The obvious choice isn’t always the best
We have become more constructive on commodities this summer, in particular on the energy complex. After many years of supply outstripping demand in oil markets leading to rising inventories, we now see the oil market moving towards balance in 2017. But is buying commodities directly the best way to express our view?
The collapse in US oil rigs over the last two years is now more clearly curbing supply, a potential OPEC production freeze is in the air (although the track record of OPEC members’ compliance with output curbs isn’t great) and natural depletion in oil production in the face of little new investments. All this makes it more likely that the surplus in the oil market disappears, removing a strong headwind to oil prices. James anticipated this shift earlier this year in his post “Oil price - Kriss Kross will make you jump, jump”.
However, is a positive commodity view best expressed through buying commodities? We refrain from buying commodities directly, as most commodity forward curves remain in contango, resulting in a negative carry drag.
In practice, investing in commodities implies going long a basket of commodity futures, which entitles you to physical delivery at a certain future date. Most investors prefer commodity futures and regularly roll those forward to avoid actual physical delivery. However, when rolling commodity futures you may incur a cost or make a gain depending on the shape of the commodity forward curve. Today, the main commodity forward curves are in contango (as opposed to in backwardation). With forward prices higher than current spot prices, this results in a negative roll yield as you sell the nearby future at a lower price, while buying the distant future at a higher price.
The chart below shows the annualised cost of owning a basket of commodity futures (using the Bloomberg Commodity Index (BCOM) for the individual commodity weights).
Instead we prefer buying assets that benefit from rising energy prices, while still earning a positive yield. These can be found in energy stocks, which normally pay a dividend, or in oil exporting countries’ currencies like the Russian rouble or Norwegian krone. Especially the rouble provides an interesting carry given the high level in local interest rates.
Where we have a more flexible mandate, we even express this in a relative value strategy, whereby we go long the Russian rouble while shorting direct commodities (or underweighting direct commodities versus its benchmark weight). This strategy comes with a high basis risk (both sides of the strategy are not perfectly correlated), but earns a high risk premium. Earning other type of risk premium on top of the normal market risk premium makes sense in multi-asset portfolios in our view, and this particular strategy is a good example of it.
This shows that it can pay to not always jump to the most obvious choice and it’s worth shopping around for alternatives.