Investors should look to assets that generate returns, not merely store value, argues Joseph Mariathasan

“The Stone Age did not end for lack of stone, and the Oil Age will end long before the world runs out of oil” is an oft-quoted comment by Sheikh Ahmed Zaki Yamani, the former Saudi oil minister. And whilst there is plenty of talk about alternatives to fossil fuels, and electric cars are coming into use, it is still difficult to see a complete transition from the petrol engine for possibly decades.

But oil prices have collapsed since mid-2014. Perhaps that is why almost one-third of the most active oil futures contract, West Texas Intermediate, was held by ETFs at one stage. They were hoping to be in at the bottom when (and if) the oil price rebounds. Inflows into commodity baskets rose to a 16-month high in the first half of November, according to ETF Securities.

But investors face a major problem with commodity investment often glossed over by intermediaries. Investment in via the futures markets – either directly or indirectly through use of indices based on futures contracts – generate returns through three different sources.

The first is the changes in the headline spot prices of the commodities. The second is the return on the collateral used to back up investment in futures by an institutional investor that typically would not be leveraging its investment, so a $100m (€94m) investment via futures contracts would generate a Treasury bill rate of interest on the capital. The third is the so-called “roll yield” obtained through switching from a maturing futures contract to one of longer maturity.

In the case of energy futures, the longer-dated contracts have often stood at a lower price than maturing contracts, giving rise to a ‘backwardation’ in prices, in contrast to the situation seen in financial futures markets and precious metals such as gold, where the longer-dated contracts are in ‘contango’ – i.e. priced above maturing contracts. The size of the contango or backwardation can change rapidly reflecting supply and demand but also interest rates, storage and borrowing costs.

What this has meant is that a major source of returns for investors in energy contracts has been obtained through rolling the futures contracts. In 2006, when oil went from $35 to $50 a barrel, the S&P GSCI index had a negative return of 14% because the energy markets were in contango, whilst in 2007, with the markets in backwardation, the return was 32% when oil prices shifted from $50 to $80 a barrel. When the oil futures markets are in contango, as has been the case recently, investors in ETFs that are rolling futures will be making losses every time.

Institutional investors that have made major investments into commodities, particularly energy, either exclusively or through tracking indices such as the S&P GSCI or Dow Jones, may need to think deeply about what role commodities play in their portfolios. Perhaps investors also need to be aware that, in every other asset class, capitalism works for them. Companies exist to make profits, so the value of ownership goes up, while bonds pay interest and capital back.

Whether that is true for commodities is unclear. Gold may provide diversification, but its price can just as easily go down 50% as go up, and there is no reason why the price of a barrel of oil has to be worth more in 50 years’ time than it costs today. It can be useful to include commodities in a portfolio primarily for their correlation characteristics. A lot of assets don’t like inflation – bonds, for example, and even equities in the short term. Commodities in that sense are often seen as inflation hedges. But, on a pure return and volatility basis, their weight would be zero.

The danger for institutional investors is that, whilst commodities can act as a powerful diversifier for institutions that need to reduce volatility, even by small amounts, the prospects for extraordinary gains are more suspect. Moreover, the timing, even for diversification benefits, may be unattractive if the lack of backwardation driven by the influx of investment by the institutions themselves means the opportunity for positive returns is greatly diminished.

It is interesting to note that even proponents of risk parity acknowledge that commodities should not have the same risk weighting as equities and bonds. Long-term institutional investors should look to assets that can generate economic returns rather than serve as a volatile store of value. 

Joseph Mariathasan is a contributing editor at IPE