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Commodity markets have enjoyed a solid rally to start the year after a disappointing finish to 2023. The Bloomberg Commodity Index, a widely recognized proxy for the asset class, rose nearly 7% through the end of May, lifted by strength across nearly all segments except grains.
As we move into the second half of 2024, let’s take a look at a familiar market dynamic that’s often misunderstood in commodity investing: Current inventory levels may be much tighter than futures curves are signaling. Historically, tight inventories have often been associated with better performance for the asset class—but also greater volatility.
Surplus pricing illusion
Back in the summer of 2022, we observed a confluence of supply-side constraints brought on by the pandemic and Russia’s invasion of Ukraine, which sent raw material prices to new records. Simultaneously, this environment pushed commodity futures markets significantly into backwardation—a phenomenon where spot prices trade at a substantial premium to futures prices. The opposite state is referred to as contango, where spot prices trade below futures prices.[1]
Today, these effects seem to have dissipated. Commodity markets overall appear to be trading with a slight degree of contango. As of May 31, the average level was roughly -0.4%.
A market in contango would suggest that near-term supplies of a commodity are sufficient to meet current demand. Contango is typically observed during periods of surplus inventory in physical raw materials and often unfairly carries a negative connotation related to investment prospects of the asset class.
Role of interest rates in futures pricing
We think it’s worth remembering that interest rates play an important role in setting futures prices. Under normal market conditions, futures prices are higher than spot prices because they incorporate costs that a seller would incur for buying and financing the commodity. Said another way, interest rates contribute to the steepness of the futures curve. As interest rates rise, futures prices appear more expensive relative to spot prices—the futures curve steepens. That means the degree of contango in commodity futures has increased with the increase in rates, which can potentially mask what’s going on in the physical market.
Undoubtedly, the US Federal Reserve’s aggressive moves to raise interest rates in response to recent inflation helps to explain why commodity markets shifted from backwardation to contango over the past two years. As recently as late 2021, the yield on a 12-month Treasury Bill was effectively zero. Today, it’s well over 5%.
To strip out the impact of rising yields and get a better sense of the underlying inventory conditions, we can adjust the futures curve by adding back an equivalent Treasury yield. After this adjustment, we find that the average level of backwardation is actually around 5%. This is unusually high from a historical perspective—on par with conditions earlier in this inflation cycle. In effect, the present adjusted level of backwardation implies that inventories remain relatively tight across many commodities.
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