily favors energy with no exposure to meats. The RJ-CRB balances energy with agriculture and the AMCI focuses almost exclusively on metals (57%) and energy (40%).
Ultimately, the goal of major index funds is to be transparent and conservative to provide market exposure and diversification to their owners. The value of commodity indices has grown dramatically in recent years (see chart to the left). All four dollar-denominated indices have increased by at least 40% since early 2005. This growth in value has accelerated since late in 2007. Not surprisingly, much of this increase stems from the rise in oil prices over the same time period. Since energy is a key component of each index, their values are intertwined.
In my next entry, I will detail how commodity index funds maintain their commodity allocation by rolling futures contracts. I will also explain how the structure of futures curves impact the value of index funds. In the final installment, I will estimate the total amount of money invested in index funds and examine the vast increases in overall commodity derivative trading since 2004.
“Rolling” Contracts
In my last entry I discussed the structure of commodity index funds. For these funds to maintain open positions in the market, they must continually sell and purchase new futures with later maturity dates. This process of settling contracts and purchasing new ones is called “rolling” futures contracts.
Rolling is essential for index funds because they do not want to take physical possession of the commodities in which they invest. Open positions give index funds the market exposure they need to provide diversification and returns to investors. The timeline for rolling depend on the underlying commodity. Most energy contracts are rolled monthly but metals and other non-perishable commodities are usually rolled quarterly or semi-annually depending on the specifications of the contracts involved.
Challenges when Rolling
As you might expect, funds face significant logistical challenges when rolling a large volume of contracts at one time. To help ease some of the pressure, funds will usually roll a single commodity over a period of days. Most funds will turn over 20% of its futures each day for five days. However, these timelines can vary from firm to firm or between different commodities.
A major advantage of rolling contracts over a period of several days is increased liquidity. If a firm tried to sell all of its contracts in one day, it might have trouble finding counter-parties for its transactions. Additionally, funds generally report their contract rolling schedules to the public to remain transparent. This means that other market participants can move against a firm it knows will engage in large rolls. By spreading out the buying and selling of futures, funds try to minimize volatility. Generally, commodity markets are adept at correcting for price variation created by large fund contract rolls.
Rolling Creates Open Interest
Patterns of contract rolls create large amounts of open interest in commodity markets. In this case, open interest is simply the number of futures which are not closed or delivered on a given day. One way to quantify the number of open contacts is to compare them to the volumes stored or produced of the commodities they represent.
The London Metal Exchange (LME) is the world’s leading options and futures exchange for base metals like lead and aluminum. Since commodity index funds have large stakes in these metals, the LME offers several good examples of large open interest (see chart to right). The LME publishes statistics on the level of open interest in each of its commodities. It also tracks the amount of each commodity it holds in licensed warehouses for the physical settlement of contracts, as well as annual global production. We can compare the volume of a commodity’s open interest to these two figures to gauge the scope of trading activity.
Market Open Interest is the most broad category of open contracts (“lots”) and represents both exchange and client activity. Exchange open interest represents only client transactions. By multiplying the number of open lots by the size of each lot, we can see the quantity of the commodity being traded. For the five metals shown in the chart, the volume of open interest dwarfs the quantity stored in LME warehouses. For example, open interest represents 86 times the amount of copper the LME has in storage. The level of trading is even more impressive when compared to the annual global production of each commodity. The amount of open interest in zinc represents an entire year’s worth of global output. Of course, most of these open positions will be settled in cash and the owners have no intention of ever owning the underlying commodity. However, the volume of trading is staggering.
A similar example can be seen in the corn market. Corn trades on the Chicago Board of Trade in lots of 5,000 bushels per contract. We can look at the level of open interest in corn and compare it to
Friday, August 1, 2008
Update - Commodity Trading Series
I am filming the conclusion to the series on commodity trading tonight and hope to have the update posted by the end of tomorrow or Friday morning. I have found some intriguing information on index investment and have spent more time than I had planned doing some data analysis. I hope it will be interesting and help you understand why commodity investment is volatile right now.
Check back tomorrow or Friday for all the new information!
Check back tomorrow or Friday for all the new information!
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