Don't Be Backwards About Commodity Issues

[Optionskid777]

An article I like.

We have spoken many times over the years of the importance of including commodities in your asset allocation mix. For numerous reasons this makes sense, such as the non-correlation to equities, and therefore true diversification it provides to the portfolio. As well, commodities have been in a strong relative strength position compared to other asset classes, and therefore have been a source of performance, or alpha for the portfolio. This condition of relative outperformance by commodities vis a vis other assets persists today, and as a result you should continue to have exposure in some way, shape or form to commodities in your account. The good news is that this is now much easier to accomplish today than it was just a couple of years ago, thanks in large part to the ETF and ETN products. There are now over 30 different commodity ETF's or ETN's available, covering all different sectors from Energy and Grains, to Livestock.



This is all well and good, if not great for the investor. But at the same time, it is important to understand some basic concepts inherent to the commodity market, with respect to structure, as these structural idiosyncrasies can have a monumental effect on performance of the ETF or ETN. So today we wanted to spend a little time going over two such terms or concepts that tend to have a material effect on the performance of a given ETF or ETN: contango and backwardation. For the sake of our discussion today, we are going to use the Crude Oil ETF's and ETN's for example purposes.

First, let's take a look at the Unites States Oil Fund [USO]. The way that the Oil Fund (USO) is constructed is actually very different than the manner in which the first commodity-based ETFs are created. The USO is created through the use of futures contracts, while the Gold & Silver ETFs (IAU, GLD, and SLV) are actually backed with the raw material in physical form, and the iPath ETN's are created using note-linked securities. The assets of the Gold and Silver Bullion-related ETF's consist of stacks of Gold or Silver bars in a vault somewhere. A share of these ETFs represents actual ownership in bullion, rather than a futures contract. There is no such vault with barrels upon barrels of Crude Oil that represent units of the USO ETF. Rather, the managers of the USO essentially maintain a balance of Crude Oil futures contracts and cash, which together replicate the price of Crude Oil. The periodic problem with this construction, as many investors saw in the early going of the fund (in 2006 and early 2007), was the potential for tracking error due to contango (or backwardation).



Contango, specifically, is a term familiar to commodities traders that describes the occurrence of forward contracts being more expensive than near-month futures contracts upon expiration. This means that commodity traders rolling out of the near month futures contract to the next month have to somehow make up for the difference in price between the two. This causes slippage to the ETF as buys the requisite number of futures contracts to maintain its proper exposure to the commodity. (As seen in the image below, Gold is in a condition of contango).



Backwardation is just the opposite. The forward contracts of the given commodity are less expensive than the near-month futures contracts upon expiration. So a benefit is accrued to the ETF when it rolls out to the next month. Such a condition now exists for Crude Oil. Notice in the image below how June Crude Oil (CL/M8) is trading at 125.71, while July is 125.51, and August is trading at 125.27; each subsequent month is trading less than the previous. This condition of backwardation has existed since roughly mid-July 2007, and therefore has benefited those ETF's, such as the USO that roll out each month to the next contract.

The iPath Goldman Sachs Crude Oil Total Return Index [OIL] began trading on the NYSE in 2006 as an exchange-traded note (ETN), which is constructed quite differently. Essentially transferring a large portion of the tracking risk to the fund provider (Barclays) and away from the investor. Clearly, buying OIL is not without risk, it just carries different risks. One risk is obviously that Crude Oil may actually go down in price, adversely affecting the price of something tied to the price of Crude Oil. Another risk specific to the iPath Oil Fund, and other iPath's, is that Barclays could file Chapter 11. However, the tracking risk is a bit different with an ETN, as it tracks the Goldman Sachs Crude Oil Total Return Index. This index measures the performance of a simple investment in oil futures, and that performance includes the change in the price of the futures contracts, the “roll yield” (positive if in backwardation, or negative if in contango), and the Treasury Bill rate of interest that could be earned on collateral funds. The benefit on that front when compared to the OIL shares is that there is no “slippage” in actually transacting a move from one contract to the next, eliminating some of the tracking error risk. But, because the GSCI Total Return Index does not finesse the “roll” of the futures contracts to maximize profits (contracts are simply rolled from the expiring month to the next month) the index may lag other strategies when the oil markets remain in contango, or will show similar benefits as the USO, for example, when in backwardation.



Then came yet another structure for commodity-based ETFs, primarily as a result of the exploited tracking error risk in the earlier funds. Early in 2007 PowerShares launched a number of commodity-based products, one of which being the PowerShares DB Oil Fund [DBO], which is based upon the Deutsche Bank Liquid Commodity Index. The similarity to the other funds is that it is composed of futures contracts on Light Sweet Crude Oil [CL/], and is intended to reflect the performance of crude oil. The primary difference is that the index it tracks uses an “Optimum Yield” strategy that employs a rules-based method of selecting which contracts to “roll” to each month. The fund is structured such that it may look out up to 13 months to try to minimize the effects of contango, and maximize any backwardation that may be present within the Oil markets. This fund actually invests in Crude Oil futures contracts like the US Oil Fund, but applies a very different strategy in managing the fund over time. In sum, by the nature of its construction, it "smooths" out the effects of both contango and backwardation.

So now hopefully you understand some basic differences in how commodities are structured, and as a result understand how the issues of contango and backwardation can affect the performance of a given ETF or ETN, in theory. But I think the best way to really witness these effects is to see an actual example. For this we again turn to the different Crude Oil-related ETF's and ETN's. Specifically, as seen in the image below, let's first take a look at how the condition of contango hurt the USO early on. Look at the tracking error of the USO for the first few months after it began trading in April 2006. This was a period in time where Crude Oil futures were in “contango” the entire time, and therefore the source of considerable tracking error from the Spot Crude market. While Crude Oil rose from $68.25 (April 2006) to $73.30 by August 2006, the USO had slipped from $68.25 to $67.42. The situation had worsened by October 2007 (as Crude Oil was in contango throughout 2006 until July 2007). Crude Oil had risen to $80.05 yet the USO had slipped to $61.63. The USO has managed to rally substantially since July 2007, scratching back from a huge contango-induced deficit, now that it is in backwardation. But notice that although the USO now trades at $100.11, it is still shy of the spot Crude price of $124.10.



Clearly though, since July 2007 you have been best rewarded by playing those Crude Oil ETF's and ETN's that benefit the most from a backwardated market, such as the USO and OIL, as the numbers below show. Surely the DBO has logged an impressive gain, but its performance lags that of the USO and OIL as a function of this. This was just the opposite when Crude was in contango.

So as the above example points out, it pays to be aware of what commodities make up a given ETF or ETN, and then to be abreast of whether or not the given commodity or commodities are in a condition of contango or backwardation.

Hope you guys like this

[trustdnb]

Very interesting. I will need to re-read this a little more closely. Seems like if you could arbitrage the tracking error in related ETFs if you can predict whether the market is in backwardation or contango. I.e. if the market is backwardating, go long the backwardation positive ETF and short the contango/optimized positive one (e.g. long USO, short DBO) or vice versa.

This is also very useful when selecting which of several ETFs tracking the same commodity to trade.