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Bransby Whitton, Kate Botting
Current market conditions may be making commodities more attractive to investors – roll yield, or what an investor would earn if a commodity’s forward
curve did not change, has turned positive. Over the past several years, most commodity forward curves were often upward-sloping, a phenomenon known as
contango (see sidebar and “Contending with Contango,” July 20101
). This caused many investors to receive negative roll yield on their commodity allocations. Today, many commodity forward curves are downward-sloping – a
phenomenon known as backwardation. This has created a tailwind of positive roll yield, making it possible for investors to earn positive returns by simply
holding commodities in their portfolios.
Commodities can also provide several other benefits in a broader portfolio context, including diversification, inflation hedging and return potential from
changes in commodity futures prices (see “We See Opportunities in Commodities,” March 2014).
What are contango, backwardation and roll yield?
Contango refers to a condition in the commodity futures markets in which the forward price of a contract is greater than the current (spot) price,
producing an upward-sloping forward curve. The higher forward price is partially based on the seasonality as well as the “cost of carry” related to the
underlying physical commodity (e.g., storage, insurance and security costs). When contango occurs, it creates a headwind for index investors. They are
forced to sell low and buy high as they “roll” their positions forward. This price difference is “roll yield.”
The opposite condition is called backwardation, which produces a downward-sloping forward curve. The higher current (or nearby) price reflects the market’s
willingness to pay a convenience premium for prompt delivery of the physical commodity when inventories are tight. Backwardation can provide a tailwind of
positive roll yield for index investors, since they are selling high and rolling to a lower-priced distant contract.
However, history shows that contango and backwardation come and go in individual commodity markets. Today, half of the 22 commodities in the Bloomberg
Commodity Index (formerly the Dow Jones-UBS Commodity Index) have a positive roll yield as measured on a 12-month forward basis (to avoid the impact of
seasonality). At the index level, this translates into a weighted average roll yield of 3.4% (as of 30 June 2014), a notable improvement over the previous
decade (Figure 1). Similarly, the weighted average roll yield for the Credit Suisse Commodity Benchmark is 3.8%.
What is driving backwardation today?Of all the commodities in these indexes that are in backwardation, crude oil stands out as the most stable source of positive roll yield. We expect
persistent backwardation in crude oil due to the combination of supply growth, primarily from U.S. shale oil production, and OPEC’s management of
short-term inventory balances.
U.S. shale oil production has been the first material source of new oil supply since the 1970s, providing confidence about supply growth. This growth is
keeping longer-term oil prices anchored at the marginal cost of new production, around $90/barrel. This differs considerably from most of the prior decade,
when the back end of the oil market closely followed spot prices higher. In 2008, in particular, the five-year forward price of oil rallied to $140/barrel
as the front hit $140/barrel given the absence of foreseeable supply to anchor expectations. In addition, shale production increases producer hedging,
introducing a natural seller for longer-dated oil, which further supports backwardation in the oil curve.
Other commodities are also meaningfully contributing to a positive index-level roll yield – for example, gasoline, soybeans and lean hogs. Soybean prices
have been supported by strong Chinese imports. Lean hogs are pricing in a premium due to a deadly disease that affected supply. And while these conditions
may not be as persistent as the shale oil revolution, we expect that other supply-side issues may arise in individual commodity markets over time, creating
downward-sloping forward curves and contributing to a positive index-level roll yield.
Why active management is keyWhether commodity curves are in contango or backwardation, active management of commodity exposure is key when implementing a portfolio strategy.
When markets are in contango, an index investor can utilize a number of active strategies to help mitigate the effect of negative roll yield, including
holding positions further out on the forward curve where the slope is flatter and negative roll yield is smaller, or holding positions in an equivalent
market where the negative roll yield is less severe, such as Matif wheat instead of Chicago wheat. During periods of negative index roll yield, PIMCO has
implemented these and many other active commodity strategies in an effort to deliver consistent positive commodity alpha.
With commodity markets now in backwardation, investors may have more flexibility to pivot away from holding positions further out on the forward curve.
When roll yield is positive, investors are often better off at the front of forward curves, where the slope tends to be the steepest. As an active manager
of commodities, PIMCO has scaled down deferred-month holdings in favor of front-month positions, and we continue to take advantage of other opportunities
in commodity markets in an effort to deliver additional returns to our clients.
The authors would like to thank Bob Greer for his contribution to this paper.
1Available upon request
Past performance is not a guarantee or a reliable indicator of future results. All investments
contain risk and may lose value. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and
may not be suitable for all investors. Derivatives and commodity-linked derivatives may involve certain costs and risks, such as
liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative
instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity,
such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in
derivatives could lose more than the amount invested. Diversification does not ensure against loss.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee
that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to
invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an
The Bloomberg Commodity Total Return Index is an unmanaged index composed of futures contracts on 22 physical commodities. The index is designed to be a
highly liquid and diversified benchmark for commodities as an asset class. Prior to 30 June 2014, this index was known as the Dow Jones UBS Commodity Total
Return Index. The Credit Suisse Commodity Benchmark Index is an unmanaged index composed of futures contracts on 34 physical commodities. The index is
designed to be a highly liquid and diversified benchmark for commodities as an asset class. It is not possible to invest directly in an unmanaged index.
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