Gasoline And Coffee Fuel Our Daily Lives. Can Commodities Also Fuel Our Investment Portfolios? by Bransby Whitton, Klaus Thuerbach and Kate Botting, PIMCO
Commodities are a tangible part of our daily lives. They are the food we eat, the energy that powers our cars and heats our homes, the metals that go into our electrical wiring and our jewelry. Yet investing in commodities can seem elusive.
Unlike stocks and bonds, commodities are physical assets. And for the vast majority of investors, taking delivery of barrels of oil, bushels of wheat and other physical assets is impractical. For centuries, people have used futures markets to solve this problem; the first official exchange with standardized contracts and centralized clearing emerged in Japan in the early 1600s. In the United States, futures contracts on wheat and cotton began trading in the mid-1800s.
Today, commodity exchanges are ubiquitous. They give investors a way to gain or offset exposure to a spectrum of commodity prices without having to deal with delivery and storage. They also give investors access to an asset class that can help diversify portfolios, hedge inflation and event risks, and provide a return potential that can be enhanced through skilled active management. In addition, commodity exchanges offer an important service to commodity producers by allowing them the ability to offset pricing risk or to hedge future production costs.
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The case for commodities today
In the broader portfolio context, investors typically look to a commodities allocation to provide three key benefits: diversification, inflation protection and return potential.
Admittedly, the return benefit has been questioned in recent years given a challenging performance period. However, commodity returns tend to be cyclical, so commodities’ recent history should not be extrapolated into the future. The past few years of commodity returns are not an aberration, but nor are they the norm. Commodity asset class returns tend to go through cycles of positive and negative performance, which largely coincide with economic growth cycles.
To illustrate, Figure 1 compares the return of a 55% equity/40% bond/5% commodity portfolio versus a 60/40 stocks-and-bonds portfolio. The relative performance of the portfolio containing commodities has varied over time, with periods of underperformance during economic downturns, as expected. Commodities as a whole are growth-sensitive assets, especially in recessions that coincide with plentiful commodity supplies and weak demand – exactly what occurred during the global financial crisis (GFC). Importantly, these periods have been followed by years of recovery in commodity returns and the outperformance of the 55/40/5 portfolio. Therefore it is worth taking a longer-term perspective when evaluating the ongoing return potential for the commodity asset class.
While the return benefit of including commodities in a broader portfolio can be cyclical over time, the diversification benefit has remained consistently positive, which has led to better risk-adjusted returns over time. As Figure 1 shows, the volatility of the 55/40/5 portfolio has been below that of the 60/40 portfolio during various economic cycles over the past 45 years.
The correlation of commodities to equities did pick up temporarily in the aftermath of the GFC. This followed the decline in aggregate demand that uniformly affected many asset classes, resulting in higher correlations among them. However, commodities have since returned to responding more to fundamental supply factors. These can include weather, which affects natural gas and grains prices; geopolitical instability, which influences crude oil; or mining strikes, which move metals. Importantly, these factors do not tend to affect stock or bond market returns, and accordingly, correlations between commodities and other asset classes have fallen. Recently, correlations also have declined among individual commodities as the markets have emerged from the GFC. This low correlation among commodities contrasts sharply with the generally high sector correlations within other asset classes. As an example, Figure 2 presents a comparison of correlations across commodities sectors and correlations across equity sectors. The fact that commodity cross-sector correlations have returned to lower levels in the past few years is additional evidence that supply fundamentals are once again driving commodity markets and that each commodity is responding to idiosyncratic conditions rather than the effects of aggregate demand on the entire asset class.
Finally, commodities can help hedge a broad portfolio against inflation shocks. While food and energy constitute approximately one-quarter of the Consumer Price Index (CPI), they drive the majority of changes, especially unexpected changes, in inflation. In other words, food and energy account for the majority of CPI volatility. This unexpected volatility can be especially harmful to stock and bond returns. The commodity asset class, on the other hand, has a positive correlation to changes in inflation because commodities drive these changes. Furthermore, commodities tend to exhibit an outsized response to inflation – when inflation increases above expectations, commodity returns tend to increase more than the change in the inflation rate. Thus, to the extent that inflation surprises to the upside, a commodity allocation can provide a potential hedge against inflation beyond just the original dollar amount invested.
Weighing investment implementation alternatives
Owning physical commodities is impractical and creates concerns about which commodities to buy and how to pay for storage and insurance. One can invest in equity of commodity producers, but this too comes with complications. Commodity producers may hedge away their exposure to commodity prices, and the return on equity may be affected by the financial structure, unrelated business activities and the talent of company management. Consider the 2010 Deepwater Horizon oil spill: Oil prices were rising while BP’s stock price was plummeting. Managed futures strategies (i.e., commodity trading advisors (CTAs)) offer exposure to commodity prices; however, these strategies lose some of the inherent benefits of the asset class because they do not consistently allocate to a broad basket of commodities and can shift exposures between long and short holdings.
Broad commodity indexes, on the other hand, are constructed to provide investors with systematic exposure to commodities as an asset class. A commodity index-based investment involves holding long futures contracts on an array of underlying physical commodities, with allocation percentages based on global economic importance. This approach offers investors consistent long exposure to prices of a basket of commodities, which in turn offers the potential for diversification and inflation-hedging benefits to the overall portfolio.
The most widely used commodity indexes include the S&P Goldman Sachs Commodity Index (S&P GSCI), the Bloomberg Commodity Index (BCOM) and the Credit Suisse Commodity Benchmark (CSCB). Each is designed to provide the benefits of the commodities asset class but differs slightly in construction. For example, S&P GSCI places greater weight in the energy sector, which gives it a higher sensitivity to inflation but with higher volatility. BCOM incorporates caps on each of the underlying sector weights and thus is more diversified. BCOM and S&P GSCI can be considered first-generation indexes because they hold their exposures in front-month futures contracts, and when those contracts approach maturity they roll this exposure to the next available month during a narrow trading-day window at the beginning of each month. CSCB, a second-generation index, holds contracts in the first three months for each commodity and rolls this exposure over a wider trading window.
What all commodity indexes have in common is that each has predetermined rules that govern construction, contract holdings and roll schedules. This creates predictable trading patterns that an active commodity investor can seek to exploit.
Adding value through active management
We have established that the commodity futures markets are distinct from traditional investable assets such as stocks and bonds, and that commodity index-based investments can offer a variety of investor benefits including portfolio diversification, inflation hedging and return potential. In addition, commodities offer a fertile opportunity for active management and potential for alpha generation for capable investment managers. The three main layers of value-add in commodities are (1) structural, or rules-based, inefficiencies; (2) commodity market-specific risk premia; and (3) in-depth bottom-up fundamental analysis.
As previously described, a static buy-and-hold approach is impossible for commodities because futures contracts must be rolled to avoid physical delivery. Most long-only investors find themselves investing in collective vehicles where professional money managers can manage frequent rolling of futures contracts and potentially take advantage of a number of structural inefficiencies inherent in commodity indexes.
Optimized roll strategies. Because commodity indexes follow a predetermined roll schedule, the precise moment when an entire passive commodity portfolio will turn over the following month is known. Because these flows are predictable, avoiding rolling during those predetermined trading days, by rolling either before or after them, historically has led to better execution and results. We believe this strategy continues to be a value-additive trade.
Holding deferred contracts. Holding commodity contracts further out the futures curve than specified in the indexes offers another structural source of potential outperformance over passive indexation. Because commodity futures curves normally are upward sloping and the curve is steeper in the front months, moving out on the curve may have positive implications on realized roll yield. In addition, holding deferred contracts reduces overall volatility because front-month contracts tend to be the most volatile.
Of course, as with any active deviations from a benchmark, it is crucial to avoid blindly implementing structural trades without considering the fundamentals driving markets. For example, pre-rolling natural gas exposure during early 2014 was a risky proposition because extreme weather from the polar vortex increased market volatility, especially in the front months, thereby elevating the active risk of pre-rolling without improving the expected returns of the trade.
Earning risk premia in commodities
Another important distinction between commodity futures and traditional asset markets is the difference in motivations among market participants. Investors in stocks generally seek to profit from a company’s business operations through dividends and stock price increases. Profit maximization in commodity investing is a legitimate incentive but by no means the only or even the dominant motive of many market participants. A large part of commodity futures transactions is undertaken by so-called hedgers, most often representing companies that use commodities as an input or output of their business activities. Their intention could be to offset pricing risk or to hedge future production costs. Said differently, hedgers do not require their commodity trading activities to be profitable to gain an economic benefit.
One recent example is hedging activity by U.S. shale oil producers. Selling West Texas Intermediate (WTI) crude oil futures one year out hedges their price risk, and as long as they know they can produce the oil for less than the forward price they will realize a profit and be comfortable scaling their operations. And for the service of price protection, they are willing to pay a premium. This is a premium that commodity investors can earn.
Note that this premium is not earned automatically by buying passive long-only exposure. As explained above, commodity indexes gain exposure in the front of the futures curve; hedgers might be active further out the curve. To take advantage of such flow dynamics, an active approach to commodity investing is required.
Hedging by economic market participants offers another source of structural premia in commodity markets. For example, weather has a high impact on natural gas demand (and also, to a lesser extent, on production). Generally speaking, the colder the winter, the more natural gas is demanded. In fact, the impact of weather on natural gas demand is so great that every year there is a small risk of running out of natural gas by winter’s end. This could happen, for example, when extreme cold affects demand and limits production, thereby leading to significant repercussions on balances and prices.
To manage this price risk at the end of the winter season, natural gas buyers (e.g., utility companies) typically hedge their exposures by buying March natural gas futures. This way they can be sure to fulfill their natural gas needs, no matter the spot price. As a consequence, March natural gas tends to trade significantly above April or other post-winter natural gas contracts. The utilities are willing to overpay for the March contract because they gain an economic benefit for their operations.
Active commodity managers can benefit from the utilities’ hedging activities. By selling the expensive March natural gas contract and simultaneously buying the cheaper April natural gas contract, they can profit as prices of the two contracts converge once it is certain that natural gas will not run out that year. Figure 3 illustrates how the premium between March and April declines over time in most years. We also see that despite the generous premium to be earned, the trade can be volatile — making a risk-managed approach to sizing these types of trades imperative.
Fundamental analysis in trading commodities
Finally, the third layer of additional value comes from fundamental analysis. It is arguably the most difficult to implement, but it is also the most rewarding if done right. Fundamental analysis evaluates current and future supply and demand balances across commodities and regions to identify potential mispricings. It requires extensive market knowledge and experience and can entail significant resources to develop more reliable models of shifts in future commodity supply/demand balances.
As an example, fundamental pricing relationships between different crude oil contracts can present compelling opportunities for active management. One such opportunity arose following the start of the U.S. shale revolution. Before 2011, the price relationship between U.S. crude oil (WTI) and globally traded Brent crude oil was more stable. But starting in 2011, WTI began trading at a notable discount to Brent. This resulted from the massive flow of U.S. crude oil to a delivery point in Cushing, Oklahoma. However, there was not enough pipeline capacity to get WTI from Cushing to Gulf Coast refineries, leading to elevated Cushing inventories and depressed WTI prices relative to Brent. Understanding the drivers of this price dislocation and evaluating the potential catalysts for a price reconnection created an opportunity to express a relative value view between the two variants of crude oil. Research into energy transportation would have brought to light infrastructure developments to move WTI from the middle of the country to the Gulf Coast, and knowing the timing of the projects’ completion would have added another important layer to formalizing a long WTI versus short Brent trade.
Figure 4 highlights outgoing pipeline capacity from Cushing to the Gulf Coast and plots the price differential between WTI and Brent crude. Pipeline capacity from Cushing, in fact, grew when the Seaway pipeline reversed to flow to the Gulf Coast in June 2012 and expanded when the Seaway project was completed in the first quarter of 2013. The completion of additional pipeline projects in the second quarter of 2013 effectively finalized the convergence of WTI and Brent.
Trading March versus April natural gas or WTI versus Brent crude are just two examples of active positioning within the commodity allocation that may help achieve returns above a passive commodity index. But, in addition to conducting thorough bottom-up research at the individual commodity level to generate views and active trade ideas, it is equally important to have a broad opportunity set and a robust approach to portfolio construction.
First, it may prove beneficial to look across all commodity sectors that are represented in the commodity index — e.g., petroleum, natural gas, agriculture and metals — to source ideas for active trades. Doing so achieves the flexibility to shift active portfolio risk to those sectors that offer the most compelling opportunities and helps avoid being forced into trades with suboptimal risk/return profiles.
Furthermore, we believe it is prudent to construct a diversified portfolio of active views with uncorrelated investment themes so no single trade can dominate the risk profile. By ensuring that the portfolio does not have concentrated risk exposure, a negative move in any one trade should not result in a severe shock to the overall portfolio, because it is likely to be offset by returns from other active views. As such, this approach is designed to offer a more consistent pattern of excess returns over time.
Summary: Why commodities can fuel investment portfolios
Commodities have a place in many investors’ portfolios. Despite the most recent performance challenges of the asset class, commodities continue to offer potential inflation protection, portfolio diversification and enhanced longer-term returns.
Commodities also may offer – possibly more so than most asset classes – significant opportunities to add value through active management. The economic foundation for these opportunities is provided by:
- Rules-based commodity indexes and passive investors
- A significant share of non-financial participants, i.e., hedgers, seeking to transfer price risk and willing to pay a premium for that economic benefit
- Bottom-up fundamental analysis to uncover mispricings due to supply/demand imbalances
In managing commodities, implementation considerations are paramount. Commodities always have been a volatile asset class and active positions in commodities should be held in a risk-controlled manner. This requires significant risk management expertise and investment in state-of-the-art risk management systems. In other words, evaluation of risk management capabilities should be at the forefront of due diligence on active commodity investment managers.
Mr. Whitton is an executive vice president and real return product manager in the Newport Beach office. He previously spent five years in Singapore as a director and head of PIMCO Asia Private Limited, overseeing all aspects of the client servicing and business development efforts in Southeast Asia. Mr. Whitton joined the firm as an account manager and a credit product specialist in Newport Beach before relocating to Singapore in 2006. Prior to joining PIMCO in 2002, he was with Merrill Lynch and Deloitte Consulting. He has 14 years of investment experience and holds an MBA from the MIT Sloan School of Management and undergraduate degrees from California Polytechnic State University, San Luis Obispo.
Mr. Thuerbach is a vice president and real return product manager in the Newport Beach office. Prior to joining PIMCO in 2012, he was a relationship manager at Bankhaus Metzler in Germany. Previously, he worked for the commingled funds group at Wellington Management Company in Boston and London. He has nine years of investment experience and holds an MBA from The Wharton School of the University of Pennsylvania, where he was a Palmer Scholar. He received undergraduate degrees in international business from Northeastern University, Boston and ESB Reutlingen, Germany.
Ms. Botting is a senior product associate in the Newport Beach office, focusing on PIMCO’s real return strategies, including commodities and inflation-linked bonds. Prior to joining the product management group, she worked in PIMCO’s legal and compliance department. She joined the firm in 2006. She has nine years of investment experience and holds an undergraduate degree in economics from the University of California, Berkeley and is currently pursuing an MBA at the Anderson School of Management at the University of California, Los Angeles.
The authors would like to thank Shawn Coffman for his contribution to this article.