After the price of WTI (West Texas Intermediate) crude oil fell, many investors are suspecting a bargain. But they cannot invest directly in oil and other commodities. Investors need to buy financial products that are based on commodity futures – a treacherous market that one should not enter without adequate background knowledge. Investors can diversify their portfolio with commodities – or make short-term bets, for example on the price of crude oil. But only those who understand how commodity futures work can understand the performance of financial products on commodities and are safe from unpleasant surprises.
What are futures on commodities?
A future is a standardized contract that certifies the delivery or acceptance of certain goods at a exact date in the future at a fixed price. The term of futures is therefore limited in time, the contract expires on the delivery date. The seller of a raw material future is obliged to deliver the goods, the buyer to accept them. A seller of a future on a futures exchange holds a so-called short position, while the buyer is “long”. A position must always be matched by an opposing position (otherwise no forward transaction would be concluded) so that the sum of all short and long positions is always zero. Financial investors and speculators close their positions with an offsetting transaction before their contracts become due in order not to actually have to purchase or deliver the physical goods.
Who are the buyers and sellers?
Commodity futures exchanges have a long history and are of great economic importance. In these markets, producers and consumers use futures to hedge against price fluctuations. While producers protect themselves against falling prices, consumers want to protect themselves against price increases. For a muesli bar manufacturer who expects grain prices to rise, it can be useful, for example, to agree the price of the wheat delivery that he needs in a few months using a forward contract. As a rule, commodity consumers hold long positions (buyers), while producers of commodities are on the short side (sellers).
The third group that is bustling around on the futures markets – to an ever greater extent and with more and more money – are the so-called speculators, i.e. financial investors. Even if the term speculation has negative connotations, hardly any economist denies the economic benefit of speculation. Because financial investors act on the futures markets as important liquidity providers who take on price risks and want to be compensated for them with a premium. Ultimately, it’s nothing more than a kind of insurance business. Financial investors, including private investors, hold mostly long positions, which is ultimately also due to the construction of the indices through which they invest in the futures markets.
What have raw materials discarded in the past?
So, there is no general answer for it.Because the success of an investment depends solely on the strategy pursued. The fact that the spot price for oil has risen by 100% in a certain period of time does not mean that the capital invested has doubled as it does on the stock markets. The return of a futures investor can be significantly higher, but also much lower. It might be surprise for you, but studies show that the excess return on a single average future has historically been zero. Risk premiums only yielded portfolios that consisted of several commodity contracts. In the case of commodity future depots, the components of which were regularly reset to the starting weights, a so-called diversification yield could also be demonstrated. It results from the lower volatility of a portfolio compared to the individual components and is higher the more the individual commodities fluctuate.
What are the risks of raw materials?
A total loss with long positions on futures markets for commodities is unlikely. This can only happen if, for example, OPEC gave away its oil in the future and the price fell to zero. Of course, it is conceivable that new inventions will reduce the use of certain raw materials or even make them superfluous. However, it usually takes years to develop such technologies until they are ready for the market. Losses can also arise due to strong price fluctuations, although an investor was always “correctly” positioned depending on the market situation. Especially when commodity prices have risen sharply, the risk of a sharp correction increases, during which spot prices in a backwardation market can fall far below the futures price paid. Then a long investor gets lousy, even though he has actually done everything right. Conversely, in euphoric bull markets, spot price increases can rise higher than expected on the futures market. Anyone who has previously taken a normally promising short position in such a contango situation will lose money. The examples show that sometimes there is no risk premium to be earned. Then those on the winning side are those who bet that the “insurers” were wrong with their price expectations.