So far in December, commodities have delivered gains across all sectors, led by grains and energy. Despite several challenges, the BCOMTR Index has achieved a return of over 5% year-to-date. We explain how the slope of the futures curve results in significant differences between total returns and changes in futures prices. Two key examples are the tight cocoa market and the oversupply in the U.S. natural gas market.
As the holiday and New Year period approaches, market activity begins to slow down. Traders and investors adjust their positions, often reducing them, in anticipation of a quieter period. This strategy helps protect profits and avoid new losses amid decreasing liquidity, which can increase volatility in response to potential unexpected events.
In commodities, December has so far yielded gains across all sectors, with grains and energy leading the way. Overall, the Bloomberg Commodity Total Return Index (BCOMTR), which tracks a basket of 24 major commodity futures contracts covering energy, metals, and agriculture, has risen by about 1% this month, heading toward an annual gain of around 5.5%. This is a solid result considering the numerous challenges this year, including a 6% rise in the USD against a basket of major currencies, lower grain prices following another record production year, and concerns about a slowdown in China affecting demand for energy and industrial metals.
It’s worth noting that cocoa, the best-performing asset this year, is not included in this index. Excluding natural gas, which fell by one-third, the BCOMTR return would exceed 9%. The difference between the total return and changes in futures prices, which can be quite significant, depends on the structure of the futures curve – a topic worth exploring further.
Year-to-Date Total Returns on Key Commodities
Adverse weather conditions caused significant price increases for cocoa, coffee, and orange juice. These agricultural commodities depend heavily on production in specific regions, making them vulnerable to weather phenomena such as those seen in Vietnam, West Africa, and Brazil this year.
Meanwhile, gold has maintained a record uptrend this year. Looking from a multi-year perspective, it is on track to achieve an unprecedented eighth consecutive December increase. Riding the momentum of rising gold prices and higher industrial metal prices, silver has also delivered strong returns. Like gold, silver has risen by over 30% year-to-date. However, while gold hit new record highs, silver reached a 12-year high of $34.90 per ounce, still far below its 2011 peak of $50 per ounce.
When analyzing individual and overall returns in the commodities market, it’s worth revisiting the impact of the futures curve shape on investor returns. For example, why do near-term natural gas contracts show a 38% price increase this year, while the actual total return from investment fell by 34%?
Backwardation and Contango Explained
Backwardation is a market condition where the price of a futures or forward contract for a commodity is lower than the spot (current) price of that commodity. In other words, contracts for future delivery are priced below the current market price. This scenario often occurs in markets where the commodity is in limited supply or there is high demand for immediate delivery. The total return from investing in commodities includes both the return from the spot price change (the price change of the commodity itself) and the return from rolling futures contracts (the profit or loss from moving a position from an expiring contract to a new contract with a later delivery date). In a backwardated market, the roll yield is typically positive, which can boost the total return for investors. This is the opposite of contango, where the futures price is higher than the spot price, often leading to a negative roll yield, reducing the total return on investment.
The Impact of Contango and Backwardation on Investment Returns
This year, particularly in the coffee and cocoa markets, where conditions were exceptionally tight, futures prices for immediate delivery significantly exceeded those for later delivery. Rolling a long position from an expiring futures contract to the next one thus resulted in a positive roll yield, meaning selling the expiring contract at a higher price than the subsequent contract. Therefore, the futures curve slope influenced the actual return. This is why the total return on cocoa investments this year exceeded 300%, while the actual price change of futures contracts during this period was “only” 158%.
This positive factor also benefited investors in oil and fuel markets. Both Brent and WTI prices are lower than at the beginning of the year. Nevertheless, the persistent backwardation, supported by OPEC+ production cuts, contributed to positive returns on both markets, particularly WTI, which experienced slightly deeper backwardation than Brent throughout the year. This explains the current 11% return on WTI, while Brent prices fell by 2% compared to early-year levels.
Conversely, natural gas remains a sector that is consistently difficult to trade with a bullish stance. This is primarily due to the futures curve structure, which typically exhibits contango – not only due to the difference between lower summer prices and higher winter prices but also because of the general expectation of higher future prices. As a result, despite a 38% rise in natural gas futures prices over the past year, the total return on investment recorded a loss of about 34%.
One-Year Roll Yields on Key Commodities
Ultimately, whether the futures market is in backwardation or contango plays a crucial role in returns on long-position investments. In recent years, the BCOMTR Index, supported by several markets trading in backwardation, has outperformed the spot market, and we believe this positive trend will continue to support commodity investments in the coming year. Additionally, the ongoing monetary policy easing, which reduces the cost of holding physical assets, makes the commodity sector an attractive diversification tool compared to more traditional investment assets such as bonds and stocks.
Author: Ole Hansen, Head of Commodity Strategy, Saxo
Source: CEO
