[T.S.R:16510] Is Backwardation Good For Investors In Commodities? (FT)

Commodities Daily: Last contango in prospect?

ByJavier Blas

Published: December 6 2010 08:43 | Last updated: December 6 2010 08:43

Backwardation is an ugly word.

But for unsophisticated, long-only, passive commodities investors who pour money into first-generation indices such as the popular S&P GSCI or the DJ-UBS, backwardation – when futures prices are lower than the prevailing front-month price – is beautiful.

In commodities markets, the recent spike in front-month prices, from crude oil to copper, has drawn most of the attention. But even more important is the change in the shape of the futures curve. The reason lies within the mechanics of commodities indices.

The first generation commodities indices are baskets of raw materials, and the investors who track them invest in front-month futures and roll their positions to the following contract ahead of the expiry date. As investors mechanically sell one future and buy the following one, the shape of the futures curve is crucial to the profitability of the investment in commodities indices.

In addition to the spot return, which depends of the ups and downs of prices, commodity index investors obtain a separate return – known as the "roll yield" – as they roll over trades. That return is positive – a backwardated market – and negative when futures prices are higher, or in contango.

All equal, backwardation boosts returns for investors in unsophisticated indices.

For most of the early 2000s, when commodity indices were the star vehicle to gain access to commodities, the markets were in deep backwardation, and offered strong "roll yield" returns to investors. But the last 24 months, commodities markets had been largely in profound contangos, hurting returns of unsophisticated investors.

The S&P GSCI is a good exampl. The index total return, which besides the spot and roll yields, includes interest returns on the collateral, is down 0.34 per cent from January to November.

The drop is not because of lower commodities prices. On the contrary, the spot return of the index is up significantly, to the tune of nearly 10 per cent over the first ten months of the year. The low returns are because big contangos earlier this year, particularly for crude oil.

The talk and buzz of the market right now is the return, after nearly two years, of backwardation to some commodities markets: Brent crude oil and copper are already exeriencing it and others could follow in 2011 as fundamentals tighten.

As commodities markets move into backwardation the returns of unsophisticated indices will increase, outperforming returns of the second-generation of so-called enhanced commodities indices.

For example, in November, with backwardation returning, the S&P GSCI total return was up for the month 1.08 per cent, while an enhanced variation of the index, which minimises the impact of the shape of the curve by investing in five-month forward contracts, was up by half.

Is backwardation – and , hence, strong returns for unsophisticated indices – here to stay? The market is unlikely to see the deep backwardation of the early 2000s, but as conditions tighten, markets have clearly moved out of the punishing contangos over the last two years. The worst case scenario for next year, traders and analysts say, is a mild form of "shallow contango".

As such, await for fresh inflows of money into conventional indices early January 2011 to profit from the new situation.

 

Safe Harbor Statement:

Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.

 

Nothing in this article is, or should be construed as, investment advice.

 

 

 

 

 

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