Commodities Have Suddenly Become A Much Flashier Investment

Commodities Have Suddenly Become A Much Flashier Investment
Stéphane Renevier, CFA

almost 2 years ago4 mins

  • Backwardation – when the prices of long-term contracts is lower than those of near-term ones – tends to be a bullish signal for commodity prices.

  • But it also means you’re buying the commodity at a discount, and can expect to make extra returns even if prices in the physical markets don’t move.

  • So right now may be a great time to buy commodities, particularly backwardated ones: prices may not only rise further, but you’re also paid an extra yield for holding the position.

Backwardation – when the prices of long-term contracts is lower than those of near-term ones – tends to be a bullish signal for commodity prices.

But it also means you’re buying the commodity at a discount, and can expect to make extra returns even if prices in the physical markets don’t move.

So right now may be a great time to buy commodities, particularly backwardated ones: prices may not only rise further, but you’re also paid an extra yield for holding the position.

For the past two decades, investing in commodities would’ve cost you a pretty penny: as much as 20% a year, in fact. But that’s all about to change. Because not only does the arrival of “backwardation” hint at the start of a commodity price rally, it means you’ll finally actually be paid to hold the assets. Potentially enough to put dividends to shame, too.

What exactly is backwardation?

When you invest in commodities, you probably do so using a futures contract – a derivative that enables you to speculate on the value of the asset, rather than buy it outright. No one wants a yard full of oil, after all.

By buying a futures contract, you agree to buy or sell the commodity at a set price on a certain date in the future. So say you’re bullish on oil, which is currently sitting at $119 a barrel. You might buy a futures contract on Brent crude that expires at the end of August for $103. If the oil price is higher than $103 by then, you’d get paid the difference. If it ends up lower, you’d have to pay the difference.

You can buy all sorts of futures contracts, all with different expiry dates and agreed prices. Generally speaking, those prices are higher for long-term contracts than those of near-term ones – a state known as contango. But when the supply of commodities can’t keep up with demand, the prices of near-term contracts climb higher than those of long-term ones. That much less common scenario is known as backwardation, and it’s exactly what we’re seeing now.

What’s happening now?

Backwardation has reached pretty extreme levels across almost all commodities, and there are a couple of reasons why.

On the one hand, demand has been strong: massive fiscal stimulus kicked off a boom for many commodities, which only got stronger after economies reopened following their respective lockdowns. On the other, supply chain disruptions, geopolitical tensions, and years of low prices and regulatory pressures have significantly reduced the ability of suppliers to quickly adjust to this higher demand.

All in, that means there’s a record amount of commodities trading in backwardation right now. In fact, 21 of the 28 most important commodities in every sector are backwardated.

Record backwardation across commodities. Source: MacroOps
Record backwardation across commodities. Source: MacroOps

The message in this record backwardation is quite clear: for the first time in decades, the world is running out of commodities.

Why does backwardation matter?

If backwardation reflects shortages in the physical market on which futures are based, it’s obviously a bullish signal for commodity prices. The bigger the difference between short-term and long-term prices, after all, the tighter the supply is in relation to demand.

But that’s not the half of it. Because when prices are backwardated, you’re essentially buying the commodity at a discount. As time passes, the price of the futures contract will converge to the higher current “physical” price, meaning you’ll pocket the difference between the two. Take oil, for example: by buying the August contract for $103, you can expect to make an extra $16 as prices converge to the current price of $119. So even if prices in physical markets don’t change, investors in the futures markets are still earning a nice profit when prices are in backwardation. Let’s call that profit (which is commonly and misleadingly known as the “roll yield”) the “backwardation yield”.

Annual cost of holding commodity futures. Source: WisdomTree
Annual cost of holding commodity futures. Source: WisdomTree

What’s the opportunity here?

Now might be the time to take full advantage of the backwardation yield – not least because it’s much more enticing than a dividend or a bond’s coupon rate, with the potential to reach a double-digit percentage for some commodities. That’s the case for oil right now. And it means that, at best, prices will rise even more and compound your gains, and, at worst, you’d have a nice buffer before you start to suffer a loss.

So as long as you don’t expect a recession to significantly impact future demand, you could exclusively buy commodities in backwardation, maximizing the return you’re expected to make. That might take some research on your part, but barchart.com should help you get going: it shows a clear table of prices for all different maturities, as well as allows you to plot the difference in price between two specific contracts.

Alternatively, you could invest in the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (ticker: PDBC, expense ratio: 0.62%): it’s not exclusively invested in commodities in backwardation, but it does take into account the level of backwardation when selecting which contracts to buy.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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