Washington, 17 November 2010

Backwardation is becoming a more widespread and frequent feature in commodity futures markets, as the global recovery works down excess stocks and the large number of financial participants with short positions get squeezed by delivery problems. But the end of two years of punishing contango may be too late for many investors and banks, who have been giving up on commodity indices just as their returns look set to improve.

Of 24 contracts included in the Standard and Poor's Goldman Sachs Commodity Index, 17 have traded in nearby backwardations at some stage during the second half of 2010, up from just 12 in January-June and eight in H2 2009 [see figures below]. The total number of days trading in backwardation across all 24 contracts has jumped to 573, a faster rate than 585 for the whole of H1 and 381 in H2 2009. The number of "backwardation-days" is set to hit its highest since commodity prices spiked in H2 2007 and H1 2008. The number of contracts trading in backwardation has already hit its highest for more than a decade

Backwardations are not restricted to contracts in the GSCI. The last few months have seen backwardations in contracts such as Liffe cocoa and the Newcastle coal market that are not included in any of the major indices.

The return of backwardation after several years of mostly contango trading is due to a combination of three factors:

(1) While consumption in the advanced economies remains depressed, well below levels recorded in 2006-2008, continued demand from emerging markets has stabilised and begun to reduce excess stocks of oil and raw materials.

(2) Stable contangos have encouraged producers, consumers and merchants to carry high volumes of physical inventories and hedge them with short positions in futures markets. Much of this working inventory is not immediately deliverable against short futures positions because it is in the wrong form, the wrong grade or the wrong location, leaving the hedge shorts vulnerable to squeezes as the commodity cycle turns.

(3) Stable contangos have also encouraged many financial investors to run short futures positions in order to capture positive roll yields or as part of a spread strategy (for example short nearby oil futures and long further forward, or short nearby in oil and long in a market such as copper).

Naked shorts like this have left them very vulnerable to squeezes on the nearby delivery dates. In most cases, the immediate trigger for a backwardation has been a supply disruption (such as a refinery outage) and/or the emergence of a dominant long position in the contract closest to delivery. But the underlying cause is the high number of short positions put on by market participants in no position to deliver against them.

Prolonged contango trading has encouraged a complacent attitude about delivery risk. Shorts have delayed too long before rolling positions in the expectation contangos would last forever.

Every successful trading strategy sows the seeds of its own destruction. The long period of contango trading is no exception. It has encouraged too many financial participants and hedgers to play the market from the short side, making the trade crowded, and leaving them vulnerable to a squeeze by the longs. Now the pendulum is swinging back.

So far backwardations are not widespread enough or lasting long enough to generate positive roll returns for investors in the GSCI overall. Roll returns for the GSCI and its energy and non-energy components are still negative. But the monthly losses are much smaller than in 2009 and early 2010.

There is no reason to expect commodity markets (with the exception of precious metals and grains) will revert to the pre-2005 pattern of trading mostly in backwardation, generating positive rolls for investors in long-only indices.

But the exceptional contangos recorded in the last two years look set to narrow, reducing the cost to pension funds and others of using indices to protect their portfolios against inflation and dollar devaluation.

Ends --

John Kemp, Reuters market analyst - for Commodities Now. The views expressed are his own.

Attachments:

GSCI_ROLL-RETURNS.pdf	20 Kb
GSCI_SPR-VOL.pdf	60 Kb