Steep 'contango' forces traders to adapt commodities plans
Chris Flood

Spot commodities prices enjoyed an unexpectedly strong performance in the first quarter in spite of the worst economic recession since the 1930s. However, investors have lost money because of the unfavourable shape of the futures curve of most commodities, particularly crude oil.

The shape of the futures curve is crucial to institutional investors who deploy capital passively via commodity indices, such as the S&P GSCI or the DJ-AIG, the two most widely followed benchmarks in the market.

In addition to the spot return, investors in commodity indices obtain a separate return, known as the roll yield, as they shift their positions each month from the expiring futures contract into the following month.

Roll yields are positive when futures prices are lower than the prevailing front-month price, known as "backwardation", but negative when futures prices are higher, known as "contango". Most commodity markets are currently in a steep contango.

So, while the spot price component of the S&P GSCI index has risen 0.6 per cent this year, the total return measure, which is what investors care about and which also includes the cost of rolling the futures positions, is down 12.5 per cent.

Deutsche Bank says that poor returns last year were largely due to falling spot prices but negative roll returns have become the "Achilles heel" for investors that follow the market via long-only passive commodity indices.

"Contango will remain a feature of forward curves," warns Michael Lewis, commodity strategist at Deutsche Bank.

Barclays Capital notes a growing focus among investors on active management strategies rather than broadly passive, long-only exposures across a range of markets. The bank says combined long/short strategies which do not take a simple directional view are growing in popularity.

Among individual commodities, crude oil has risen 8.5 per cent this year while copper has jumped 31 per cent and raw sugar has added 6 per cent.

These gains have surprised many market observers, who assumed prices would remain under pressure due to the deepening global economic downturn.

"If this is how commodity prices behave during the world's worst economic times for generations, then surely the only thing we have to fear is fear itself," says Stephen Briggs, commodities analyst at RBS

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