Risk Premia and Commodities

Coverage of the 2015 Investment Innovation Conference

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story_images_wheat-fieldCommodity markets have faced a tough road during the last two years, driven by factors such as slowing economic growth in China and the recent shock to oil process. However, they still play a valuable role in pension portfolios and their risks must be managed, despite volatility in prices, noted Nicholas J. Johnson, executive vice-president, PIMCO.

During his presentation, “Utilizing a Risk Premium Approach to Identify Opportunities in Commodities,” he explained that commodity markets are rife with risk premia – factors that are created by supply and demand imbalances, the high volatility of spot prices that drive producers’ need for compensation, and variances between the liquidity of different commodity contracts. Johnson said that investors using commodities can and should take steps to understand where risk premia are and why they emerge.

He explained that risk premiums are found across financial markets – they act as compensation for taking on risk or uncertainty in cases where other investors are unwilling to assume it. In credit, for example, there is a default risk premium – compensation for the chance an issuer will not be able to make the required coupon or principal repayments.

In the commodity space, a different set of risk premiums exist.

The power of roll yield 

For example, said Johnson, seasonality can lead to a mismatch between the supply and demand cycles, creating opportunities for investors. Another is roll yield – the yield that is created when a futures contract converges on the spot price for a given commodity. For example, investors seeking long exposure to oil tend to buy oil futures contracts – as the contract approaches maturity, it must be rolled.

Over time, returns from oil futures are derived from any changes in price along with the roll yield.

So where is the risk premium?

Johnson explained that at times when roll yields are positive, spot prices tend to be high. Hence, investors are being paid to “wear the risk of prices falling – and vice versa when prices are low,” he added.

Over short time periods, movements in spot price explain the majority of commodity performance – however, over long time periods, roll yields are the biggest contributor. Understanding how roll yields work, therefore, is critical for long-term investors.

A key factor in any commodity, explained Johnson, is storage:

“Never underestimate the importance of storage costs. They predict roll yield,” he said. Compare, for example, the price to store corn versus that of gold – “A small box can contain a lot of gold value – not so much with corn.”

According to Johnson, storage costs will become a key driver of commodity beta in the future – commodities with low storage costs will thrive, he said, using the example of soybeans versus corn. Soybeans have historically outperformed corn due to better roll yield. That is a direct result of lower storage costs.

One way to capture roll yield premia is to build an index that selects commodities with the lowest storage cost in each sector– from energy to base metals to agriculture. This will help investors identify the best roll yield over time.

Other risk premia investors need to keep in mind are liquidity (the fact that hedgers in less liquid contracts distort prices), tail risk (speculators are compensated for assuming risks others won’t bear), and volatility (implied volatility trades structurally above realized volatility).

Johnson concluded by noting that an absolute return strategy can help investors by delivering diversified returns relative to commodity beta.

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