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February 12, 2015

Commodity ETFs: not the real deal?

Commdity ETFs have become popular products to get cheap and easy exposure to the commodity story. But is this really true? Do commodity ETFs really reflect commdity spot prices?

It will probably come as a surprise to many commodity ETF investors that the ETF price has diverged meaningfully from the spot price. Why is that the case? Because commodity ETFs are based on futures and not on the physical spot price. Changes in the slope of the futures curve can have a big impact on the roll-costs (positive if you have backwardation, negative if you have contango).

As an example, let’s look at the price of oil and compare it with ETF prices. As the following chart shows, the price of the largest oil ETF has diverged by more than -50% since 2007. The picture for other commodities is similar.

OIL ETF - engl

Investors have started to figure out that they have been gamed and began to refuse to carry costs and losses further. This partly explains the recent drop in commoditiy prices, i.e. it is part of a greater definancialisation effect as investors retreat from commodities as an asset class.

But here is the real question: why should investors even have commodity exposure in their portfolio in the first place? The historical evidence on the real return of spot commodities is overwhelming: there is no real return potential. For proof, consider the following 130 year chart by SocGen:

Commodity return

Case in point: the price of oil is currently trading close to $50, the same inflation-adjusted price where it traded at around 30 years ago, near the lows of the last oil downturn. A 30 year period of zero real returns for this and other spot commodities once again shows the apparent lesson of history that spot commodities do not produce real returns.

What the providers of commodity investment products never properly explained: Why should commodities offer investors with a real return? A sensible case can even be made that prices should actually decline in real terms over time. A bushel of wheat, a lump of iron-ore or an ounce of gold today is identical to a bushel of wheat, lump of iron-ore or ounce of gold produced one thousand years ago. The only difference is that they are generally cheaper to produce because over time, human innovation has lowered the cost of production. When you buy commodities, you are selling human ingenuity.

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