FT Alphaville has speculated before about the chances that the financial credit crunch led a number of commodity players to turn to the term-structure of their markets to access an alternative type of funding. You can read about it here, here and here.
As a trend, the process effectively mimics the one already long established in the gold markets, where producers like Barrick Gold and Ashanti for many years helped finance their production by selling off tomorrow’s production today.
This was only possible though because of the level of passive demand for long positions in the markets (the opposite side of the trade, effectively).
Ironically, the gold producers stepped out of the arrangement prominently last year not because the long demand had gone, but because gold’s price rise had led to insatiable ‘flat price’ opportunity losses.
But, as John Kemp of Reuters also notes on Thursday, the so-called ‘cash and carry‘ trade seems to have flourished elsewhere on an even wider level, largely thanks to the growing demand for long-only commodity investments.
In a nutshell, the passive length sitting on the commodity curve has been able not only to finance producers (naturally long) — at a time when financing has become costly to some — but to generate profits for anyone with the guts to take the opposite side of the passive trade. That essentially means any institution with access to cheap funding (so mainly banks) wanting to fund a long at the front and short at the back position.
He explains it thus (better than we could):
Banks, swap dealers and merchants have mostly taken the opposite side to investors, buying and storing record quantities of raw materials, and hedging their physical stock with a short position in commodity futures, rolling the short futures position forward each month to obtain the contango.
The strategy (known as cash-and-carry) is profitable because returns available from rolling a short position forward in the contango far exceed the actual costs of storage and borrowing money to finance the physical position.
It has been especially profitable for banks and large oil companies with access to cheap borrowing.
Cash-and-carry strategies have essentially depended on the availability of cheap finance from central banks and the money markets. The system has contributed to record profits for the commodity divisions of major banks, as well as companies specialising in storing petroleum, metals and grains. The rush to secure cheap storage and exploit synergies with trading business has prompted a wave of takeovers of LME warehousing firms by investment banks this year.
Of course, those producer/bank profits have to come at someone else’s expense. And they have done so: mainly via losses from funds’ contango rollovers, which eat away the net asset values of the passive investment pools (more on that here).
Accordingly, says Kemp, it was only a matter of time before such funds would catch on. As he notes, major index operators have already responded by promoting variants which aim to minimise roll losses. They either roll less frequently or over a larger or different part of the curve.
However, what is really interesting is that there’s further proof, says Kemp, that the smart fund money may have been well ahead of the curve (as usual) in reallocating to the short-side. This can be seen from the CFTC open interest data trends. As he notes:
Quarterly data on investors’ index positions published by the U.S. Commodity Futures Trading Commission (CFTC) show the ratio of long positions to shorts had fallen to just 3.95:1 at the end of Q1 2010, down from 4.70:1 when the commodity boom was peaking in Q2 2008.
The shift is even more pronounced in energy futures contracts, which have been plagued by the greatest degree of contango, where the ratio of longs to shorts has fallen to just 3.88:1, down from 5.34:1 at the end of Q2 2008 (Chart 3).
Essentially this is further proof of there being plenty of contango-trades in the market, and across the entire spectrum of commodities (i.e. anything with a contango structure that’s in the carry, which means covering cost of financing and storage).
As ever, though, the greatest risk to a contango trade remains backwardation (the opposite of a contango) which, in the event it transpired, would and could prompt a massive liquidation of the short-end longs.
But with commodities having lost touch with true fundamentals anyway, it’s not actually certain the trade might unwind any time soon. The market demands contango, and contango it will have — providing, of course, the long-only passive guys don’t figure it out how the’re losing out and move over to the short-side en masse too.
Oops, though — there are increasing signs that they have.
Related links:
Is something really scary coming in October? - FT Alphaville
A GLD contango strategy – FT Alphaville
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