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Contango and the real cost of carry

London, 23 July 2010

For the last two years, the contango structure embedded in futures prices has far exceeded the actual cost of owning physical raw materials such as crude oil, aluminium and copper, explaining the strong interest from traders and hedge funds in owning inventories or the warehouses, elevators and tank farms that store them.

Well-connected banks and physical traders have exploited the difference between the actual cost of financing, storing and insuring raw materials and the implied cost in upward sloping futures prices, as a source of comparatively low risk profits.

It has helped commodity markets carry record stocks and supported overproduction of many raw materials through the recession and the early stages of the recovery with only minimal downward pressure on prices.

But the days of physical commodity storage as a licence to print money are ending. An increasing number of other institutions and hedge funds have created their own "virtual storage" plays, with negative positions in the spreads, or a short position against commodity indices or customised swaps.

As storage plays become more crowded, the contango will continue to erode gradually until it resembles the actual costs of finance, storage and insurance, and this source of relatively risk-free profit is removed.

Market Inefficiency

The gap between the contango and the actual cost of carry stems from a number of imperfections in physical and financial markets:

(1) Contango compensates stockholders for the interest cost associated with buying and carrying inventories. But the actual cost of finance varies widely. In the current environment, high-rated issuers, banks with access to official liquidity, and other institutions long of cash face a much cheaper cost of funding than other participants. They have natural advantages funding and owning raw materials. They can transform their privileged position in the financial markets into a privileged position in commodities.

(2) Storage costs are not uniform. Firms which own or lease warehouses, tank farms and grain silos have an obvious advantage (though real profits depend on the cost of capital for carrying these physical assets). Even firms which do not own or lease facilities may be able to strike attractive storage deals below "normal" market rates in return for guaranteeing minimum levels and duration of usage.

(3) There are opportunities for banks and physical merchants with very high ratings or close banking relationships to "make the turn" by engaging in maturity transformation -- financing medium or long-term positions in inventory by borrowing cheap funds short-term, and constantly rolling them forward.

ZIRP and High Stocks

Several aspects of the current environment have combined to make cash-and-carry strategies extremely profitable:

(a) Banks and physical traders have exploited the gap between the low cost of funds for institutions at the heart of the financial system and the much higher cost of borrowing for everyone else, as well as the big gap between short term and long term rates.

(b) Central bank commitments to keep rates at exceptionally low levels for an extended period have slashed risks associated with maturity transformation.

(c) High inventories and persistent oversupply have reduced the likelihood stocks will be needed in the short to medium term, making it less risky to strike storage deals in exchange for guaranteeing stock will be held for a minimum period. Recession, the credit crunch and zero interest rate policies (ZIRP) have come together to create ideal positions for cash-and-carry strategies.

Pension Fund Prisoners

The final factor has been strong interest from pension funds, other institutions and retail investors who see commodity indices and exchange-traded products (ETPs) as a hedge against inflation, dollar devaluation and counterparty risk.

By establishing long positions in futures and options, but never wanting to take physical delivery, pension funds and investors are natural counterparties for the cash-and-carry trade, which wants to be short futures and options, but never have to make delivery.

Constant rolling of index and ETP positions has forced many markets into much larger and more persistent contango structures than before 2004-2005 (when commodities first became popular as an "asset class").

In theory, there is no reason index and ETP rolls should force markets into a big contango, any more than cashand-carry shorts should force them into a big backwardation.

In practice, the shorts have had two advantages which have given them the upper hand. First while longs have no choice but to roll forward, however large the contango becomes, since they can't take delivery, the cash-and-carry shorts always have the option to deliver.

Second, the investment objectives of the longs are very long term. They are using commodities as a hedge against the risk of inflation/devaluation/repudiation at some unspecified point in the future, possibly the far future. The prospect of capturing some massive leap in prices in future has made them insensitive to the month by month costs of holding long positions in the meantime.

In contrast, most cash-and-carry traders are price sensitive. They will not roll shorts in a backwardated market unless the backwardation is small and/or expected to be fleeting. In event of a large or sustained backwardation they will close out short positions by delivery, since any money made on the turn is quickly dwarfed by roll losses.

Pension funds and other investors have become prisoners of their own long-term thinking about inflation and insensitivity to roll costs. The longer inflation has failed to materialise the more losses have mounted.

The cash and carry trade has been the main beneficiary, together with commodity producers who have been able to continue selling (surplus) production at higher-thannormal prices for this stage in the cycle.

Trade Becoming Crowded

The high profits associated with cash-and-carry strategies, as well as the losses from long positions in indices and ETPs are encouraging a growing number of other market participants to join the short side of the market to benefit from the super-normal contango.

One option is to enter the cash-and-carry trade directly. There are reports of hedge funds and special purpose vehicles (SPVs) buying and storing large quantities of physical products off market. Primary aluminium and copper are two markets frequently mentioned but the strategy is probably common.

The ideal structure involves relationships between a producer, a hedge fund or SPV, a bank and a distributor or eventual end-user. The producer sells surplus output to the hedge fund or SPV to book the sale, generate cash flow, and keep it from depressing market prices. The hedge fund/SPV locks up the stock with a storage deal and a financing arrangement (secured against the stock itself) sharing the profits of the cash and carry trade with a bank. When demand picks up sufficiently and the inventory cycle turns, the stock can be sold back to the original producer, or put back into the market to a distributor or user.

The other option is to create a "synthetic" warehouse by establishing a negative position in the spread (running a short position in nearby futures and a long position further forward). Risk is limited to possibility of a backwardation between the two dates (limited at this point in the cycle).

Meanwhile the position holder collects the contango. For those with more risk appetite, there is the option of going outright short nearby, rolling at a profit while the contango lasts, and being ready to close out if and when the market moves into a backwardation.

All of these strategies have increased in popularity over the last 12 months. As a result demand for short positions nearby has outstripped the demand for fresh longs from pension funds, competing away the contango which made the strategy attractive in the first place, and pushing it much closer to the actual cost of funds and storage.

Ends --

By John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.