Commodity kickers

Retail investors are showing greater interest in commodity-linked products. but most of the structures launched in Europe so far have been based on small, tailor-made baskets. By Patrick Fletcher

Cash invested in commodity indexes has reached around $50 billion, a rise of about 900% over the past five years. The Dow Jones AIG Commodity Index alone had grown to $9 billion as of the end of March – that’s a whopping 1,700% increase since 2003. Most of that cash has come from institutional investors looking to diversify away from equity and bonds amid sluggish returns in those markets over the past few years.

More recently, retail investors have taken a strong interest in the commodity markets, encouraged by record high oil prices and a growing recognition of the benefits of diversification. In response, dealers have increasingly been looking to add commodity kickers to retail structured products. In Asia, a handful of products have emerged that add a commodity component to a predominantly equity-focused structured product. And while there have been relatively few commodity-linked structured products launched in Europe to date, dealers believe the retail market is likely to be one of the highest growth areas for commodities.

However, while many equity, interest rate and even hedge fund structured products have been linked to indexes – whether it is the Dow Jones Industrial Index, US dollar Libor or the FTSE Hedge Fund Index – the retail commodity products launched in Europe so far have been based on small, tailor-made baskets.

For instance, Dawnay Day Quantum (DDQ), a subsidiary of Dawnay Day Group, a UK financial services and property group, launched a commodity-linked product aimed at retail investors in the UK in November last year. The four-year product is referenced to an equally weighted basket of crude oil, heating oil, natural gas, aluminium, lead, copper, nickel and platinum, and pays investors 160% of the commodity basket performance at maturity, calculated as the average price of the eight underlying spot prices during the last week of the investment. The firm has since launched two more commodity products – a four-year product that pays 150% of any increase in the same commodity portfolio, launched in March; and a five-year structure that pays 200% of any rise in the commodity portfolio, launched in April.

Mark Mathias, chief executive of DDQ, says his company opted against using a commodity index because it wanted to narrow its focus on specific sectors – energy and metals. “It’s all down to what we want to leave out,” he explains. “We don’t want agricultural or soft commodities such as cocoa and coffee in the portfolio.”

Agricultural prices, he says, are subject to a broader range of variables such as weather conditions, often making them unsuitable for inclusion in retail products. “The supply and demand factors are the same as in other commodities, but they are too weather-dependent. You may make all the correct calls regarding the trends, but then you get bumper harvests and the price crashes because the supply rockets,” he says.

The commodity indexes aim to give investors exposure to a broader range of commodities. The Dow Jones AIG Commodity Index, for instance, has a 30.2% weighting to agricultural and soft commodities, with a 10.5% weighting to livestock. The Deutsche Bank Liquid Commodity Index Mean Reversion, on the other hand, has a 25.4% weighting to wheat and a 24.7% weighting to corn. The GSCI has the highest weighting to energy at 74.4%, but still has an 11% weighting to agricultural commodities.

These weightings are problematic for some product providers. “The Goldman Sachs Commodity Index is overweight in oil, while the Dow Jones AIG is overweight in agricultural and soft commodities, which is not what people want,” says Marc Gordon, managing director of Close Fund Management, the specialist investment management arm of the Close Brothers Group, a London-based merchant bank.

Close Fund Management launched a commodity fund in the UK at the end of February, which gave investors exposure to a basket of one-third crude oil, one-third gold, and one-third industrial metals (equally weighted between aluminium, copper and zinc). Investors receive twice the performance of the commodity basket at maturity. Gordon says investors wanted to have oil and gold in the portfolio, but were wary of allocating too much capital to other markets with which they were less familiar.

The commodity index providers offer a variety of sub-indexes to give investors exposure to specific sectors. For example, Goldman Sachs provides sub-indexes on energy, agriculture, livestock, industrial metals and precious metals. However, product providers point out that many retail investors want exposure to specific commodities that they may have strong views on – primarily oil and gold. Baskets enable them to tailor the content and weighting of the commodity component to suit investor preferences and risk appetite.

At the same time, buying an out-of-the-money option for a five-year basket can be a cost-effective way of getting leverage to the commodity markets. “Volatility at the front end of the market, where the indexes operate, is much higher than volatility five years forward. This means that if you’re buying an option on a basket of five-year commodity forwards, it is usually quite cheap compared with an option on an index with similar components,” says Torsten de Santos, co-head of commodity investor solutions at Barclays Capital.

The indexes, however, operate by buying futures contracts much closer to the front of the market. Each index has a different formula for rolling positions in the front month contract to the second month. Goldman Sachs, for instance, rolls its futures from the fifth to ninth business day each month, selling the first month contract and buying the second.

“The pricing of options on indexes has become dearer in the past few months because of rising volatility in commodity markets,” says Sebastian Lemoine, head of structured transactions on commodities at BNP Paribas. “It is obviously a deterrent to some structures because the gearing you can get on the upside is getting lower and compares less favourably with the type of gearing you can get on a commodity basket.”

Nonetheless, there are some advantages to investing in indexes. The commodity indexes benefit from a roll yield that would not be achievable on basket products. This roll yield occurs when the market is in backwardation – when the spot price is greater than the forward price – meaning future oil can be bought at a discount and sold at a higher cost one month later during the roll.

The returns available on index investment will therefore be higher when the market is in backwardation than simply taking exposure to the underlying spot prices. “Significant opportunities exist in commodity markets from being long front-month commodities prior to unexpected supply disruptions,” says Arun Assumall, head of Goldman Sachs Commodity Index (GSCI) marketing for Europe.

For instance, if a hurricane prevents an oil tanker from docking and unloading its oil, the first-delivery oil contract could rally several dollars due to the disruption of supply. The second and third contracts, however, would not rise as much as the front of the market due to the fact that the hurricane is a temporary disruption. “The market will always pay more to ensure immediate delivery in the event of unexpected supply disruptions, in anticipation that in the next month or at the very least the month after that, supply should be back to normal,” says Assumall. “The rolling structure of the GSCI allows the investor to capture these price spikes, even if they are temporary in nature.”

The risk to index investors is when the market is in contango – when the future price is higher than the spot price. In fact, the oil market is currently in contango (see box), while many industrial metals were in contango for much of the 1990s. Although this would mean a loss for the index each month, market contango is limited (because the spot price is floored at zero), while backwardation is unlimited.

As interest in the commodity market grows among retail investors, it’s likely that a wider variety of commodity-linked structured products will emerge in the European market. In Asia, a small number of ‘best-of’ products has already emerged, giving investors a payout linked to the best performing index in a basket of commodity, equity, foreign exchange and interest rate indexes. Similar products could also eventually emerge in Europe, say dealers. “There are good opportunities in each of the strategies [index and basket],” says Assumall.

Contango down to fundamentals, says Goldman

Recent contango in the oil markets, which has seen the spot price trading up to a $2 discount to the forwards, has been attributed by some dealers to the increase in commodity index investments over the past year. However, Goldman Sachs, in a recent report on the anomaly, said the contango is more to do with market fundamentals. Some dealers have argued that the rolling of index investments from the front-month contract to the second month creates strong demand for the second-month contract, pushing prices up in the forwards market (see chart). The spread between the front- and second-month contracts turned negative late last year. “It has been suggested that this anomaly is the result of investor activity concentrated in near-dated contracts and, in particular, a substantial increase in passive commodity index investments,” says the Goldman report, published in April. Fundamentals However, the US bank says this contango can be explained by market fundamentals. High oil prices are causing an appreciation at the back end of the curve, a phenomenon caused by higher long-term price expectations of the market. In addition, improved inventory management by oil companies has allowed the market to operate at lower inventory levels than in the past, “reducing the inventory level at which the near-dated time spread shifts into contango”. “Taking both these factors into account, the recent spread weakness can be completely explained by weaker fundamentals, and does not suggest that the increase in commodity investments has affected either the shape of the oil forward curve, or likely returns from commodity investments,” the report says. Kevin Norrish, head of commodities research at Barclays Capital, estimates that the $40 billion–50 billion of commodity index investment accounts for around 4% of average monthly turnover in the commodity markets. “Four per cent is relatively small and suggests that investment in the indexes doesn’t have a significant effect on outright price levels. But it may have some impact on the term structure of the market,” he says. However, although the contango may not be caused by the index rolls, it certainly hasn’t helped. “We have looked at what happens to the WTI spreads during the index roll periods,” says Norrish. “Over the past couple of years, if the market was in backwardation, this backwardation has tended to be narrower during the roll period. And when the market has been in contango, the contango has been that bit steeper. So that would imply there is some effect there. But it’s very difficult to say whether that’s arising from simple capacity issues or from other market participants taking positions against the rolls.” But a strategy of going short on the front-month spread just prior to the index rolls is risky due to the physical nature of the markets and the presence of the oil majors in the market, say dealers. “BP is really a dominant force in crude oil and refining in the area [Cushing, Oklahoma, where the WTI contract physically delivers]. If they see a market where every month everybody goes short the front spread to buy it back a few days later, eventually they will take you to the cleaners,” says one hedge fund manager.