After reading The Little Book of Commodity Investing, I started looking into commodity* investing (See Should Canadians Add Commodities to their Portfolios, July 18, 2010, A Survey of Commodity Indices, July 20, 2010 and A survey of broad commodity index ETFs and ETNs, July 21, 2010) out of curiosity. Ever the skeptic, Larry MacDonald pointed out that with too many investors (including passive, buy-and-hold types) fishing in the commodities pond these days, the days of equity-like returns might be well past. Turns out, that’s exactly what is happening.
In its recent cover story, Bloomberg Businessweek termed the recent experience of commodity investors, Amber Waves of Pain. The culprit is a market condition called “contango”, which means futures contracts that are further away from expiry trade at a higher price than the contracts that are approaching expiration. Since commodity ETFs purchase near-term contracts and roll it over as they approach expiry, a buy-and-hold investor in these securities is steadily losing money (because contracts are rolled over into ever more expensive contracts) as long as markets remain in contango.
It is very interesting why contango exists in the first place. Commodity ETFs roll over their contracts at specific dates in a month making for easy pickings for professional traders who exploit the set times by buying ahead of ETF purchases and driving down the price by selling before the ETFs. The Businessweek article provides a wonderful illustration: In May 2010, ETFs sold June contracts of crude oil at an average price of $75.67 and rolled into July contracts at an average price of $79.68. When the ETFs were done buying, July contracts fell back to $75.43. In other words, ETFs investing in crude oil lost big time in May 2010 in rolling over the contracts.
The above example explains why, since inception, the US Oil Fund (USO) has lost half its value and the US Natural Gas Fund (UNG) has losses approaching 85%. It is hard for investors of any stripe to recover from losses of such magnitude. The commodity ETFs is a reminder yet again that every new-fangled financial innovation coming out of Wall Street and Bay Street should prima facie be greeted with deep suspicion and skepticism.
* Note that commodities in this post refers to commodity futures — i.e. contracts that promise delivery of a specific quantity of a commodity at a designated time in the future. For example, Sep 2010 Light Sweet Crude Oil at $77 is a contract to accept delivery of 1,000 barrels in September at $77 per barrel.
