Commodities 101

The S&P 500 posted its worst first half of the year since 1970, down 20% through Second Quarter 2022.   Worries about surging inflation and Federal Reserve rate hikes hurt valuations, as did Russia’s ongoing war on Ukraine and Covid-19 lockdowns in China.  Bonds, down 10% for the same period, had their worst year since 1788.  Only one broad asset class seems to have escaped the carnage this year: commodities, which ended the quarter up 18% for the year.

Defined as useful goods with interchangeable properties, commodities include energy, agricultural goods, metals and raw materials.  The Goldman Sachs Commodity Index (GSCI), now owned and maintained by S&P, is a common index used to represent the commodities market.  The index is weighted according to average world production in five sectors over the past five years.  Energy is the largest commodity sector at 54% of the index, with Crude Oil alone at 50%.  Wheat, corn and soybeans are the majority of agriculture at 16% of the total.  This means that factors affecting the price and production of oil often have a large impact on the commodity sector as a whole.  The index performance is created by tracking performance of future contracts.

A futures contract is a legal agreement that obligates the parties to buy and sell a specific amount of a certain commodity at a specified time in the future.  The largest volumes of futures contracts are typically traded for the “front months” or the nearest expiration date contracts for a given commodity.  The average daily volume of contracts traded typically exceeds the average daily use of the commodity.   This results from both commodity related companies hedging their own exposure and also non-related market participants seeking to profit from predictions that differ from the market.

The spread between the underlying security’s front month futures price and its spot (immediate) price will usually narrow until converging at expiration.  When the spot price is lower than futures month, the market is in contango.  When the spot price is higher than the front month, the market enters backwardation.  Primarily, a shortage of a commodity in the present and/or an estimated oversupply in the future cause backwardation. Commodity traders can harvest this differential as long as the market remains in a deficit by moving their exposure from the front month into longer dated contracts, which are expected to increase.

Since the beginning of the first human societies from 9,000-6,000 BC, commodities have functioned as a valuable part of our economy.  Farming, mining, and logging were once the vast majority of human economies across the globe.  However, at the end of the Second Quarter 2022, the materials and energy sectors combined represent only 7% of the S&P 500.  The rest of the economy is now dominated by other sectors like Information Technology at 27% and Health Care at 15%.  Even though commodity related companies are currently such a small part of the publicly traded index, they deserve a closer look for their unique performance.

Outside of direct futures contracts, investors can gain access to commodity exposure through several different vehicles.  The main underlying exposures are either the commodity itself through futures, or through securities of companies that are directly involved with the commodity such as oil drillers.  These securities can be accessed directly, which come with company specific risk.  Exchange Traded Funds (ETFs) offer a basket of related companies in order to diversify company specific risk while retaining commodity and equity exposure.  Invesco, iShares and many others offer both diversified and sector-based commodity exposure.  Finally, accredited investors can access alternative strategies that combine long and short exposure with other hedging.  A chart on the next page compares exposure to oil futures (Unites States Oil ETF) with the companies drilling that oil (Energy Equities ETF).  The broad commodities futures index is also on the chart, along with an alternative strategy that uses both long and short positions in commodities, combined with other hedges.  The right strategy for you depends on your specific goals and tolerances. 

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