We have often explained the importance of forward rates in assessing the value present in bonds across the yield curve today. Today’s yield curves across developed-market (DM) and emerging-market (EM) economies are displaying a positive slope. It reflects an expectation that central banks will raise policy rates over years to come. When calculating forward rates, one observes that these plot above the current yield curve. Investors that believe that policy normalisation will go faster on balance are advised to refrain from carry portfolios with intermediate-to-long durations as future long rates will realise above forwards. The reverse is true if participants believe central banks will take more time to normalise by keeping rates low for longer leading to realised forward rates below these expected today. Under this scenario, carry portfolios become valuable.
Commodity markets work in a similar fashion. The forward commodity curve is the tool used to analyse the future demand and supply balance or imbalance. Commodities swing back and forth between backwardation and contango. Backwardation means tight supplies, as nearby prices are higher than deferred prices. Contango means glut or oversupply, as nearby prices are lower than deferred or future prices. Forward spreads are the cost of carrying inventory of a raw material. The forward spread (contract difference) between November 2021 WTI crude oil (closing at USD 82.66) and November 2022 (closing at USD 73.47) finished at USD 9.19, a rare condition. This difference reflects, in real time, the tightness of demand-supply and incorporate interest rates, the cost of storage and funding cost.
Commodities are an extremely volatile asset class. The WTI oil contract changes hands in ‘at the money’ option markets at implied volatilities between 30% and 35%. For natural gas option contracts, these implied volatilities went above 100% over the next 5 months and drop towards 50% as of April. The reason behind such a drop relates to seasonality features. Tightness in natural gas often occurs between October and March, and drop off as inventory build-up occurs over spring and summer.
Clearly, the energy commodity complex is under heavy strain. This might not abate over the next six months, as reflected in oil, natural gas and coal contracts 6 months out. Coal prices on the February 2023 contract trade at half the price of the November 2021 contract. The enormous tightness in natural gas markets creates intense substitution flows towards oil and coal. Indeed, within the energy complex, most contracts support each other as capacity has been heavily depleted over the corona episode. Capex is slow to recover. Energy companies are not in a hurry. Making things worse, the energy complex is also the playground for speculators at this very moment. Much less so in other commodity sectors. Bypassing tight supply conditions in energy towards precious metals, base metals and soft commodities is a bridge too far.
Precious metals gold and silver trade in contango, reflecting oversupply. Both gold and silver have dropped in ranking as a flight-to-safety instrument. Declining real rates did not translate into a commensurate rise in the gold price. A resistant and current strengthening USD index is not helping either. The rise of bitcoin as a contender for portfolio diversification is adding to the pain incurred by traditional gold believers. Anyhow, the physical market in both gold, silver and platinum does not portend supply tightness over 2022.
In base metal, we witnessed an overall upward shift of the copper and aluminium curve. The contract table exhibits a flat structure. Having gone through global peak growth over H1 2021, awaiting sound but lower growth conditions over 2022, we should not import energy related stress towards base metals. Same goes for soybeans, corn, wheat and coffee. Forward curves across these soft commodities are not showing heavy backwardation. Inventory control and management are not out of bound. Speculators across precious and base metals are not in control. Nor do we see any persistent control in softs. Lumber was a good example. Construction seasonality and corona constraints caused prices to double between January and May 2021, only to see similar prices from the start of the year again today. A perfect turn-around trip. Yes, within commodities, reversals can strike hard and fast.
It is amazing to see that financial market strategists call on everyone to, with a high sense of urgency, add to commodity exposure as diversifier in times of high inflation. I wonder if their timing is right, especially considering the high and aggressive volatility profile of these commodities. One should track two composite indices: the CRB (Commodity Research Bureau) Rind index of raw industrials, for which no active financial futures contracts exist, plots at a 40-year high. This raw material index broke through the 2011 highs. The main CRB All Commodity index is within striking distance of breaking the all-time high also reached over 2011.
The probability is high that we reached peak growth over H1 2021. The probability that, over the next 6 months, we will go through peak inflation conditions might increase from here onwards. Monetary authorities become courageous in the tapering and policy rate tightening debate.
Interestingly, back in 2011, the commodity complex made its high (a level that we see back today) over the month of March…by December 2011 commodities were down 16%. By the end of 2015 the complex was down 35%.
The message conveyed here is that commodity markets are specialist markets. Pulling the broader public into commodities as a hedge against inflation (fear) or as portfolio diversification is a sign of our times. It is nurturing speculation causing many negative externalities. From an ESG perspective, it does not fall under the Do-Not-Significantly-Harm principle. Let demand-supply conditions normalise naturally. Underlying demand-supply frictions should be allowed to rebalance correctly. ‘Putting out fire with gasoline’ was a great David Bowie track. Let’s hope the financial industry doesn’t put this into practice. Because, yet again, ‘Joe Sixpack’ will have to pick up the price tag.
