IN JOSEPH HELLER’S modern classic, Catch 22, the entrepreneurial mess officer Milo Minderbinder seizes the opportunity to buy up the entire Egyptian cotton crop. The result is a disaster – Milo finds himself unable to sell the cotton to anyone. After trying to turn it into food, eventually he unloads it onto the government.
Today it is relatively rare for commodity speculators to get stuck with the same problem as Milo – few ever take physical delivery because markets are liquid enough that it is possible to speculate entirely using futures contracts, rolling them over into new contracts as they expire.
Of late, however, the possibilities for investing in actual warehouses full of goods have widened. Seeking to expand on the success of physically backed precious metal funds, ETF Securities recently launched three physically backed base metals exchange traded funds (ETFs). They track the prices of nickel, copper and tin.
But the fees on an ETF Securities copper ETF add up to 0.81 per cent, plus 36 dollar cents a day per tonne of metal owned – or about another 1.3 per cent per year at current copper prices. On a futures contract, the fee is just 0.49 per cent. So why would anyone want a share of a warehouse full of industrial metals?
According to Gayle Berry, a commodities researcher at Barclays Capital, a good reason not to is the difference between spot prices (the price for delivery now) and futures prices (the price now for delivery in the future).
For much of the last 18 months, futures prices of many metals have been more expensive than spot prices – known as a “contango” – thanks to the combination of low current demand due to the recession and high-expected future demand. In a contango, the cost of rolling over futures contracts cuts profits, while physically backed products – which trade at the spot price – benefit.
But for the last three months, copper and tin at least have moved into “backwardation”, where futures prices are lower than spot prices. That means that futures based products will do better than spot based products by benefiting from a “positive roll yield”.
Berry reckons that copper and tin will carry on in backwardation for some time, as London Metal Exchange (LME) inventory supply is extremely tight. At least partly as a result, physical base metal ETFs are unlikely to catch on – already, demand for the new products has been much lower than expected – while futures based products are likely to carry on growing.
The idea of owning part of a warehouse full of metal at a time of ever tightening demand and high inflation is somehow emotionally appealing. But given the high fees and the availability of futures contracts in a tight market, there are few good economic reasons for wanting to right now. Investors need to avoid making the mistake Milo made. New opportunities are not always good ones and hoarding goods you can’t use yourself isn’t often very clever.
ECONOMICS FOCUS | FUTURES AND SPOT PRICES
The spot price of a commodity (or of any financial product) is the price at which it can be currently bought, while the futures price is the price it can be bought at now for delivery at a future date.
Producers sell forward contracts so as to ensure a particular price for future production and so hedge against uncertainty. Consumers purchase them for the same reason. The seller goes short while the buyer goes long.
Economic theory says that futures prices and spot prices should be approximately equal except for financing and (if applicable) storage costs. If they weren’t, traders could make a guaranteed profit by arbitraging – buying now and hoarding, or else selling inventories and buying them back later. It is not clear how well that rule holds in practice.