Drought and high temperatures in Russia and Kazakhstan and wet conditions which have limited planting in parts of Western Canada have been weighing on the outlook for global wheat production. In its latest World Agricultural Supply and Demand Estimates, published in July, the U.S. Department of Agriculture revised its outlook for global wheat production downwards by about 7.5 million metric tons, or 1.1%. A more modest-sized reduction in global use means that the USDA projects the world will now end the year’s harvest with just over 12 weeks of wheat stored in the bread bin. In combination with stories of wheat supplies rotting in storage in India and the potential for an export ban in Russia, Ukraine, or Kazakhstan, these increasingly dim forecasts have led wheat prices to rally at a rate not seen since the early 70s—when a wheat-short Soviet Union soaked up nearly all of the U.S.’s excess output.
The potential for a further deterioration in the outlook for global wheat—and further rise in wheat prices—have led to a surge of speculative interest in the market. Trading volume in ETF Securities’ ETFS Wheat exchange-traded commodity (ETC) on the London Stock Exchange has surged in recent weeks, and the ETC gained over 29% in the month of July. So is now a good time to be piling into what might be a thesis that is already fully baked into the ETC’s price? We can think of at least one reason why the answer might be “no”.
As we have discussed extensively in previous articles and our monthly conference call series, a pre-requisite to investing in commodities with exchange traded products (ETPs) is a deeper understanding of the true underlying exposure being offered by the various vehicles. In the case of ETFS Wheat, investors are exposed to the performance of the Dow Jones-UBS Wheat Sub-Index. This index provides exposure to a long-only futures strategy that deals in wheat futures traded on the Chicago Mercantile Exchange. Like other commodity futures strategies, this one has three sources of return: spot price return, roll return, and collateral return. In the case of wheat, the recent spike in spot prices has led to the dominance of the spot return in driving the total return of the index. However, we think it will behoove investors to take a closer look at the outlook for the roll returns that may be experienced by this strategy in the coming weeks.
The index rolls into new wheat futures contract four times per calendar year. At the end of August, the index will roll out of (sell) September futures contracts and buy December contracts. As of the middle of the trading day on August 4, September wheat contracts were trading for 708.2 U.S. cents and December contracts for 742.6. If the index were to roll its entire position in wheat futures at these prices—selling September contracts and buying relatively high-priced December futures—it would incur a negative roll yield of 4.8%.
Spot price movements in wheat markets in the coming weeks and months could very well dominate the effects of contago-driven negative roll yield and lead to continued positive performance for ETFS Wheat. But investors should not lose sight of the potential drawbacks of using futures-following ETPs to implement their commodity-related investment theses.
