The Carry Trade in Commodities: what is it?

  • Carry exists across all asset classes as compensation paid to speculators for assuming market risk.
  • We argue that, as in equities, bonds, and currency, the carry trade in commodities represents a persistent source of beta-like returns.

What is a carry strategy?

The returns to a carry strategy carry are, broadly speaking, a compensation paid to speculators who are willing to assume the risk of market participants. Properly regarded, the equity risk premium is a carry premium, as it rewards speculators for assuming the risks associated with the uncertainty of a firm’s profit. Similarly, the term premium in bonds is a carry premium, as it is compensation for lending at riskier time horizons (we have less knowledge about what the world will look like in ten years’ time than five). The currency carry trade is a premium paid to speculators who are willing to lend to riskier economies (who normally have current account deficits).

How does this work in Commodities?

In commodities, as with currencies, the carry trade consists in taking long positions in those commodities where the roll yield is positive[1], and short positions where the roll yield is negative. In currencies, this means taking a long positions in high interest rate currencies (where the futures price is at a discount to spot) and short positions in low interest rate currencies (where the futures price is at a premium to spot). The Carry trade in commodities is analogous to this. The investor takes a long position in backwardated[2] commodities, and a short position in commodities which are in contango.[3]

Why not just long positions?

In the mid-2000s, commodities indices were developed which took long positions across the commodities complex. These “long-only” indices took positions on the assumption that commodities futures were an asset class, like equities or bonds. The poor performance of these indices over their lifetimes suggests that this view is mistaken. Commodities, like currencies, equities and bonds, are an asset class. Commodities futures, like currency forwards, are not.

What do backwardation and Contango represent?

The slope of the futures curve provides information about the relative value of the commodity now and in the future. A commodity which is scarce relative to its past supply (measured by the stocks-to-use ratio) will tend to be in backwardation, so that it becomes more expensive to purchase the commodity now, rather than in the future. With steep contango, the opposite is the case: the price of the commodity for delivery today is at a discount, reflecting its relative abundance. The “neutral” state of a commodities curve is also contango, reflecting the impact of storage costs which means that anyone wishing to forgo the physical cost of storing the commodity by buying it forward will have to pay a premium.

The relationship between the stocks-to-use ratio and the slope of the futures curve is illustrated in figure 1 for Crude Oil.

Figure 1 Source: NYMEX, Macrobond, Record. inventory Scarcity is measured as the z-score of the inverse of the inventory of WTI stocks at Cushing, Oklahoma. Backwardation is measured as the % slope of the futures curve over the first six months

Figure 1 Source: NYMEX, Macrobond, Record. inventory Scarcity is measured as the z-score of the inverse of the inventory of WTI stocks at Cushing, Oklahoma. Backwardation is measured as the % slope of the futures curve over the first six months

What produces the returns from the carry trade?

Note that the carry trade consists in taking a long position in commodities in which the market is expected to relax (backwardated) and a short position in commodities in which the market is expected to tighten (in Contango). This suggests that the spot return to this strategy should be negative, and indeed it is! However, the roll yield more than cancels out the negative spot return on average.

So the returns from the carry trade come from the fact that on average, a commodity which is in backwardation will tend to fall in price, but not by as much as the futures curve predicts, and a commodity which is Contango will tend to increase in price, but not by as much as the futures curve predicts.

Figure 2 Source: Record. The Roll Return here is 4, reflecting the fact that the futures curve is at a discount of 4 relative to the spot price. The spot moves against the long position by 2, but this does not cancel out the roll return, leaving the speculator with a total return of 2

Figure 2 Source: Record. The Roll Return here is 4, reflecting the fact that the futures curve is at a discount of 4 relative to the spot price. The spot moves against the long position by 2, but this does not cancel out the roll return, leaving the speculator with a total return of 2

Why are these returns not arbitraged out?

At first glance, this is a violation of the efficient markets hypothesis. It appears that the futures curve systematically misjudges the spot movement. This is misleading, however. As with other carry trades, the non-zero expected returns to this strategy come as a compensation for risk. In return for taking on the risk of the spot price movements, the speculator is rewarded with a premium.

Who pays?

The defining feature of a beta (as opposed to alpha) source of return, is that it reflects a pure exchange of risk in which there are no “losers”. In explaining why betas occur, it is therefore important to explain who is losing money in expected returns, and why they are willing to do so.

A firm issuing equity, for example, is willing to pay a higher cost of funding than one issuing debt because in doing so, it faces obligations which are conditional on its performance, thus transferring risk from itself to speculators. In bonds, firms pay interest rates higher than the time value of money when they are transferring risk to the bond holders, who are accepting the possibility of capital losses in the event that the firm defaults.

To understand where these returns come from in the commodity carry trade, it is important to understand the commercial purpose of commodities futures. Commodities futures were deigned to allow those with natural, undiversified exposure to commodities prices to reduce or eliminate this exposure. Thus, a shale oil producer may lock in an oil price before beginning drilling by taking a short position in WTI futures. Large food producers may take long positions in corn futures to hedge their natural short position. These entities’ cost of hedging is the flip side of the speculator’s returns to the carry trade…

[1] The Roll yield, also known as the basis, is the return which accrues to the speculator due to the difference between the spot price and the future price. For example, if the spot price is $10 and the futures price is $8, a long position in the futures contract generates a roll yield of $2.

[2] Backwardated commodities have lower futures prices than spot prices.

[3] A commodity with a higher futures prices than spot prices is said to be “in Contango”

How tight is the Copper market? Implications for Chile

A large part of the story of emerging market currencies over the last year is the impact of commodity price movements in effecting significant transfers of wealth. An extreme case of this is Chile. The world’s largest producer of Copper Ore depends on this resource for a little over half of its exports. The recent plunge of the metal’s price has accompanied a severe deterioration in its terms of trade

There is evidence that the tide may be turning for the economy’s main export, with Chinese imports well above trend. However, historically, it requires very high levels of scarcity for there to be serious price rises in metals market. There is a hockey-stick-like relationship between the stock-to-use ratio and backwardation (the slope of the futures curve and a good proxy for the tightness of the market). The “normal” state of the copper market is very loose, going into backwardation only during periods of rapid constriction of excess capacity and stocks (see Figure 1). It took phenomenal growth of over 250% in Chinese demand from 2000-2007 to bring about the kind of price increases we saw in the mid-2000s. To bet on rapidly-rising prices is to bet on a historically rare phenomenon.

Figure 1: Source Bloomberg data

Figure 1: Source Bloomberg data

So just how tight is the copper market? Taking the stock-to-use ratio as implied by the World Bureau of Metal Statistics (WBMS) data, in the last month for which there is data, there were only 1.8 weeks’ consumption of stocks in the world. This is nearly as low as during the surging copper prices of 2006-2007. Ostensibly, stocks are bullish for Copper.

However, the wildcard in the copper market is the Chinese State Reserves Bureau (SRB). Time and again it has intervened to influence the copper market by buying and warehousing stock or taking short positions. In 2005, a scandalous investment decision which cost the organisation $200 million sent the price of copper tumbling to $4160/MT. In 2009, buying by the SRB helped support world prices, and in 2015, it is rumoured that SRB exploited low global prices to build up its stock piles. The quantities involved here are significant: the most recent intervention was supposedly to the tune of 200,000 MT, almost as many as the stocks accounted for by the WBMS.

So just how much copper is there out there, and how different is it to the official time series? One way to get a ball-park idea of the difference is to compare global surpluses (axiomatically, this is equal to stock growth) to official stock growth. Taking these time series and cumulating them from 2006 (Figure 2) shows a significant rise in stocks above-and-beyond those available in the official data series. Contrary to the data from official warehouses and surveys, stocks did not fall as the copper price declined. And crucially, the market is not now anywhere near as tight as it was in 2006.

Figure 2: Source Bloomberg data

Figure 2: Source Bloomberg data

Although we are not justified in arguing that it accounts for all the difference, SRB interventions are discernible in this data series as well. Taking the difference between the cumulative surpluses and the WBMS stocks (Figure 3), we can see the series jump in 2009 as the SRB intervened to support the world copper price. We can also see confirmation that the SRB has exploited recent low prices to expand its reserves.

Figure 3: Source Bloomberg data

Figure 3: Source Bloomberg data

SRB policy will then be vital for the performance of copper in 2016. If prices stay low, it may well continue its policy of buying at what it perceives to be the bottom of the market. But if prices rise, we may see the SRB selling off its copper stocks to support China’s housing market… or keeping hold of them to support Chinese smelters. The magnitude of the difference between publically available stock data and cumulative surpluses suggests that the answer to this question will be vital. To take a position on copper is to second-guess SRB policy- any takers?

And what does this mean for Chile? To take a position on Chile for the next year would also be to second-guess SRB policy but a silver lining for the economy is that the extent of pass-through from the copper price to growth in the medium-to-long run can be overstated. For a flexible economy, such a shock should have only temporary effects. In the case of Chile, Eyraud[1] provides comfort by demonstrating that statistically, nominal GDP and nominal copper prices are cointegrated, so a fall in copper prices should lead to a one-off hit to GDP, but not harm long-run growth. Moreover, most of the decline is over the first three years. This paints a more optimistic long-term picture in which the pain may be (mostly) over for Chile, regardless of the future evolution of the copper price.

[1] L. Eyraud (2015). “End of the Supercyle and Growth of Commodity Producers: The Case of Chile”, IMF Working Paper