A physical vs forward commodity market disconnect A strange thing is happening in commodity markets. As we already commented on Twitter, what the physical supply and demand situation is telling us is getting increasingly disconnected from what the forward and futures markets are saying. The curve, in short, is feeling mispriced. And not in the, "oh the market has corrected for too much supply but the forward curve has not caught up" way, but rather in the "physical market in many commodities is still looking weak, if not weaker, yet the curve is going the opposite" way. Weird. Luckily it's not just us thinking this. Goldman (of all people) were out with a note this Monday commenting on much the same phenomenon: Specifically, oil demand is coming from a relatively low base and is expected to improve later this year, whereas copper demand is coming from a high base and is expected to slow into next year (see Exhibits 3 and 4). However, it is important to emphasize that the recent optimism has been mostly based on the momentum and forward-looking survey data and far less on hard data and physical markets, which remain lackluster. This difference has been the driver of both our forecasts and our trading recommendations. What's really interesting, however, is that Goldman recommends investors take on positions that should allow them to profit from "roll-yield" in response. It's something known as the backwardation trade. But, err.. how can that be, if the curve is mispriced to the upside? Wouldn't that usually solicit a contango trade recommendation? Well, as we've noted before, it takes a helluva lot more backwardation these days to actually encourage destocking in the market. And that means in many markets backwardation is now becoming the new contango trade. From an investor point of view that means you can still sit on the curve and pick-up what looks like attractive "roll yield" at face value, but end up an overall loser in the end. This is because the yield collected by no means compensates the investor enough for the real risk they are taking by effectively funding larger inventories than needed by the market to be held back. Another way of looking at it, because money is now pretty much negative yielding for many market participants, producers need much more of a backwardation signal to incentivise them to hold money on account instead commodities in storage. In markets where there is a contango - metals, mostly at the moment - there is absolutely no incentive to cash-in those commodities at all (since they can still create a positive yield). In today's world that's the ideal scenario for most physical commodity participants. Meanwhile, in markets where there is real weakness anticipated if and when current inventories do get released, there is no incentive to destock at all if you can still get financial players to fund/hedge the inventory in storage at a break-even rate. It's important to remember that inventories and forward prices are always intimately interconnected, due to their role as supply and demand shock-absorbers for the system. Inventories build up during ample supply times - Joseph and pharaoh style - because the market anticipates they will be needed if and when supplies inevitably undershoot one day. Call it rainy day scenario planning. On top of that, because the act of storing contracts the free-float of supply available in the market today, the act of storing supports prices at the same time. When that sudden supply shortfall comes along, the market begins to compensate those who were savvy enough to accumulate during ample times to destock. The act of destocking, meanwhile, depresses prices which would otherwise be rising. As Goldman themselves state when explaining the roll-yield: Conversely, a negative roll yield implies a headwind to commodity returns. Importantly, however, it has often been the case that negative roll yields coincide with periods of rising commodity spot prices. Which conversely still - even though they don't say it themselves - can be taken to mean that a positive roll yield (backwardation) coincides with periods of falling commodity spot prices. In short, it seems to us that what we have in many markets today is a mispriced curve (priced higher than it should be) within a backwardation structure, and Goldman banging the drum for investors to take up more of the yield on offer, even though history tells us that profiting from backwardation roll-yield is usually associated with risky price exposure to the downside. That said, this time may be slightly different. Usually, the curve backwardates due to a sudden supply shortfall which sees spot prices rise just enough to encourage producers to unwind the hedges associated with warehoused commodities, sell at a premium, and store cash in the bank at a positive yield. This time, arguably, the curve has got more backwardated despite only a marginal spot price increase in relative terms. This suggests financial investors and speculators may have grown tired of waiting for the price rise usually associated with contango negative roll yield to materialise. Since the promise of much higher commodity prices never arrived, they pulled out from the non-physical futures markets, pushing the curve into backwardation in the process. All of which leaves oil prices, in particular, in a very unique (if not vulnerable) position. On one hand producers are facing backwardation. On the other hand there hasn't been enough of a price rise to incentivise them to pull out of pre-hedged deals or to destock at all. On that basis what happens next to the spare inventory - which, may or may not be stored in material form* - will probably entirely dictate the course of market prices in the short to medium term. Much inventory may, for example, be stored as so-called pre-financed inventory, so "reserved" by the financial market, but not yet extracted. If backwardation intensifies, not only will it be less logical to store new inventories, old inventories already financed by the market (and therefore hedged from the perspective of producers) will become ever more valuable. Yet, from the perspective of the financial hedger on the other side, the loss associated with the position only grows larger by the day. Also, hedges don't last forever. Once the hedges expire, the financial speculators on the other side will face two choices: 1) take delivery of the commodity in question - knowing full well he can no longer hedge it without capturing a negative roll-yield - or 2) financially realise (settle) the exposure (at a very big loss). Option 1) is clearly not an option for most financial players, which means the situation we are most likely facing is option 2). Yet, while this leaves the producer/physical player holding a profitable cash profit, it also leaves him with an ongoing commodity long in a market environment that no longer allows him to hedge it without significant cost. Or in the case of pre-financed crude, long a resource he can never afford to produce without collapsing prices. The temptation to liquidate above ground stock is thus greater than ever - a fact that now leaves the market price vulnerable to further collapse. Unless, of course ... financial investors can be found to support the market, or producers can be persuaded to cut supply elsewhere instead. The latter won't happen willingly. But how to persuade financial investors - who are now wise not only to contango roll costs but also to the fact that contango is no guarantee of a spot price rise - to bid up the futures price back to contango levels? A new story and rationale must be found for buying futures, one which no longer aims to restore contango but hopes for the next thing: lowering the costs associated with hedging all that risky crude on producer/physical player balance sheets - and in the best case scenario allows these parties to break-even on storage costs. "Now's the time to profit from backwardation roll-yield" is arguably that story. Indeed, every time a financial investor can successfully be persuaded to benefit from roll yield he inadvertently ends up supporting the curve (and market), disincentivising the market from destocking. What he probably doesn't appreciate, however, is that it is he who is taking on ever more of the price risk and doing so probably at far too cheap a price. The more the curve misprices, the greater the incentive for the market to lock-in what are actually extremely favourable hedging rates, all things considered. From the perspective of Joseph and the pharaoh, it's much like Joseph having been hugely wrong about the seven years of drought he predicted, and doing everything he can to either disguise or dampen the price impact of the inventories he still has stashed in an ever more commodity abundant world. His current solution: paying someone in the market a very modest fee to take all of the price risk away from pharaoh. Related links: Confused curve signals - FT Alphaville The negative carry universe - FT Alphaville Pariah profits in an age of "negative carry" - FT Alphaville Scarcity amid plenty, oil edition - FT Alphaville