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The futures market is signalling significant trouble ahead for commodity prices. The issue is complicated enough to be under-followed – though Izabella Kaminska has delved deeply into the topic on FT Alphaville – and yet, it is second only to domestic household debt in terms of the biggest risks to Canadian equity portfolios for 2013.
The futures curves for major commodities like oil and copper are hugely downwards sloping in a formation known as backwardation. In the case of WTI crude for instance, the price of oil for delivery in February 2014 is $93.47 per barrel, more than $5 lower than December 2013 oil. Futures traders, which include both speculators and companies like utilities and steel manufacturers that need to secure supply, are locking in commodity prices well below current levels.
Under normal circumstances, resource producers would respond to backwardation by selling existing physical inventories into the open market – current prices are much higher than future prices. This would cause a glut in short term supply and a decline in commodity prices.
Locking in supply at lower prices is attractive for both speculators and commodity buyers, but there is also money to be made through what is called "positive roll." With backwardation, the value of a futures contract rises as time passes. For example, let's imagine that according to today's downwards-sloping futures curve, a crude contract for 100,000 barrels to be delivered in March 2013 costs $100/barrel, whereas the same number of barrels to be delivered six months later, in September 2013, will cost $95/barrel, and the same number in a year (March 2014) will cost $90/barrel, and so on as we follow the curve downwards.
Now jump forward six months, to September 2013. The contract you purchased six months ago – 100,000 barrels to be delivered in March 2014, which is now only six months away – would be worth $95/barrel, which is more than the $90/barrel price you originally paid. Why? Look back at how much these contracts cost in March 2013, when we originally bought our 100,000-barrels-at-$90-a-barrel, delivery-in-March-2014 contract. Back then, a six-month contract was worth more than a one-year contract – the price dropped as the delivery date got further away; the curve sloped downwards. But in September 2013, your one-year contract is now a six-month contract, and a brand new six-month contract costs more than a brand-new one-year contract – just as a one-year contract did back then. The curve hasn't changed, you're just further along it.
The big question is, why do resource producers continue to hold large inventories? Low interest rates are a big part of the explanation. When a producer sells inventory, they receive payment in cash. The two options for what to do with this cash are invest in future production or financial assets – money market or sovereign debt. But, inventories are already increasing so more production is not required and rates on sovereign debt are unprecedentedly low.
The financialization of commodity inventories is also offsetting the costs of holding inventories. Producers can loan out their inventory to companies issuing ETFs that track the commodity price.
At some point, something has to give. Commodity producers can't afford to sell their product at sharply lower prices in the future forever. Holdings of physical supply will be released into the market causing lower commodity prices. Canadian resource companies – 43 per cent of the S&P/TSX Composite - will suffer drops in revenue as a result.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow