Part 1: Policy pressures….
Nick Leung, Research Analyst at WisdomTree
In this two-part series, we will look into the two key drivers that can affect an optimised rolling commodity strategy – changing market conditions arising from policy pressures and seasonality. We will show how the ability in managing the roll component, coupled with lower volatility, highlights how an optimised strategy can better manage the different return components of commodities investing without sacrificing performance.
A looming US infrastructure boom and OPEC supply cuts give commodity investors plenty of reason to be upbeat for 2017. Whilst the spot price of oil can drive headline news, investors typically have to gain exposure via futures. Therefore, unless investors are attentive to the return components driving commodity futures, they could be left disappointed with their investment performance.
How can an optimised commodity strategy help investors better manage these return components and what are the key drivers for considering curve-optimising strategies?
Investing in commodity futures comprises three components: the spot return, roll yield and collateral return. Most commodity strategies place the greatest emphasis on spot returns, attempting to replicate spot price changes by deriving exposure to front-month futures. However, the roll yield is an important component that is often ignored and, depending on the shape of a futures curve, can have significant implications for investors’ returns.
Take crude oil for example. Following OPEC’s supply cut announcement in November, the WTI futures curve shifted dramatically both in direction and shape from December to February as shown in Figure 1.
The upwards curve shifts reflect the increase in spot prices on the back of a 5% cut in OPEC production. The flattening of the curve’s shape, from steep contango in December 2016 to modest medium term backwardation in January 2017, signals a balancing of demand and supply expectations for 2018. To understand what this means for investors, we can compare the respective futures positioning under different commodity strategies.
Under a standard front-month rolling strategy such as the Bloomberg Commodity Index (BCOM), the contracts held every month (denoted by the red dots in Figure 1) would be positioned at the front of each curve in order to best capture spot price changes. Specifically, the Jan 2017 contract would be held in December 2016, before being rolled to the March 2017 contract the following month and remaining there.
This position corresponds with being the steepest section of the curve, and for markets in contango, where longer maturity futures contracts become progressively more expensive, the periodic rolling of expiring contracts into more expensive near-month contracts incurs a negative roll yield. Given how markets can stay in either contango or backwardation for prolonged periods, the effect of roll yield can be amplified, significantly dragging on returns.
Opt for optimised
By contrast, an optimised roll strategy, such as S&P’s dynamic roll as seen in our WisdomTree Enhanced Commodity UCITS ETF – USD Acc, focuses on managing roll yield by either positioning on the flattest section of the curve for markets in contango, or on the steepest section for markets in backwardation. This would mean holding a contract much further out, as represented by the green dots in Figure 1, such as the November 18 future (no contract change across periods suggests no observable benefit can be achieved by switching positions subject to liquidity and trading cost requirements). By positioning further out along the curve, the strategy becomes inherently less sensitive to spot price fluctuations and this has the effect of dampening volatility.
So, what are the implications for investors?
Rising policy pressures from OPEC and a pro-growth US administration have the potential to boost commodity prices higher, driving shifts in futures curves along the way. Yet, the possibility remains for Trump’s economic agenda to underwhelm and for OPEC’s output agreements to unravel, paving the way for greater volatility in commodity prices for 2017. With this in mind, the combination of lower volatility and better roll management offered by optimised commodity strategies are two crucial benefits that should help investors navigate changing market conditions in the year ahead.