John Kemp, at Reuters, continues his sterling work on how contango in commodity markets is influencing trading strategies — and to what degree ‘cash-for-commodity‘ strategies are now getting overly crowded.
The big new thing he adds are ‘synthetic’ cash-for-commodity deals, in which position holders collect contango yields by establishing negative spread positions (shorting near-dated futures and going long future further forward).
Here’s his explanation of what’s happening, how it’s happening and who’s doing it (search “Kemp” on a Reuters terminal):
The high profits associated with cash-and-carry strategies, as well as the losses from long positions in indices and ETPs are encouraging a growing number of other market participants to join the short side of the market to benefit from the super-normal contango.
One option is to enter the cash-and-carry trade directly. There are reports of hedge funds and special purpose vehicles (SPVs) buying and storing large quantities of physical products off market.
Primary aluminium and copper are two markets frequently mentioned but the strategy is probably common.
The ideal structure involves relationships between a producer, a hedge fund or SPV, a bank and a distributor or eventual end-user.
The producer sells surplus output to the hedge fund or SPV to book the sale, generate cash flow, and keep it from depressing market prices. The hedge fund/SPV locks up the stock with a storage deal and a financing arrangement (secured against the stock itself) sharing the profits of the cash and carry trade with a bank.
When demand picks up sufficiently and the inventory cycle turns, the stock can be sold back to the original producer, or put back into the market to a distributor or user.
And the synthetic alternative:
The other option is to create a “synthetic” warehouse by establishing a negative position in the spread (running a short position in nearby futures and a long position further forward). Risk is limited to possibility of a backwardation between the two dates (limited at this point in the cycle). Meanwhile the position holder collects the contango.
For those with more risk appetite, there is the option of going outright short nearby, rolling at a profit while the contango lasts, and being ready to close out if and when the market moves into a backwardation.
And the impact:
All of these strategies have increased in popularity over the last 12 months. As a result demand for short positions nearby has outstripped the demand for fresh longs from pension funds, competing away the contango which made the strategy attractive in the first place, and pushing it much closer to the actual cost of funds and storage.
You can find the full note in the usual place.
Related links:
Is ‘cash for commodity’ the biggest trade in town? - FT Alphaville
The gold contango trade, charts du jour - FT Alphaville
A GLD contango strategy? - FT Alphaville
Copyright The Financial Times Limited . All rights reserved. Please don't copy articles from FT.com and redistribute by email or post to the web.