Lex

COMMODITIES

Financial Times (UK)
January 17, 2006 - 14:15 UT

http://news.ft.com/cms/s/ac3dddb6-873c-11da-8762-0000779e2340.html (subscribers only)

Commodities allow you take a punt on the potential for war in Iran while speculating about how much copper Chinese plumbers will need to tide them over their New Year holiday. Investors pumped $1.7bn into U.S. commodity-linked investment funds in December, the best month on record. There are good reasons to hold commodities, chiefly the portfolio diversification effect. It helps that commodity indices chalked up their fourth consecutive year of double-digit returns in 2005.

The theory still holds, but financial gains could be elusive this year. Commodity returns have three sources: the rise in the underlying spot price; interest earned on the margin held as collateral on futures contracts; and the "roll yield."

The latter is derived from buying cheaper long-dated commodity futures and waiting for the price to rise as the delivery date nears. This works when futures curves are downward sloping. Roll yield accounted for almost half of the 20 per cent annual return in Deutsche Bank's crude oil index between 1989-2004.

Fears of supply shortages pushed the oil market into near-term contango -- upward sloping -- in 2005. Roll yields turned sharply negative. Deutsche Bank reckons that, should this persist, oil indices will require an average spot price of $77 a barrel -- 18 per cent above the current level -- just to break even this year.

Volatility will increase, even as more funds are piling in. Metals markets are similarly dependent on short-term hopes and fears, rather than longer-term trends. Speculative buying continues to push the price of copper to new records, even as inventories keep building, albeit from a very low base. Unravelling esoteric fundamentals is one thing. But markets that are spiralling higher exert a special fascination all of their own.