Amid surging consumer and producer prices, inflation is making the headlines across economies in America, Europe and Asia. It is coming back with a vengeance because of continued supply chain disruptions for key commodities and heightened geopolitical risks since Russia’s invasion of Ukraine, among other drivers.
In this article, Ivo A. Sarjanovic, former Cargill trader and lecturer at the University of Geneva’s commodities programme, and Alan G. Futerman, adjunct professor of institutional economics at the UCEL university in Argentina, examine the different ways commodities can be used as a hedging tool by companies looking to protect their portfolio from inflation. In a podcast recorded in September 2021 with Paul Chapman, Managing Partner of HC Group, Sarjanovic had already explained the risks faced by commodity participants due to inflation. Here, in a glimpse of an upcoming book, the authors highlight the potential pitfalls of these strategies considering the specific characteristics of recent commodities price spikes.
Contango versus Backwardation
Before commodity prices hit record-breaking levels following the global coronavirus pandemic, the investment industry, the trading community, as well as finance departments in academia had arguably tagged inflation as a thing of the past. Professional economists have been confused about the phenomenon too, so much so that they didn’t expect inflation to reach current levels. This is fueling fears that the ongoing price increases are of a structural nature, rather than a temporary glitch.
One of the most common responses from the investment industry currently is to buy commodities. The idea that this asset class represents an optimal hedging tool against inflation stems back to the great inflationary decade in the seventies. However, according to our research, the correlation between commodities and inflation is not as linear as it seems.
Firstly, one can look at the futures market, a standard instrument used to build a position in commodities. Inflation expectations contribute to futures curves being in contango, a scenario where the future price of a commodity is higher than the spot price. This scenario is also referred to as ‘carry’, as the premium above the current spot price for a particular expiration date is usually associated with the cost of carrying any charges investors need to pay to hold the asset over a period.
The contango structure makes sense if the market believes that prices will rise in the future, as inflation remains on its upward trend too. But this is hardly a profitable strategy in the long term because the cost of rolling the position could entail continuous losses.
So, a successful approach requires the price curve to be in backwardation (or inverted) to be profitable. Backwardation refers to a situation where the spot or nearby price of an asset is higher than prices trading in deferred positions. However, the forward curve that is typical of inverted markets is not compatible with the sequence of forward prices gradually moving up month after month due to rising inflation.
Moreover, backwardation is a consequence of real supply and demand imbalances. And production (or supply) eventually tends to increase while demand softens, allowing the market to return to a lower equilibrium price. Spot prices would be adjusted downward, and the futures curve would revert to a carry. In other words, for backwardation to persist for a long period of time under an inflationary scenario, real demand should continue to exceed supply. Crucially, that would be a fundamental phenomenon, not a monetary one.
But there is another challenge. If expectations of higher inflation keep up, the profitable trade strategy would be to go long on the back end of the curve to avoid exposure to a more expensive spot position. Sooner or later, this would most likely end up driving the forward curve back in contango, making it then costly to roll the position and affecting the full return of such a hedging tactic.
So, futures markets represent a complicated instrument to play with if one is to shape an efficient inflation hedging strategy. Of course, exchange-traded funds (ETFs) that follow commodity indices face these problems as well.
Nominal Versus Real Data
Data and indices are key. If taken from beginning to end, the period 1960-2022 shows that not every commodity yielded returns above the inflation rate for the US Consumer Price Index (CPI). Over the last five decades, only the 1970s and 2000s showed that commodities consistently generated higher returns than the CPI. Moreover, although inflation was undoubtedly a leading factor during the 1970s, fundamentals were a big reason behind higher commodities prices, especially during the 2000s.
Let’s now focus on nominal prices which are unadjusted rates that do not take inflation or other factors into account. In the event of commodities price spikes such as those seen a few months after the start of the COVID-19 pandemic, some analysts tend to overlook real prices which are adjusted for inflation and use historical nominal highs as a benchmark to measure the strength of the price rally. But this approach is inaccurate when considering commodities as an inflation hedging tool. Real prices should form the basis of any analysis and strategic move. They are often ignored, precisely because inflation has been low for so long that it is deemed irrelevant. But this is certainly not the case.
As an example, the highest price of gold in January 1980, $873 per ounce, would now be equivalent to almost $2,950 per ounce. But some analysts look at the recent price around $2,080 per ounce as an illustration of the market reaching new highs. Similarly, the Brent crude oil price reached a high of $147.50/bbl in July 2008, which today would be equivalent to around $195/bbl. Recently, it ‘only’ got to a level of $138/bbl. But not only that. In this case, this was mainly due to real reasons (mostly the war in Ukraine), not inflation per se.
Yet, there are several reasons why commodities are still seen as an inflation hedging tool. Firstly, in some very specific periods, the profits made from some commodities (especially energy and precious metals) positively correlated with higher inflation rates. Secondly, any expectation of higher inflation would trigger a rush to buy commodities in anticipation of actual inflationary gains in a short-term reaction referred to as ‘overshooting’. Overshooting means that prices exaggerate the upward move and trade for a certain period above the long-term equilibrium value. However, this is unsustainable precisely because a trend of supply and demand elasticities is likely to be set in motion for prices to find this new long-term equilibrium.
Therefore, the key for commodities to be a good hedging tool under an inflationary scenario, is not only that inflation expectations rise, but more importantly, that real fundamentals support the rally. Only real factors can sustain a long-lasting bullish commodities market. In the last two years, there were indeed real reasons, like supply chain disruptions, an erratic energy transition, crop losses due to extreme weather, biofuels policies and now the war in Ukraine. Inflation certainly contributed but it wasn’t the main factor. Low inventories, inverses and strong premiums or basis are the evidence that this is more a fundamental than a nominal event.
In this context, timing is a fundamental criterion when taking a long position and exiting it. For instance, in 2008, many commodity traders took long positions for hedging purposes. The Standard & Poor’s Goldman Sachs Commodity Index fell from around 893 in July 2008 to 730 currently, while inflation rose by 30% over the same period. The index lost value in nominal terms and the strategy adopted by these traders yielded even worse results when considering the impact of inflation during this period.
At the same time, data shows that not all commodities react equally to a change in expected inflation and therefore not all indices built with different commodity baskets evolve in the same way. Metals and energy price correlations are stronger while correlations with agricultural products are weaker. On both an absolute and relative basis, agriculture prices tend to lag behind inflation. This is not surprising since the price-elasticity on the supply side of this sector is greater thanks to much larger rates of productivity growth compared with the other commodity sectors. This is another argument supporting the idea that it is real factors that drive commodity prices, not nominal ones.
But importantly, we are talking here about commodities as an inflation hedge in the context of a passive strategy. A passive strategy on a position implies that once the position is built, it remains unchanged for a long time, unlike an active strategy which is managed daily, weekly or monthly. Active strategies can be deployed effectively as a hedge against inflation. But regardless, inflation should be mostly treated as noise in the decision-making process of investing passively in commodities as a long-term strategy hedge.
However, given the expected role of industrial metals and biofuels during the energy transition, led by policy and not by markets, different correlations could emerge in the medium to longer term. Yet, such a premise is controversial and remains unpredictable, not least because of disruptions in energy markets like those triggered in Europe due to the war in Ukraine. Increased price volatility is likely to compromise the transition to a cleaner energy future.
As a matter of principle, one should consider buying commodities if there is a compelling fundamental bullish story to do so. Fundamentals remain a key factor to consider in a buy strategy designed as a purely long-term and passive hedging tactic against inflation. It is key to manage one’s entry point and the make-up of a commodity’s index because it could turn out to be flawed.
This view goes against the consensus amongst the investment and commodity community. Undeniably, there are reasons to buy some commodity families for hedging purposes. However, the general case for such a trading approach should be considered in the context of the fundamental drivers of this complex asset class and not just as a mere reaction to inflation.