Talking Commodities, Contango, and ETFs With Satch Chada
Satch Chada is the Managing Director and Global Head of Investor Solutions for Jefferies Asset Management, LLC. He recently took time out of his busy schedule to discuss some of the nuances of commodity investing and offer his thoughts on the various forms of commodity exposure now offered by exchange-traded products.
ETF Database (ETFdb): Over the last few years there has been a tremendous surge in interest in commodities as an asset class. What is the appeal of adding commodity exposure to a traditional stock and bond portfolio?
Satch Chada (SC): From a portfolio diversification perspective, commodities have historically provided some merit in terms of diversification. They have had a tendency to have low to negative correlation to both the equity and bond markets. By adding commodities, you may have a better ability to weather extreme volatilities than a portfolio consisting of just bonds and equities.
That’s the first step; the second step is looking back at the history of bond and equity markets. There is an argument to be made that there have been phases where commodities have outperformed equities and other phases where equities have outperformed commodities. There have been different cycles and we have clearly been in a cycle since the late 1990s where commodities have outperformed the equity markets. If you take a look at the commodity performance over the last 10 to 12 years, you will notice that commodities have had double digit returns, while the equity markets have more or less been flat or negative depending on which index you are considering.
We believe that we are in a commodities growth cycle as opposed to an equity growth cycle. That is just another reason that fundamentally there are a lot of macroeconomic factors for having higher weights allocated to the commodity sector.
ETFdb: Much of the growth in the ETF industry has been attributable to futures-based commodity products. Recently, some investors have started to express frustration with the returns delivered by these products. They get into them thinking they may be achieving exposure to spot prices and then are surprised when the return on the ETF lags behind the hypothetical return on the natural resource. Why do some of these exchange-traded commodity products tend to lag behind the return or change in the spot price of the natural resource?
SC: First, I think we have to talk about how investors can access commodities. Ideally the best way for investors to access commodities is by owning spot (actual) commodities; for example a barrel of crude oil or a pipeline full of natural gas–physical ownership of these various commodities. But unfortunately, it is not so easy for investors to invest in spot commodities, with the exception of a small subset of the precious metals, such as gold. You can’t hold bushels of wheat in your living room or barrels of crude oil in your basement.
There has been a great deal of innovation in some of the precious metal sectors. Gold is the best example; investors have been able to access proxies for spot investments in gold. But for most commodities, investing in spot commodities is more difficult. So what investors really have to look at is investments in vehicles that are proxies for investing at spot prices. The most common way that investors do that is through indexes, and specifically indexes that track the performance of futures contracts.
Futures contracts themselves are bilateral agreements that essentially track the performance of an underlying commodity, but for a specific period of time. And that is important because a futures contract has a maturity date. So if I hold a futures contract that is linked to the price of natural gas, for example, my futures contract will tend to trade in line with the price of natural gas until the maturity of the contract, which is typically very short–a month or two months or three months. Once that contract matures, an investor has to re-establish exposure to that underlying market measure, whether it is oil or natural gas or whatever.
And the way in which most investors do that is to re-enter into subsequent futures contracts; that is, you “roll” that contract forward. And so every time you do that “rolling,” you may incur a cost. If the new contract costs more than the expired contract, a market condition known as “contango,” the direct cost of holding a long term investment in oil or natural gas is further increased. That comes about from investing in a passive futures-based strategy and so the implicit cost of that has been very significant.
So when you compare the performance of the Dow Jones UBS Commodity Index over the last five years to the Dow Jones UBS Commodity Spot Index, what you will find is that the futures index has underperformed relative to the spot index. And that difference is effectively the annual cost of rolling those futures contracts forward. But most investors aren’t able to invest in spot commodities, so they are accessing commodities through futures markets and frequently rolling their holdings. And it is those frictions that investors are realizing is a potential drawback to the way they are currently accessing commodities.
ETFdb: As an alternative to these products some investors have elected to achieve commodity exposure through stocks of commodity producing companies or companies that engage in the extraction of commodities. What is the case for achieving commodity exposure this way as opposed to futures contracts?
SC: Ultimately, there is no easy answer to accessing spot commodity prices. ALPS Advisers manages a series of Jefferies-branded products that offer investors access to the commodity market via companies that are “pure play” producers of commodities. What I mean by “pure play” is those companies that derive at least 50% of their revenues from the production and distribution of commodities. A company such Exxon Mobil would be a clear example of a pure play energy company, and similarly Monsanto would be another example of a pure play commodity company by our definition.
The CRBQ and related ETF products are built around the CRB-EQ family of indices, which trace roots to the well known Thomson Reuters /Jefferies CRB Index. The CRBQX, the composite index, is broken into energy, agriculture, precious metals, and industrial metals sub-sectors, with companies from those sectors that are good representatives of pure play commodity companies.
So how does this offer exposure to commodity prices? Our fundamental belief is that for a company like Exxon Mobil if the price of oil goes up, the revenue for the company goes up. With the help of S-Network Global Indexes, sponsor of the CBR-EQ Indices, we compiled a study that examined how earnings of energy companies react to changes in the price of oil over time. And what we realized is that as the price of oil goes up, the revenues of these companies go up. Now that could simply be because the oil that they are selling is being sold at a higher price. But they are also purchasing oil at a higher price, so it is possible that cost of goods is rising along with revenues. And so the next step is to look at how earnings are being impacted for these companies. Are companies like Exxon Mobil able to pass through the increase in prices of oil to retain higher levels of earnings and therefore better able to benefit from those increases?
What we find for a basket of large, global energy companies is that as oil prices go up, earnings actually increase pretty dramatically. And similarly as oil prices go down the earnings go down, which effectively means that cost of goods sold isn’t necessarily increasing inline as the price of oil increases.
It’s also worth noting that a handful of companies control a significant portion of known oil reserves. So it effectively means that if the price of oil goes up, their inventory positions that they are holding or that are held below ground in various oil fields that their inventory positions are actually increasing in value as well. These companies have leverage as the price of oil goes up. If you are able to select those companies that are very focused in the extraction, the distribution, and the production and the development of these various commodity type products, those companies actually benefit.
And this is equally applicable to the gold mining stocks or the agricultural type stocks and so on. In fact, if you take a look at the performance of some of these natural resources indexes out there, what you will find is that they actually track the spot price in the commodities much more closely than the commodity futures indexes.
There are some inherent limitations. People are quick to point out that owning a company that is managed by various managers is not the same thing as owning a particular commodity; you are subject to the whims of executives and their strategies.
The second argument that people will make is that commodity equities clearly do not offer the same type of diversification benefits as investments in commodity futures or commodity spot prices. But there is a misunderstanding on what correlation is in the market. Imagine two stocks: one stock that goes up 1% every single day and another stock that goes up 2% every single day. The correlation of those two securities is 100%, but the investment experience that someone who holds the security moving up 2% every day is far better.
So when some investors discuss correlation and the diversification benefits, it’s important to be clear on this point. The spot price in commodities is completely disconnected from futures prices in many ways because of the “contango” effect that we spoke about, but they move very much in tandem. The commodity futures prices and commodity spot prices move in perfect correlation, but the spot prices are moving at a pace that is much higher than the futures prices.
I will submit that the correlations with commodity futures prices and therefore the commodity spot prices with stocks and bonds is low or negative. And when we take a look at historical data that is absolutely true. When we take a look at the correlation between commodity equities and equities broadly, we see much higher correlation between commodities equities and, for example, the S&P 500. But interestingly enough you do have the correlation differences between the S&P 500 and commodity futures versus the correlation differences between the commodity equities and commodity futures is meaningfully different. Commodity equities do have a very different return profile and correlation profile when compared to futures and to the broader equity market.
ETFdb: In addition to the CRB proxies that you mentioned ALPS offers one of the more unique ETFs out there, the Wildcatters ETF (WCAT). What is under the hood of this ETF and how might it fit into a portfolio?
SC: As a firm we are very bullish in the long run on the commodities space, and the energy space in particular is something that we want to be very engaged in. In the next five or ten years we believe that it is the right sector to be in; in other words, we believe that the commodity markets will outpace other sectors in the medium to long-term.
Now, there are different aspects to that market. The Wildcatters, a Jefferies-branded ETF managed by ALPS Advisers, focuses in on the small-cap energy companies in North America: energy exploration and production companies. And a good portion of that focuses in on natural gas; approximately 60% of holdings focus on natural gas exploration and the remainder on broader energy. Much like the way investors diversify their U.S. equity exposure, what we are recommending is that investors consider a product like WCAT to diversify exposure to the energy sector. There are a number of ETFs out there that offer exposure to the large cap energy market; in fact most large cap ETFs probably have very significant exposure to the energy sector.
But companies that are in WCAT typically have a market cap in the range of $200 million market cap to $2 billion. So they are generally very small companies, and for these companies the discovery of a new well or a new source of energy can be very meaningful to performance and to the potential returns.
So if these companies deploy new technologies and dig deeper and dig further out for new sources of energy, we believe that there is potential for a significant amount of upside and levered upside from these companies. WCAT has about 55 companies in its portfolio, providing some diversification. As the name would suggest, is it very speculative and it is very volatile, but by focusing in on those companies that are emerging in the energy space, it offers potential for significant returns as well.
ETFdb: Some very interesting thoughts–thanks for taking the time to share with the ETFdb audience.