Head of Commodity Strategy
Summary: Crude oil has reached a fresh cycle high as fundamentals continue to improve with supplies being kept tight at a time where the demand recovery has started to become more synchronized with local virus outbreaks in Asia starting to get under control. However, adding to this we find a continued strong pick up in demand from financial investors, especially through ETFs. In this we take a closer look at the mechanics behind broad commodity investments and how a major share of that flow ends up in crude oil futures.
What is our trading focus?
OILUKAUG21 – Brent Crude Oil (August)
OILUSJUL21 – WTI Crude Oil (July)
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Commodities of most colors continue higher on a combination of expectations for a post-pandemic growth sprint triggering supply bottlenecks, green transformation focus, weather worries and increased investment demand from speculators and investors enjoying the current momentum while seeking a hedge against the risk of accelerating inflation
The year-on-year rate of change has reached levels not seen for the past couple of decades, and with rising input cost forcing more and more companies to pass on the cost to consumers, we are increasingly seeing the risk of the current inflation spike not being the transitory phenomenon being touted by major central banks. Once inflationary pressures take hold it becomes very difficult to reverse and the risk being a self-feeding loop that may end up driving commodity prices even higher over the coming months and quarters, hence the increased focus on a new super-cycle.
While rising physical demand has been seen as the main reason behind the continued run up in commodity prices, investment demand plays an equally important role. What they all have in common is that a vast majority of investment flows from asset managers and hedge funds into commodity investments will eventually find their way to the futures market. These investments flows which often are initiated for reasons that have nothing to do with individual commodity fundamentals is therefore adding an additional layer of support. Examples of motives why asset managers decides on a broad commodity investment, apart from the fear of missing out (FOMO) can be momentum and hedging against rising inflation and a weaker dollar, both triggering reallocations from other asset classes.
Three of the best known commodity indices that in some form 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. Some aim to track the index with no discretion while others look to optimize the return by finding the most opportunistic location on the futures curve to invest.
These broad-based commodity ETFs continue to see strong demand, and a Bloomberg article highlights the recent surge in fund flows into the iShares GSCI Commodity Dynamic Roll Strategy ETF (Saxo ticker: COMT:xnas). During the past couple of weeks the ETF has seen assets more than double to the current $2.3 billion. Looking at the overall ETF market for broad-based exposure the article reports that $7.3 billion of allocations so far this year has taking assets to $17 billion overall.
As mentioned, providers of these ETFs will typically hedge their exposure in the futures market, thereby giving these markets an underlying bid as long demand continues to grow. As per the table above and using the mentioned COMT:xnas as an example we see that for each dollar invested around 55 cents goes into energy. Digging a bit deeper we find almost 40% being invested in WTI and Brent. Such flows help to explain why crude oil – obviously supported by OPEC+ keeping supplies tight – continues to be bid with very shallow corrections seen during the past few months.
The tightening market conditions that has emerged during the past six months is another reason why asset managers once again, and for the first time in a number of years, view commodities as an interesting investment case. With several commodities seeing tightening conditions their forward curves have moved in backwardation, meaning the front month contract trades at a premium to the deferred. The higher the spread, the higher the yield that can be harvested when rolling futures contracts out the curve. The chart below shows the average 12-month roll yield of 26 major commodity futures, and it shows how we just recently moved out of contango which for the past six years meant investors were left with a monthly cost of holding a position due to the negative roll yield.
We highlighted the energy sector as being the main benefactor of investment flows into ETFs and it probably helps to explain why crude oil has stayed bid without much in terms of major correction for several months now. Crude oil trades higher with WTI settling above $70 yesterday for the first time since October 2018 while Brent has broken a barrier of resistance at $72. Supported by robust demand in China, US and Europe and easing virus impact elsewhere, especially in India.
In addition, the API last night reported a 2.1 million barrel drop in US crude stockpiles, and if confirmed by the EIA today it will be the third weekly decline. With EIA’s Short-term Energy Outlook, published yesterday, only seeing moderate growth in US shale production, OPEC+ can increasingly control the price, given they are sitting on nearly 6 million barrels of spare capacity which they can release at will.
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