Commodity Commodity Commodity

Commodity investors need to understand total return

Ole Hansen

Head of Commodity Strategy

Summary:  Commodities continue to build on the best year since 2000, and the positive performance seen during the past month when turbulence struck bonds and stocks, has further increased investor awareness about an asset class that for a number of years had delivered poor returns. With the prospect for tight market conditions and inflationary pressures continuing to support the sector, it has become increasingly important for investors to understand the underlying mechanics that can either be a major headwind or as recently a significant tailwind.


Commodities continued to build on strong gains in 2021, a year where the sector recorded its best year since 2000. In our recently published Quarterly Outlook we see the prospect of even higher prices in 2022 with another year of tight supply and inflationary pressures supporting commodity returns. The decarbonization of the world will increasingly create so-called greenflation where rising demand and prices of commodities needed to support the process will be met by inelastic supply, partly driven by regulations, such as ESG, prohibiting some investors and banks from supporting mining and drilling activities.

With this in mind we will take a closer look at what signals the futures curve sends and how its shape has a significant impact on returns and investor behavior. As traders, investors and analysts we tend to focus on, and mainly chart the first traded futures month. From an investment perspective the movements in the front month contract only tells us part of the story with the realized return very much depending on the shape of the forward curve.

The chart above shows the performance of the Bloomberg Spot index, which tracks the performance of the front month contract, and the Total Return index which takes the impact of rolling the underlying futures contracts into account. During a five year period between 2016 and 2020 the Bloomberg Spot index rose by 47% while the actual return an investor would have realized was a very poor 6%. If instead we look at the last twelve months, the spot index has returned 31% while the total return index has risen by 32.2%. In order to understand this major shift between the two indices, we need to focus on the futures curves across those commodities being tracked by the Bloomberg Commodity Index.

Understanding backwardation:
Backwardation is when the current futures price of an asset is higher than prices at a later expiration. Backwardation can occur as a result of high demand for prompt delivery driving up the price relative to the contracts expiring in the coming months. Such a development signals tightness in the market and increased worries about the availability of supplies.

The front month contract in Brent crude oil trades around $89 per barrel with the deferred contracts trading increasingly cheaper. An investor with a 12-month investment horizon can either buy the front month and then roll the contract on a monthly basis or alternatively buy the contract expiring a year from now. The result is the same with an unchanged front month price in 12 months’ time giving the long position a positive return around 11%, either through picking up a small discount at each roll (selling the expiring contract at a higher price than the next) or from the price appreciation of the contract bought one year out.

Before 2021 the commodity sector had witnessed nearly half a decade of ample supply with most futures as a result trading in contango, the opposite of backwardation where the front month contract trades the cheapest. During this period investors had often suffered losses with the contango structure favoring those holding short positions instead of long.

This situation culminated in March 2020 when prices of many key commodities, most notably crude oil collapsed as global demand fell off a cliff as the pandemic led to lockdowns and reduced economic activity. Since then, however, the global recovery accelerated with central banks and government ending up overstimulating the global economy, thereby adding considerable strain on producers and their ability to supply the raw materials needed.

The fundamental turnaround seen during the past year can be seen below with rising backwardation seen across most sectors, most notably energy, agriculture and some industrial metals. The energy space has seen the one-year average carry on WTI, Brent, gasoline and diesel rise to around 12% while recently the soybeans complex has also been tightening with dry weather in South America diminishing the harvest at a time of rising demand for plant-based fuels like soybean and palm oil. Out in front we find cotton where supply chain problems and not supply shortages as such have driven prices higher due to a lack of cotton at mills around the world.

Returning to the Bloomberg Commodity Index, all the above observations has driven the 12-month weighted average roll yield to a fresh record high at 5.6%. The percentage basically reflecting the yield (minus costs) an investor can expect to achieve in 12 months’ time at unchanged spot prices on a passive long position in an ETF tracking the BCOM TR index, such as DJP:arcx, CMOD:xlon, DBZN:xetr and AIGC:xlon.

Three of the best-known commodity indices that are tracked by billions of dollars are the Bloomberg Commodity index, the S&P GSCI as well as the DBIQ Optimum yield diversified commodity index. Exchange-traded fund providers such as Invesco, iShares, iPath and WisdomTree offer different varieties of these commodity indices.

We prefer to use and track the Bloomberg Commodity Index given its specifications which says that no sector weight can exceed 33%, and no single commodity weight can exceed 15%. This in stark contrast to the S&P GSCI which has a 53.5% exposure to energy, 27.8% to agriculture and only 18.7% to metals.

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