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Here's How to Hide in Commodities

By The Financial Lexicon | Sat, 10 November 2012 00:00 | 0

I am a big believer in the notion that there is no “one size fits all” portfolio allocation to which investors should turn when building their wealth.  At the same time, in an age of money printing, constant uncertainty in the Middle East, and a worldwide population that isn’t getting any smaller, I think there is a case to be made for most investors to have some type of allocation to commodities.  That allocation could be diversified across commodities or focused on just one.

If I were forced to choose just one, my focus would be in the precious metals space, and I would be hard pressed not to choose gold.  I have much to say about precious metals (and commodities) in my new book, “The 5 Fundamentals of Building a Retirement Portfolio,” and think that gold is simply too important a commodity to ignore in today’s day and age.

With that said, given the slowdown in economic growth in Europe and China, combined with the difficult decisions facing U.S. politicians in the coming months (fiscal cliff, debt ceiling), it is prudent to remain cautious in your investing, even after the recent declines in so-called “risk assets.”  In the world of commodities, this doesn’t necessarily mean abandoning a bias to the long side.  For some portfolio managers, that might not even be an option.  Instead, it means investing wisely to minimize the potential for losses should a worldwide recession occur next year, while also maintaining the potential for capital appreciation should commodity prices suddenly rebound. 

When you are concerned about the potential for a multi-month pullback in commodity prices, one strategy for maintaining a long position but minimizing your risk is to hide out in the parts of the futures curves that are less likely to suffer the worst of a sell-off.  I would like to illustrate what I mean by using the inverted futures curve in soybeans.  The following table shows the recent prices and expiration months for various soybeans futures contracts that were traded on November 8, 2012.

Soybeans Futures Prices

The decline in prices as you go further out in time is known as an inverted futures curve (also referred to as backwardation).  The difficult weather conditions this past summer helped to push soybeans into a strong backwardation where they remain to this day.  It should not be unexpected that when near-term supply constraints become a concern, commodities traders will push a futures curve into an inverted state until the near-term supply concerns abate.  Despite the recent pullback in soybeans, it remains in a solid backwardation.  Should the futures curve remain in this state, you will have the opportunity to roll your contracts forward and purchase the next contract at a cheaper price.  Selling high and buying low is certainly a strategy favored by investors.  But if you have concerns about worldwide economic growth and think the effects of this year’s drought will wane over time, you should consider hiding out in some of the future dated contracts.  Here are a few scenarios to consider that can help you better determine where on the futures curve to hide:

1.       If you think economic growth will slow, that the possibility of a 2013 recession with a global reach is too much to ignore, and you don’t want to make the bet that next year’s weather will be a repeat of 2012, then you should focus your attention on the late 2013 to late 2014 part of the soybeans curve.  Depending on the size of your positions, certain months may be more favorable than others from a liquidity standpoint.  If concerns about weather, drought, and near-term supplies abate, the backwardation is at risk of flattening.  This means that the near-month contracts are more at risk of underperformance relative to the further-dated contracts.  It doesn’t necessarily mean soybeans will decline in price.  Even slow worldwide growth could cause the entire futures curve to rise.  But less of a concern regarding drought would portend underperformance of the near-month contracts.

2.       If you think economic growth will slow, that there is a serious risk of recession in 2013, but that drought concerns will persist, then focusing on the July 2013 to September 2013 part of the curve makes sense.  This would provide some buffer against falling prices due to economic growth concerns, but it would also prevent you from giving up the full extent of the expected premium that would persist from ongoing drought concerns.

3.       If you think economic growth will pick up and that drought concerns will persist, just stay long the near-month contracts, allowing yourself the possibility to profit from any widening in the futures curve and from the positive roll.

4.       From my perspective, the most difficult scenario to figure out would be a pickup in economic growth and drought concerns simultaneously abating.  There would likely be a narrowing of the backwardation, but it might not happen right away as traders get long the more liquid near-term contracts and justify this action by expressing concern for future supplies due to economic growth.  I think that over time, the lack of concern about a drought would trump mild economic growth from a shape of the futures curve perspective, eventually causing the inversion to flatten.  But that could take some time.

Crude oil is another popular commodity to trade, and its futures curve has a different structure (slight contango through 2013, thereafter turning into backwardation).  This curve would need to be treated differently than the soybeans curve.  It doesn’t mean you can’t hide out in future dated contracts, but you’ll have to go through a different decision-making process about what has caused the current shape of the crude oil futures curve and how that might change in the different types of scenarios outlined above.  The same is true for any other commodities you might trade. 

One final point worth noting: For energy traders who find it too difficult to decide on which part of the futures curve to hide, you could consider investing in funds that track the futures prices of multiple contracts.  This would include the United States 12 Month Oil Fund, ticker symbol USL, and the United States 12 Month Natural Gas Fund, ticker symbol UNL.

Keep in mind that just because you are long commodities but are nervous about future declines in price doesn’t mean you must abandon the long bias in your portfolio.  You do have the option of hiding out in different parts of the futures curve.

By. The Financial Lexicon

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