The Wall Street Journal had a good article yesterday (subscription required) detailing an important structural change in the energy futures markets. The change (in technical parlance, a swing from “backwardation” to “contango”) means that investors who are following a commodity indexing strategy now lose money in a flat environment. This is more than just an adverse turn in the markets, but a change that undermines the whole contention that commodities are a legitimate core investment asset class.
A commonly recognized “test” as to the legitimacy of an asset class is whether that asset provides an unmanaged return. For example, stocks produce dividends, bonds pay coupon income, real estate generates rental income, etc. Goldman Sachs and others promulgated the concept of a “commodity yield” based on a specific strategy of rolling futures contracts forward in time (i.e., contracting to buy crude oil for March delivery, then later selling out in order to establish a new contract to buy crude oil for June delivery, only to liquidate that later to enter a new contract for September delivery, and so on). This was a critical component of the commodity-as-an-asset-class story and was furthered by the development of the GCSI (Goldman Sachs Commodity Index), which was conveniently engineered to make this case — indices not so heavily weighted to energy futures did not show a positive “yield.” Now even the GCSI shows a very negative “yield.”
It’s time for portfolio managers who had bought into the commodity-as-an-asset-class story to reassess their position. Just because you can run price histories through a model doesn’t mean the output makes sense — just ask the creators of subprime mortgage securities. Commodities are consumables, not investment assets. Much of the return generated by commodities was the result of the money pouring into the sector, a self-perpetuating illusion, and a classic bubble.
The commodity craze did tremendous economic damage this year. The false inflation signals kept the Fed sidelined when it should have been easing strains on the financial system. The mass liquidation of these paper buyers has not only decimated commodity producers, but now may be leading the policymakers astray by sending false deflation signals. There’s now talk of the whole cycle revving up once again, fed by Wall Street cheerleading. There are tried and true regulatory fixes that limit the amount of participation by non-commercial participants.
This is not a case of being against a free market — it is a matter of ensuring that a free market functions.