Walking through parched London parks last weekend my thoughts quickly turned to water shortages and the knock-on effects. Britain ought to have fewer leaky pipes and better storage infrastructure – if that was the case we probably had enough rain in winter to ride out this sort of dry spell. Alas, woeful management of water resources leaves southern England desperate for rain and expensively cultivated gardens shrivelling; yet there are many places in the world where droughts are even scarier.
Along with brutal temperatures, the super El Niño climate event gathering impetus for 2026 and 2027 is likely to disrupt harvests. First and foremost that could give rise to famines but even if disaster is avoided, higher food prices will be miserable, lifting headline inflation and feeding into core inflation as the rising cost of essentials acts to push up wage demands.
Without wishing to sound mercenary, investors should also be thinking about protecting their portfolios against this sort of risk, but there are pitfalls in being too reductive. Intuitively, soft commodity prices are a natural inflation hedge. Thanks to exchange-traded commodity (ETC) products it is possible for retail investors to play these markets and get some exposure to rising prices in wheat, corn, soyabeans, coffee and sugar.
Scarcity tends to put upward pressure on prices, so this makes sense, although professional traders may already have anticipated much of the risk. Fortunately, that matters less than it might appear, as investors will generally use ETCs that do not directly track spot prices.
Instead, these products typically gain exposure through futures: exchange-listed contracts linked to the price of a commodity at an agreed date in the future. This means that returns depend on more than real-time concern about food prices, and there are technical dynamics in futures markets that would-be commodity investors must understand.
Signals for timing commodities exposure
The difference between the spot price and the price of a particular futures contract is known as its basis, although conventions differ over which price is subtracted from which. Differences between the prices of futures contracts with nearer and more distant maturities are known as calendar spreads.
Other vital concepts include contango, which describes an upward-sloping futures curve in which later-dated contracts trade above nearer-dated ones. The opposite is backwardation, which gives a downward-sloping curve.
It may seem counterintuitive, but backwardation can support investor returns because a futures contract priced below spot normally converges towards it as expiry approaches. If the spot price remains stable or declines by less than the initial discount embedded in the futures price, a long futures position can still make money.
Of course, if the bottom falls out of a commodity price that will overwhelm any benefit from backwardation. That said, during a modest decline in spot prices an ETC tracking futures could (but is not guaranteed to) lose less than price falls in underlying assets.
The best scenario is when the spot price is rising while the market remains in backwardation. Investors then benefit both from the increase in the commodity price and from positive roll yield. This is where the ETC repeatedly replaces an expiring contract with a cheaper later-dated one – a discount that can enhance returns as the new contract moves towards spot. Strictly speaking, the gain is not created on the day of the roll but accumulates through the contract’s subsequent convergence towards spot.
An ETC can still make money in contango markets if commodity prices rise sufficiently to outweigh the negative roll yield, fees and other product costs. The worst case is when prices fall while the market is in contango: the decline in the commodity weighs on returns while the ETC also absorbs accumulating losses from rolling its positions.
Investors must also examine the index methodology. ETCs may hold different contract maturities, roll at different times and use futures or swaps, meaning that two products linked to the same commodity can produce materially different returns.
Arguably changing weather patterns make it likely we’ll see more supply squeezes for soft commodities, so some portfolio exposure may be worthwhile. Although, it is more sensible to think of this in terms of being a periodic tactical insurance policy rather than a buy-and-forget strategic holding.
An attractive entry point might combine commodity prices that are inexpensive relative to their own history, improving price momentum and futures curves in backwardation. That combination is uncommon, since backwardation often accompanies immediate scarcity and elevated spot prices. Most importantly, avoid chasing commodities after a sharp price rise when the futures curve is also steeply in contango, since both a fall in spot price and negative roll yield could weigh on returns.
Source: Original Article
