Commodities

Basics of Commodities

Sectors

• Energy: Crude oil, natrual gas, coal, gasoline, and heating oil
• Industrial/Base metals: Copper, aluminum, nickel, zinc, lead, tin, and iron
• Precious metals: Gold, silver, and platinum
• Grains: Corn, soy, wheat, and rice
• Softs: Cotton, cocoa, sugar, and coffee
• Livestock: Hogs, cattle, sheep, and poultry

Primary Influences	Energy	Base metals	Precious metals	Grains	Softs	Livestock
GDP	✓	✓	✓		✓	✓
Weather	✓			✓	✓	✓
Consumer preference					✓
Consumer income				✓	✓	✓
Population growth				✓	✓
Biofuel substitution				✓
Monetary Policy					✓
Geopolitics	✓		✓
Industrial development		✓

Life cycle of commodities

• The commodity production life cycle reflects and amplifies the changes in storage, weather, and political/economic events that shift supply and demand.
• A short life cycle allows for relatively rapid adjustment to outside events. A long life cycle generally limits the ability of the market to react.
• Agricultue and livestock have well-defined seasons and growth cycles that are specific to geographic regions. Energy and metals sectors are extracted all year around.

Major participants

• Hedger trade in the market to hedge their exposure related to the commodity
• Speculator have an information advantage and seek to outperform hedgers. They also provide liquidity and price discovery for the market in exchange for a profit
• Arbitrageurs attempts to capitalize on mispricing between comodity versus future price.
• Exchanges (Clearinghouses) set trading rules and provide trading infrastructure
• Analyst are non market participants who use the exchange information to perform research and conduct policy as well as to facilitate market participation
• Regulators monitor the market.

Key characteristics that differentiate commodity index

• The breadth of coverage (number of commodities and sectors)
• The relative weightings assigned to each commodity
• The rolling methodology for determing how these contracts are rolled over into future months
• The methodology and frequency for rebalancing the weights
• The goverance of index

Criteria	S&P GSCI	CRB
Adoption date	1991	1978
Number of commodities	24	19
Weighting method	Production weighted	Fixed weighted
Rolling methodology	Monthly nearby most liquid contract	Front month to next month
Rebalancing frequency	Annually	Monthly
Individual investor funds available?	Yes	Yes as well as ETF

Theories of future returns

Spot and future pricing

• Basis is the difference between spot and futures prices
• The calendar spread is the future price difference between the near-term and longer-term contract.
• Backwardation is the situation in which spot price exceeds the future price ($S>F$), or the near-term futures price is higher than the longer term futures price. The opposite case is contango ($S<F$).

Settlement

• Cash settlement enables higher involvement of speculators and arbitrageurs
• Physical settlement ensures a convergence of the futures and spot price, which may not occur in cash-settlement market.
• Spot prices are highly localized and associated with physical delivery, limiting the ability to hedge and speculate.

Insurance theory

Under the theory, only backwardation is possible

• A commodity producer is long the physical good (natural) and thus would short future contracts to hedge its sales price and make their revenues more predictable
• The future curve is in backwardation normally because producer persistently sell futures, pushing down futures prices
• The future price has to be lowet than current spot price as a form of remuneration to speculators who takes on the price risk.

Hedging pressure hypothesis

Both sides have position in market, so $S=F$ is the normal state. If seller side is stronger $S>F$, otherwise $S<F$

Theory of storage

$$\text{Future price}=\text{Spot price}+\text{Storage costs}-\text{Convenience yield}$$

• Contago: Storage cost is higher than convenience yield
• Backwardation: Convenience yield is higher than storage

Componenets of Future Returns

There are 3 part of futrue returns

• Price return

$$\text{Price return}=\frac{\text{current}-\text{previous}}{\text{previous}}$$

• Collateral return: return from cash used to maintain position (interest rate)

• Roll return: return generated by conrtract replacement

$$\text{Roll return}=\frac{\text{Near term closing price}-\text{Farther term future closing price}}{\text{Near term closing price}}\times \text{Percentage of position being rolled}$$

NOTE

• Roll yield is generally positive in backwardation, but negative in contago
• Roll return have an important impact on single period return but overall has minor impact compared with price return
• Roll return can be less dependent by diversification

Backwardation	Contango
Spot ≥ Futures	Spot < Futures
Basis ≥ 0	Basis < 0
Near term ≥ Longer term	Near term < Longer term
Calendar spread ≥ 0	Calendar spread < 0
Roll yield ≥ 0 (positive)	Roll yield < 0 (negative)

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