The Future of Commodities Markets

Over time, the accumulated gains can be considerable for a market such as crude oil, which is often in backwardation for reasons related to storage costs, supply disruptions and transportation constraints. The losses for a commodity such as natural gas, where the discounted future often converges to a lower cash market price at expiration, can be considerable, too.

The Warning

Let's stop now and ask ourselves whether a large number of traders who identify this trade opportunity can exercise it simultaneously and with infinitely elastic liquidity. In other words, can everybody make money by capturing everybody else's inefficiencies? If a large number of traders are looking to sell the expiring January crude oil contract and buy the February crude oil contract, the realized "roll" will soon disappear. Indeed, it has shown signs of disappearing so far in 2004.

A frequently cited study of returns on commodity futures by Gary Gorton and Geert Rouwenhorst completed this past summer used historic commodity prices generated from the much smaller, less-deep and less-liquid futures markets of past decades. No adjustments were made for the limited capacity of these markets at the time, for the inevitable distortions of these markets that would arise from an observed trading pattern, or for the very substantial loss of liquidity that would occur at the historic reported prices.

Futures markets, unlike equity markets, are a zero-sum game. If Keynes' theory of normal backwardation is correct, the accumulated gains of risk-seeking speculators cannot exceed the accumulated demand for price insurance from risk-averse producers.

Two factors now arise. First, the capacity of the world's financial speculators exceeds that of the world's commodity producers by a large margin, no pun intended. Second, the very bull market in commodities predicted by so many, if it materializes, may serve to reduce the demand for price insurance by producers.

The conclusion we can draw here is that increased investor demand for commodity exposure will encounter lower profit potential as the finite pool of insurance demand gets distributed over more insurance-providing speculators.

There will be money to be made in the commodity markets over the next decade. We will need to be careful, however, in identifying our sources of return and in learning more about the markets. This is an ongoing process. From what I saw in Geneva, there is work to be done.