Commodities
You can hardly store oil, copper or wheat yourself. So investors buy commodities through futures contracts, and those bring costs that surprise many people.
Learning objective: After this lesson you can explain why commodity investments through futures have their own, often underestimated costs.
A commodity's price first follows supply and demand quite normally. If more is produced or harvested than is needed, it falls. If suddenly less is delivered, it rises. Commodities react especially sharply to crises. If an important oil region is drawn into a conflict, the price often rises before a single barrel less has been delivered. With wheat or coffee, a drought in a big growing country can do the same.
Futures instead of barrels
A barrel of oil is hard to keep in your basement. So investors buy futures. These are contracts for delivery at a future date.
Replacing expiring contracts
These contracts expire and have to be replaced by new ones again and again. If the new contract is more expensive than the old one, every switch costs money. Over the years a commodity fund can therefore lose money even though the commodity itself got more expensive.
That happened to many investors who put money into oil between 2009 and 2020. They were sometimes right about the price and still lost.
Commodities without income
Like gold, commodities produce no income. So for most private investors they aren't a necessary building block. Oil and mining companies are in every broad stock ETF anyway.
The return of a commodity index is made up of three parts: the change in the current price, the roll yield when switching into the next contract, and interest on the money held as collateral. The roll yield is positive when later contracts are cheaper. That's called backwardation. It's negative when later contracts are more expensive. That's called contango. For commodities that can be stored, contango is the normal case, because storage costs and interest are built into the later price.
Losing value in an index
That has an unpleasant consequence. Staying in a broad commodity index for a long time can lose value even if the commodity's price stays roughly the same the whole time. That's not the product's fault. It's how futures markets work.
Inflation protection
People often say commodities protect against inflation, because their prices frequently rise when prices in general are rising. The data are mixed. A lot depends on the period you look at and what's in the index. An index heavy in energy behaves differently from one heavy in grain. So don't count on reliable protection against inflation.
Summary
- Commodities are held through futures that have to be renewed constantly.
- In contango every renewal costs money, even if the price stays the same.
- Commodity companies are in every broad stock ETF anyway.
- Common mistake: treating commodities as reliable inflation protection. Their prices often swing more than stocks.
Did you get it?
What does contango mean?
Later futures contracts are more expensive than earlier ones. Every renewal then costs money.
Can a commodity fund lose even though the commodity gets more expensive?
Yes. The cost of switching into new contracts can eat up the price rise.
Do commodities reliably protect against inflation?
Not reliably. It depends heavily on the period and on which commodities are in the index.
Check your understanding
Your task
A commodity fund holds futures contracts. The commodity price rises 6 percent in a year, but switching to new, more expensive contracts costs 9 percent. Roughly calculate the result of these two parts and ignore any other components. Write down why a rising price can still lead to a loss in the fund.
Sources and further reading
- Gorton and Rouwenhorst (NBER Working Paper No. 10595, "Facts and Fantasies about Commodity Futures") analyze commodity futures from 1959 to 2004 and find a positive correlation between commodity futures and inflation, alongside a negative correlation with equities and bonds. View source ↗