Confidence in commodities at 10-year high

Confidence in commodities at 10-year high

The outlook for commodities is the best it has been for a decade, according to Hermes Fund Managers’ commodities analysis of the futures markets. 

The analysis shows that a broad ‘backwardation’ of around 1.7% – whereby current spot prices are higher than those indicated in futures contracts – exists across the broad commodity spectrum.  Last year was the first year a passive commodity investor received a positive roll return since 2003, due to a number of commodity forward curves being in strong backwardation all year, notably Brent and soybeans.
Jason Lejonvarn, strategist Hermes Commodities commented, “Sustained backwardation is unusual and a key signal for commodity investors. It indicates not only a positive roll return but an enhanced commodity risk premium overall.”
There are three sources of returns from investing in commodity futures, including roll yield, the rise in the spot price of commodities over time and the ‘risk-free cash’ return, which is priced into contracts to compensate investors for providing liquidity in the market.

The roll yield, which comes when commodity investments are rolled over from one period to the next, is the least significant historically, having returned -0.71% per annum between 1970 and 2013.
However, current backwardation offers much higher returns: roll yields in commodities in 2013 delivered a passive return of 1.5% while the current backwardation in Brent oil implies a return of 5% from the roll yield alone over the next year and a record backwardation in soybeans currently offers an annualised return of 20%.
By buying a futures contract, investors can also benefit from a rise in the spot price because backwardation indicates that a futures contract will trade at a higher price as it approaches expiry.
“The existing backwardation can be attributed to current spot prices being driven higher by surprisingly strong demand and shortages,” added Lejonvarn.

“Some of it is related to supply disruptions but it is largely a reflection of the economic cycle. Global growth has bottomed out and we are returning to trend growth, which is raising demand across the board. Commodities tend to do well in the late expansionary cycle, starting from the transition point from early to late expansion. Given where we are now, we believe it is logical that commodities will be the next asset class to outperform.”

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