Friday, 28 December 2012

Let’s get physical

Though there’s no better way to work off those mince pies than by putting your lycra (back) on and working out to an 80s classic, I’m afraid this blog only discusses how to get portfolios in better shape, not waistlines. In particular, I will be referring to some of the issues that surround ‘getting physical’ in commodity investing.

With the ongoing debasement of fiat currencies, the gold bulls remain a vocal bunch. They are also, no doubt, feeling pretty pleased with themselves, having seen the yellow metal’s price appreciate by 50% (in sterling terms) since the start of 2010. But whether it’s inflationary or deflationary fears that have been the driving force, I’m sure the opportunity ETFs have created for direct investment has also played a key role.

The city’s largest physical gold fund now stands at over £8 billion in assets under management. This ability to invest directly in the ‘barbarous relic’ has great appeal for both the retail and institutional investor, as it carries negligible counterparty risk and removes the need for complex derivative transactions. Why then, do we not see more physical commodity ETFs?

Given the ongoing, but recently heightened tensions in the Middle East, there is a perfectly rationale case for the inclusion of oil exposure within a portfolio. A physical offering would surely attract similar investors to those in the gold equivalent. The greatest impediment to the launch of such a product, however, is storage.

To add some colour to this problem, let's calculate how much storage space we would need to accommodate an £8 billion gold ETF? For comparative purposes, the calculation is made in terms of empty barrels of oil. 1 barrel is equivalent to 159 litres. 159 litres is equivalent to 159,000 cubic centimetres (cc). 30grams of gold is roughly 1.5cc in size and there are roughly 30 grams in a troy ounce. This means you can fit 10,600ozs of gold in a single barrel of oil. Assuming a gold price of £1000 ($1,700) per oz, a barrel of gold is worth £106m. An £8 billion fund, therefore, would need sufficient storage capacity to house 76 barrels. Though security costs would not come cheap, capacity is not a concern.

If a physical oil fund were to raise £8 billion of assets, and assuming an oil price of $85, it would require the purchase of 150 million barrels! In terms of storage this would require around 65 of the world’s largest oil tankers. Not only would this generate quite significant costs but, I imagine, would provoke the globe’s environmentalist community into action.

As a result of these impracticalities, if we want oil exposure we must achieve it through a series of derivative transactions. Oil ETFs or, more accurately ETCs (Exchange Traded Commodities), expose investors to ‘oil futures’ rather than purely the spot/physical price of oil.

Oil futures are contracts that, upon expiry, require the holder to buy oil at a fixed price. Contracts vary only with month of expiration and so can be bought with differing durations in order to meet a desired delivery date. The price of each contract for West Texas Intermediary (WTi) over the next 12 months is highlighted in the below chart.

Source: Bloomberg as 21/12/12

ETCs buy oil futures contracts but do not hold them until expiry because they do not want to take delivery of the commodity. Before expiration, therefore, the contract is sold and a new contract, with a longer expiry, is purchased.

This type of exposure can create significant performance differences versus the spot price of oil. First, there are the trading costs associated with buying and selling oil futures. Second, in the above chart futures are trading higher than spot. This means, should the oil price stay flat, the future will lose money over time as it inevitably converges on the spot price. This erosion of capital is explained in greater detail in the 'Investing in Fear: Part 2'.

Investors can decide to buy contracts of greater length (and decrease trading frequency), however, the further along the curve contracts are bought, the less sensitive to the spot price positions become.

Just like New Year resolutions, getting physical often proves easier said than done!

Ben Gutteridge
Divisional Director - Research

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