Let’s face it, investing in commodities is complex. Unless you’re buying gold or other precious metals, you aren’t actually buying the asset. Instead you are buying a futures contract on the asset. You are buying a promise that at some date in the future you will take delivery of an asset or, more likely, you will end up selling that contract to someone who actually wants that barrel of oil before the contract expires.

The future you hold differs in price from the got-to-have-it-today spot price. The futures price has priced in it a premium for storage or uncertainty or one of a thousand things the market thinks will happen to that commodity – be it good or bad – and so it is either higher or lower than the spot price.

Today the market is flooded with investors “getting into commodities” because of ethanol, oil shocks, China, bio-diesel, and 1,000 headline motivators. Nearly all of these investors are thinking about spot prices, which is what they read about in the newspapers. But the truth is, history shows us that spot prices are just one factor in commodity returns, and often are not even the most important factor.

The Three Sources Of Commodity Returns
There are three sources of commodity returns:

The Spot Price
The spot price is easy to understand. It is just the market price. If the spot price rises between the time you buy a commodity future and the time you sell it, you make money. If not, you lose.

The Cash Yield
The cash yield is also easy to understand. When you buy commodity futures, you only need put up a fraction of what the contract is worth: typically 5-10%. The rest of the purchase price is held as collateral. The commodity index funds and ETFs (and all smart investors) will invest this collateral in a safe asset, like Treasuries, which pay out interest income. That’s the cash yield.

The Roll Yield
The third factor that affects your commodity return is the roll yield. A futures contract is an agreement to buy the underlying asset at a certain future date: say, to buy 1,000 barrels of oil at such-and-such a date. (NYMEX oil contracts expire on the 3rd business day before the 25th calendar day of the month.) There are oil contracts available for every month of the year, but typically, the “front month” (or next month) contract is the most heavily traded.

Of course, most investors don’t want to actually take possession of a thousand barrels of oil, so they sell their contracts before expiration and buy the next month’s contracts. It’s called “rolling” their position. Since you’re selling one thing and buying something else, you either make or lose money. If the next month contract is more expensive than the one you’re selling (a condition called “contango”), the roll yield is negative and you lose money. If the next month contract is less expensive (a condition called “backwardation”), the roll yield is positive and you make money.

These sources of return are well known and well documented. Companies have spent countless hours developing investment products to mitigate the effect of contango on their returns.
Why? Because it matters.

Let’s look at some historical information on the GSCI. The GSCI is a heavily energy-based commodities index, with 73% of its holdings in the energy sector as of Jan 8, 2008. Of that 73%, 6% is from natural gas and the rest is from petroleum-derived products. In other words, the price of oil tends to move the GSCI significantly.

 Prev123Next