Monday, November 12, 2007

The Inventory Code: New Ways Investors Can Cash In on Volatile Commodities

From Knowledge @ Wharton:

Oil is marching toward $100 a barrel, largely due to China's boom. Demand for ethanol is pushing corn prices up. Soybean prices are rising because so many bean fields have been switched to corn. In short, prices of commodities worldwide are soaring, making for frenzied action in commodities futures markets, where traders buy and sell contracts setting prices to be paid months down the road.

Everyone knows that supply and demand govern prices. But much remains unclear about the subtleties of that interaction in the commodities markets -- and about the best ways to wring profits from it. "Commodities futures are an asset class that has been under-researched compared to equities in particular," says Wharton finance professor Gary B. Gorton.

New work by Gorton, Fumio Hayashi of the University of Tokyo and K. Geert Rouwenhorst of Yale, shows how investors can win bigger profits with futures-trading strategies based on the amount of a given commodity that is held in storage. Returns -- or "risk premiums" -- are bigger when low inventories make prices more volatile, Gorton and his colleagues conclude.

Over the period studied, 1990 through 2006, a trading strategy focusing on low-inventory commodities would have produced average annual returns of 13.34%, compared to 4.62% for a high-inventory strategy, and about 9% for an approach that did not take inventory levels into account. "What we show is that you get paid more if the risk is higher," Gorton says.

Most importantly, the research shows how to gauge hard-to-measure inventory levels by looking at the relationship between prices on the futures market and the spot, or cash, market where commodities are bought for immediate delivery. When the spot price rises more than the futures price, traders can infer that the inventory level has fallen -- and that the opportunities to earn outsized profits are especially good. The findings, which could be especially useful to institutional investors and commodities trading advisors (CTAs), are described in a paper titled, "The Fundamentals of Commodity Futures Returns."...MUCH MORE