Fundamentals of Commodities

How should investors think of fundamentals when it comes to commodities as an asset class? 





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ALPS Distributors, Inc. is not affiliated with USCF Investments or SummerHaven Investment Management, member FINRA.

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Transcript

Fundamentals of Commodities
Season 4: Episode 1

 Katz: Welcome to The Real Spiel with Ryan and Kurt. Let's talk a little bit about commodity inventories and fundamentals, Kurt. The fact of the matter is commodity inventories are low, pretty much across the board right now, due to underinvestment, supply chain disruption is still coming out of COVID, tough conditions for crops, geopolitical conflicts that have affected deliveries from sources that are historically pretty stable. Let's imagine someone is either adding to an existing commodities investment or maybe coming back to the asset class after some time and talk about fundamentals. Typically, when you're looking at the fundamental valuation of a stock, you can look at earnings or PE ratios, cash flows, various coverage ratios or bonds. You can look at maturity or duration, credit rating, coupon. How should investors think of fundamentals when it comes to commodities as an asset class? 

Nelson: It's a really good question, Ryan. It's not that well understood, this is something that at SummerHaven we've been looking at for a couple of decades or more and done a lot of original research into it. We've come to the conclusion that the fundamental in commodities is inventories. It is the single most important factor that drives the relative performance of any given commodity. This actually, to some degree, goes back to John Maynard Keynes, which was 100 years ago, that the reason for commodity futures and futures markets to exist is their price insurance markets. It's where a hedger, like a farmer or a mining company or an energy producer, can go and lay off risk. The person who comes in and takes on the long side of that futures trade is what we call a speculator or an investor. It's someone who could take their risk capital and put it into stocks or bonds or real estate or hedge funds, but they're coming to the commodity markets and they're doing it because they expect to earn a return. And we have a lot of evidence that when inventories are lower for any given commodity, it tends to have a higher risk premium or higher compensation for that price insurance to the investor. 

Katz: Yeah, it makes a ton of sense. But inventories are really important, but they're also difficult to observe. Oftentimes the inventory data that comes out lags, it's incorrect at first, and it's adjusted over time. Or certain commodities there just really isn't reliable inventory data at all. What other information do you use to kind of inform relative inventories and value of commodities? 

 Nelson: Right. Now, that's another good question. It's very frustrating. We have spent countless years and work hours trying to collect the best inventory data that we can and it's always incomplete. There are certain sources that are governmental like the USDA or Department of Energy that are reasonably reliable. In the metal space we've talked before that London metals exchange and some of the US or Asian exchanges have decent but incomplete data because it doesn't include non-exchange warehouses and buffer stocks. In the ag this even more challenging, I mean USDA is okay for crops in the US, but there's other commodities. For example, like sugar where there's just no data. There aren't observable inventories. We do know that if you take the commodities, where you have good, decent historical inventory information, and you just have an equally weighted basic commodity investment, call it a basic beta, that you earned since 1990, say around a 3% to 5% risk premium for wearing this price risk across this diversified group of commodities, where we have inventory data. But if you take that and bifurcate it into a low inventory and a high inventory bucket based on the inventory levels of any given commodity today, say for example, this last three-year average level, you can then say, well are oil inventories high or low relative to their prior three-year state, corn, copper, et cetera? 

What we find is actually quite dramatic, using this fundamental screen, which is that the low inventory commodities actually generate 9 to 10% risk premium per year over that same time period, and the high inventory commodities, the ones with ample storage to deliver to the market, actually tend to have zero risk premium, or slightly negative over the last 30 years going back to 1990. That's quite stunning. But we don't have inventory data for everything, and the other thing is even where you get inventory data it tends to lag. It comes out a week, a month, sometimes two or three months after the observations. How do you trade today? And what's really helpful for us is that the market, we believe, is actually reasonably efficient, and market participants' expectations of inventory are priced into the futures curve. I think we've talked about this before, Ryan, and you're very familiar with it, which is that there's this notion called contango and backwardation. Sometimes it confuses investors into the space, but it's not complicated. It's really just like a yield curve but applied to futures markets. Copper has a series of delivery contracts that are expiring in one month, two months, three months, going out a year or more. And you can see the prices of each of those futures today in real time. The shape of that creates a futures curve, which is like a yield curve in bonds, looking at short -term to long -term maturities. When that curve is upward sloping, higher prices as time goes out further and further, that's called, by some market participants, normal. It's also called contango. When you have a downward or inverted curve in futures markets for commodities, it's called backwardation. It's less common, a third or less percent of the time for any given commodity, but we know that if you map inventories to curve shape, that contango tends to broadcast or message ample storage, whereas backwardation signals risk of stock out and depletion of inventories. So even though I don't have real-time great information for maybe copper or oil, I can see the futures curve right now, real-time, every day. And even for commodities, if I make the extension to them that this same fundamental applies, I don't know what the inventories are for sugar, but I can observe its curve shape and use that as a proxy for inventories. And we found that to be a very effective tool that the benefit versus actual inventories is that it's real time, every day, it exists for every commodity. 

Further, it's not limited to just what's available as an inventory source, but it includes all market participants' expectations. So, the metals traders and speculators that are working on the LME or on the COMEX exchange in Chicago or New York, their expectations and knowledge of the market are factored in, all these private market participants who don't have to report inventories are also making trading and investment decisions based on what they know.  I think there's a reasonable efficiency we believe to commodity markets. This is a very effective tool in helping us to identify this critical fundamental across the whole complex. 

Katz: So, it's kind of a wisdom of crowds approach to where we're getting pretty reliable inventory data from the shape of the forward curve and using backwardation as a proxy for inventories and commodity selection is critical.  

Nelson: Exactly right. 

 Katz: This has been The Real Spiel with Ryan and Kurt. Thank you for tuning in. We'd love to hear from you. Any questions comments feedback TheRealSpiel@USCFInvestments.com and we'll talk to you next week.