There are some commodities that investors rarely overlook when building their exposure to the complex: gold and energy commodities being top of the list. Agricultural commodities just aren’t as popular.
This baffles people like Sal Gilbertie, president, CIO and co-founder of Teucrium Trading LLC, the only single commodity ETF provider in the US for corn, wheat, sugar and soybeans.
“People are shocked that in almost any 20-year period that you pick for the S&P 500 – sugar, soybeans, corn, wheat – are all often less correlated to the S&P 500 than gold. People tend to be under-represented on agriculturals because they don’t buy them on a cyclical downturn, even though they are less correlated to the S&P 500 than gold.
“Why wouldn’t someone take 20 per cent of their core gold holding and allocate that to agriculturals and wait for a mean reversion to potentially make some healthy returns? I’m still waiting for someone to write the headline, ‘Sell your gold and buy some corn’. An investor could reallocate some gold to corn and with a mean reversion from the current gold to corn ratio levels they’d be able to buy back almost twice as much gold. Right now the same is also true with wheat and soybeans.
“Our message is that gold is not the only yellow commodity one should have in their portfolio,” says Gilbertie.
Nitesh Shah is Associate Director, Research at ETF Securities. In his view, wheat and corn prices will see some upside in 2015 following a strong year of production in 2014, as farmers reduce planting.
According to the International Grain Council, world corn production will see a sharp drop in 2015-16, with reduced output leading to a three-year low in inventories. It estimates that next season’s world corn harvest will be 49m tonnes lower at 941m tonnes reported research firm Blackseagrain on 27 March 2015.
“Over the last couple of weeks one near-term trend that has stood out is a pick-up in demand for our long wheat ETP (WEAT). Any potential rise in wheat price will materialise before corn and soybeans, as there is more diversity in production for these commodities. As the Southern hemisphere’s winter is in our summer you could see more of an uptick in corn and soybeans later in the year,” says Shah.
Strong production in wheat led to prices falling from over USD7.50 per bushel last May to USD5.04 per bushel in September. The same trend was seen in corn. Then, a threat to a trade embargo with Russia in response to the situation in Ukraine led to a strong rally in Q4.
Gilbertie believes that of the USD100m of recorded inflows into Teucrium’s four ETFs last year, approximately USD25m was probably in response to the Ukraine situation, given how important the Black Sea region is for grains, particularly wheat. “In general, however, investors are still under-represented in terms of how many agricultural commodities they own, and how much they think about them,” says Gilbertie.
In Q4, the Teucrium Wheat Fund (WEAT) gained 24.93 per cent as prices climbed to a seven-month high.
Given the volatility in grain prices, investors should view agriculturals as more of a longer-term asset allocation and focus on buying in downward cycles on the back of a supply surplus.
“The way we construct our funds is to use three futures contracts to diminish the effects of contango and backwardation. This allows investors to buy and hold and not worry so much about the negative effects contango and backwardation could have on their portfolio,” adds Gilbertie.
Corn impacts the lives of most people in the developed world on a daily basis (from the ethanol containing in gasoline when filling the car up to the corn syrup used in soft drinks) so it is perhaps surprising that it tends to get overlooked. For example, anyone who had sold gold and bought corn in October 2014 would have made 18 per cent that month.
Agricultural commodities are no longer the purview of futures traders any more. “With ETFs like ours, anyone can trade. Hedge funds are beginning to realise that holding agricultural ETFs might actually offset some of the volatility in stock-based portfolios which could improve risk-adjusted returns,” notes Gilbertie.
Last November, Estlander & Partners launched a new commodity program with a USD30m commitment from a large Nordic institution. Entitled the E&P Commodity Fund, it runs alongside the firm’s existing systematic CTA programs, Alpha Trend and Freedom, and employs three investment themes, one of which is to exploit short-term trends by identifying potential supply shocks. The system combines different information on commodity inventories to generate a daily estimate, which is then used to plot a monthly average.
“Even though index-level volatility has been at all-time lows in commodities in recent years, there have still been huge moves in particular commodities, simply because demand is inelastic. If there is an event of some sort that impacts supply that has still led to large moves in prices. We’ve been analysing these short-term moves over the last 100 years of data.
“For short term moves we focus on markets where we believe there is an inventory shortage, which could lead to larger short-term jumps. Cocoa, for example, is an interesting opportunity right now, whereas at the other end of the spectrum crude oil has a supply glut. Cocoa inventories are very low right now. More than half of the world’s supply is geographically concentrated to the Ivory Coast and Ghana and harvests are highly varied. We are looking at the potential for an upward trend in this commodity,” explains Gillis Danielsen, Quantitative Portfolio Manager at Estlander & Partners.
Since June 2014, the price of Brent crude oil has slumped 46 per cent to a current level of USD57.79 on the back of a supply glut, thanks in large part to shale oil production in the US. WTI crude oil futures are trading at USD49.98, again way off their highs of USD98 in June. Although recent air strikes by Saudi Arabia in Yemen have caused a slight bounce upwards, the prospect of sanctions being lifted in Iran could lead to the country increasing its oil exports by 1m barrels per day. This would present a further downside risk to crude prices.
Danielsen refers to a “triple whammy” impacting oil prices right now: a strengthening US dollar, OPEC’s desire to protect market share, and the shale oil boom.
“Historically, we saw a number of demand-driven slumps, the most recent following the Lehman Bros crash in 2008, but prices recovered quite considerably within a year. However, this is a supply-driven slump and we think the market will be range-bound for quite some time. A more fundamentally similar and lengthy slump occurred in 1985 in response to the North Sea and USSR supply glut,” opines Danielsen.
Jeremy Baker is Head of Commodities at Harcourt Investment Consulting. In his opinion, shale oil production is a short-term solution to a long-term problem. Certainly, the geological conditions are unique to the US. Shale oil is not a model that can be easily replicated. Such has been the phenomenal success of shale oil that US output expanded to 9.14m barrels per day in December last year; the highest level since at least 1983 according to the US Energy Information Administration.
The number of rigs seeking oil in the US dropped by 12 to 813 this week (24 March 2014) according to oil services firm Baker Hughes, but as Reuters recently pointed out this actually signals a slight decline in closures. The number of closures in the previous two weeks were 41 and 56 respectively.
Despite this, the reduction in horizontal drilling activity is not yet being seen. US oil production continues to hit 9.4m barrels per day, even higher than those recorded in December.
“There’s a time delay factor involved here. The industry has gotten more efficient because of the lower price environment and shale oil drilling operations tend to be on a contract basis. The ones that cut off are probably contracts that have come to an end or are operating from a very high cost base. The strongest producers will survive and they’ve got better at what they are doing.”
“The real test is that if prices fall to USD40 per barrel and remain there for a number of months, how will that affect drilling activity? It could have a significant impact. But if prices stay where they are, or bounce up to USD75 per barrel then those efficient producers will continue to produce and we won’t see any meaningful decline.”
“We generally believe that, excluding any kind of exogenous event, crude oil prices should move higher into the second half of the year,” comments Baker.
Shah notes that over the last five years, shale oil has reversed more than three decades of production decline in the US.
“US rig numbers are down to a similar number to 2011 so we are seeing indications that the US wants to tighten supply. It’s much easier for non-traditional shale oil wells to be switched on and switched off so the market can respond in both directions a lot quicker. Having said that there is still a time lag between shutting off rigs and seeing a short order supply. We will see inventories come down as rigs get shut down, but there will be a time lag,” says Shah.
This could therefore present an opportunity for investors to go short WTI crude before the price recovers. Both WTI and Brent crude oil futures are in contango (an upward sloping curve where the future price is higher than the spot price). By going short under these conditions one can benefit from positive roll yield on contracts.
“In the near-term, there could be some benefits to remaining short on crude oil. The bigger picture, in my view, is to consider going long on longer-dated contracts – June and July contracts onwards,” suggests Shah.
Natural gas prices have also taken a pounding over the last 12 months. Bearish commentators were recently talking about Henry Hub natural gas prices reaching USD271 per million British Thermal Units. This week the front-month futures contract fell to USD2.60/MMBtu; a 42.89 per cent drop over the last 12 months. There are three reasons for this:
• Higher than expected supply from the Marcellus shale
• Natural gas production as a by-product of shale oil
• Increased drilling well efficiency.
“I’ve been hearing that prices could fall anywhere within the USD270 to USD250/MMBtu range,” says Baker. “In the near-term we’re moving out of winter into spring and the injection season will see production levels ramp up. People will be watching closely as to how those injections develop and the extent to which inventories build over the coming months. March through May will be a crucial period. If the injection level is solid then that could well push prices lower.”
Some believe that natural gas prices are starting to reach a floor. From a longer-term structural perspective there are reasons to be slightly bullish on natural gas. More coal-fired power stations are switching to gas, and then of course there’s liquid natural gas (LNG). If the US finds a natural market as a net exporter that could well push prices higher.
There are already a number of LNG export terminals in construction: the Sabine Pass liquefaction terminal in Louisiana, Cove Point LNG, Maryland.
“It depends whether the market, pricing wise, is ready to accept US LNG exportation. Where is it going to go? Probably to Europe, most likely Asia. It’s still in the air at the moment. I would be a little more cautious on long-term LNG exports at the moment. There are some supportive elements for longer-term natural gas demand though,” states Baker.
To conclude briefly on base metals – which will be covered more in the second editorial – Shah is not of the opinion that these present a short opportunity. He notes that for copper every one of the last four years the International Copper Study Group survey has said there would be a supply surplus, it has ended with a supply deficit.
“People really underestimate how tight copper supply is,” says Shah.
Danielsen is not completely bearish on copper. One of the key reasons for lower base metal prices over the last year has been a strengthening dollar.
“Considering how much the oil price has fallen and the US dollar has risen, base metals have been doing reasonably well; in non-dollar terms they have actually risen YTD. Energy’s role for metal prices on the supply side is sometimes overstated. In fact, the most energy-intensive of metals, Aluminium and Zinc, have only fallen about 5 per cent. On the other hand, there is a case to be made for long copper, considering the stimulative demand side effects of cheap energy in the current environment,” concludes Danielsen.
