London, December 2011: Reuters

Commodity index investors must be starting to wonder if anything will ever go right. Just as roll losses on major products such as the Goldman Sachs Commodity Index (GSCI) have begun to diminish, an increase in predicted oil and gas supplies has blunted expectations of a super-cycle.

For most of the last six years, from 2005 to 2011, index investors have made money from rising spot prices, only to lose it on rolling their positions forward each month. Rolling long futures and options positions in contango markets has cost a staggering amount of money, wiping out everything index investors have made from rising spot prices since September 2003.

Losses became eye-watering when the recession caused a huge build-up of stocks in 2008-2010 and swung the oil market in particular into a persistent super-contango. Investors paid an average of 2.4 percent each month in 2009 to roll long positions in the basic GSCI forward, and another 0.8 percent every month in 2010.

Roll losses cost pension funds and institutional investors tens of billions of dollars. Most of it was captured by banks, oil companies and grain merchants using short futures positions to hedge physical inventories (oil in floating storage and tank farms, copper and aluminium in warehouses, and grain in elevators).

BACKWARDATION REAPPEARS

For most indices, 2011 has been better, or at least less bad. Markets have flirted with backwardation as strong growth in emerging economies, fitful expansion in the advanced industrial world, and supply interruptions have worked off the stock overhang in oil and some other materials.

In three months this year (June, September and October) GSCI investors actually made a positive return from the roll. These were the first positive rolls since April 2008, and only the fourth, fifth and sixth time investors have made a profit on the monthly roll since the start of 2005.

On average, GSCI investors have still lost money on rolls, but the drag on monthly returns has shrunk to 0.3 percent, the best performance since the indexing boom began in 2004 with publication of Gary Gorton and Geert Rouwenhorst's paper on "Facts and Fantasies about Commodity Futures".

Index investors were starting to hope for even better roll returns in future, as index allocators switch from glutted U.S. crude to the tighter and more squeezable Brent market, while new rail links and pipelines as well as the reversal of the Seaway line promise to cure the over-supply problem in the U.S. midcontinent over the next 12 months.

BUT SPOT PRICES HIT PLATEAU

In a bitter blow, however, just as it has started to go better on the rolls, investors have begun to lose on spot prices. The GSCI spot index is down 1.8 percent so far this year, its worst performance since 2008, and only the third time spot prices have fallen since 2000.

Admittedly, spot prices have hit a very high plateau after two years of exceptionally strong gains in 2009 (50 percent) and 2010 (20 percent). Like other asset classes, commodities have been hit by the European debt crisis.

According to commodity bulls, price rises should resume once the euro zone storm passes and the underlying dynamics of the super-cycle (growing emerging market demand coupled with restricted supply) reassert themselves. But doubts are creeping in. New technology in the form of horizontal drilling and hydraulic fracturing has demolished fears about peak gas production over the last five years, and is now doing the same for once-popular theories about peak oil. Climbing production in North America has sent Henry Hub gas prices to their lowest level since September 2009, and before that 2002 . Natural gas futures are trading only a little over $3.

It is all very different from July 2008, when prices were over $13, let alone 2005, when prices climbed over $15, amid panic about future gas supplies, triggering a frenzy to build LNG import terminals.

FRACKING AND FORWARD PRICES

The really important changes have been at the back end of the curve, reflecting a fundamental shift in perceptions about future oil and gas supplies. At the height of price spike in 2008, prices for oil 3-5 years forward traded at a premium, reflecting an assumption the supply-demand balance would remain tight or worsen in the medium term. Now forward oil prices are trading at a discount, as investors calculate fracking will revolutionise supplies in the same way it has transformed the gas market.

David Fyfe, head of the International Energy Agency's oil industry and markets division, told Reuters this week: "We think that the market for 2011 and 2012 now looks tight to balanced, and there is the prospect of it easing somewhat after that." The market agrees with him. Brent futures are trading at big discounts for Dec 2013 ($97), Dec 2014 ($94) and Dec 2015 ($91). Forward prices for Dec 2015 have been trading around $90-100 for most of the year.

Forward prices are not a forecast. They probably understate the market's implied expectation about where the spot market will be in 2013 or 2015, given John Maynard Keynes' theories about hedging pressure and normal backwardation. But the turnaround is stark. In July 2008, the market's four-year forward oil price was $144. In November 2011, it is $93 .

Fracking affects only the energy components of the GSCI and similar indices, though given the huge combined weighting of crude oil, refined products and natural gas in almost all index products, it has a decisive impact on performance in many cases.

But even in other areas, such as grains, livestock, iron ore and non-ferrous base metals, the stimulus provided by record prices, heavy investment and substitution has started to ease fears about peak food, peak copper and peak iron ore. The food and metal components of the GSCI and other commodity indices have performed even worse than the energy contracts in 2011.

COMMODITY RETURNS RECONSIDERED

It must sometimes appear to index investors that they are doomed. Excess returns to investors over and above the risk-free (!) rate on their collateral has been essentially zero over the last decade.

Second and third-generation indices holding futures with longer maturities and rolling them more creatively are essentially variants on the same trade. While back-testing reveals that they would have provided superior returns than the generation-one GSCI, the fundamental problem is the same, and better returns will quickly evaporate as money is reallocated to them.

In practice, there appear to be two sources of long-run returns in commodity derivatives markets: (1) returns to liquidity and scarcity (what Keynes termed normal backwardation); and (2) returns to speculators' skill in timing cyclical price movements.

Like money, there are (separate) interest rates for an investment in commodity futures contracts for gold, copper, oil or wheat. But unlike money, where the interest rate is quoted explicitly, interest rates in commodity futures are quoted implicitly, embedded in the structure of premiums and discounts for forward prices.

Because markets for commodities are a good deal less liquid than cash and government bonds, implied rates are generally higher. That is why commodity markets generally trade at less than full carry, and one reason why Keynes thought markets would exhibit "normal backwardation".

Gorton and Rouwenhorst's research appeared to show that investors could have captured that higher interest rate (or risk premium) if they had invested in a fully collateralised diversified basket of commodity futures between 1959 and 2004.

But the premium depended on lack of liquidity, and hedgers paying a premium to investors to assume price risk. As investors have piled into commodity markets, liquidity has improved enormously, but the premium for risk and illiquidity has vanished.

That leaves investors scrambling for returns to skill/market timing, which explains the upsurge in interest in relative value. For investors facing increasingly overcrowded market, the possible end of the super-cycle, and perennially underperforming indices, it may be the only strategy left.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now with permission.

The views expressed here are his own.