the basics of commodities

Transcription

1 the basics of commodities About (ETNs) Investors have shown increasing interest in commodities, which as an asset class can offer opportunities to fine-tune a portfolio s risk and return characteristics. The commodities asset class has experienced strong growth in recent years, for example, commodity exchange-traded product Assets under Management (AUM) has risen to $186 billion as of September 2011, with total inflows of $31 billion so far in 2011.* The low historical correlation to financial assets, equitytype returns and risk characteristics offered by commodities provide investors with a means to diversify portfolios. Please see important disclaimers at the end of this document. This material is to be read in conjunction with the relevant base prospectus and relevant final terms referred to in the disclaimers. * Source: Barclays Capital, as of 21/10/2011.

2 The Basics of Commodities OPINIONS SUBJECT TO CHANGE All opinions and estimates are given as of the date hereof and are subject to change. Barclays is not obligated to inform you of any change to such opinions or estimates. Barclays will not be liable for any use you make of any opinion or estimate provided. 2

3 what are commodities? Commodities are the physical goods used in the initial phase of the manufacturing process, and refer to real assets such as energy, industrial and precious metals, agriculture and livestock. How are commodities traded? Unlike shares and bonds, much of the commodity market does not trade for physical settlement and delivery within a few days of trade date. The reason for this stems from the very nature of the asset class and one need only consider the practicality and cost of the transportation, storage and in many cases potential for spoilage. Commodity specialist investors typically trade commodities in the form of listed futures contracts. Furthermore, many of these contracts are closed out before the contract s expiry date. (A trade is said to be closed out when the investor who holds a position in a futures contract subsequently trades the equal and opposite position to what he or she had taken originally, thus resulting in a net position of zero.) The result is that the investor has to settle, in cash, the difference between the value of the original and new contract, but does not have to physically deliver the commodity. Listed Futures Contract A futures contract is a standardised contract which amounts to an agreement to buy or sell a specified asset of standardised quantity and quality at a specified future date (known as the contract s expiry date ) at a price agreed today (the futures price). For example*: if an investor were to agree to buy the 100 troy ounce gold contract with an expiry date in December 2011 paying $1,400, then following expiration of that contract, they would be obliged to accept delivery of 100 troy ounces of gold and pay $1,400.* if an investor were to agree to sell the 100 troy ounce gold contract with an expiry date in December 2011 at $1,400, then following expiration of that contract, they would be obliged to deliver 100 troy ounces of gold and receive $1,400. * This is a simplified example of a futures contract and does not incorporate all aspects of a futures contract What are commodity indices? A commodity index is a fixed weight or (weighted) average of selected commodity prices, which may be based on spot or futures prices. The spot price of a particular commodity is the current prevailing market price of that commodity being quoted for immediate (spot) settlement. A commodity index could be designed to be representative of the broad commodity asset class, a specific subset of commodities, such as metals or energy, or to track a specific single commodity such as Gold. An investor who would like to maintain a continuous exposure to commodities in a non-physical form could face some practical issues. If an investor in a commodity futures contract wishes to maintain a futures position past the expiry date of the futures contract they hold, they must sell it prior to its expiry date and purchase a futures contract with a delivery date further in the future (often the next succeeding futures contract). This is known as rolling from one future to another. Fortunately, a number of index providers now calculate indices in commodities on the basis of rolling from one future to another. Some of the most popular indices of this type are: the Standard & Poor s GSCI family of indices, and the Dow Jones-UBS family of indices These index providers offer indices on: single commodities, e.g. on aluminium there is a S&P GSCI Aluminium Index Total Return specific commodity sectors, e.g. on precious metals there is the S&P GSCI Precious Metals Index Total Return the wider commodity market, e.g. S&P GSCI Index Total Return and Dow Jones-UBS Commodity Index Total Return SM The details of how the indices are calculated are beyond the scope of this note, but could be provided by the relevant Index Sponsor. However, it is worth noting that both the S&P GSCI Index Total Return and Dow Jones-UBS Commodity Index Total Return SM aim at using constituent weights reflecting the liquidity and production of the underlying commodities. Furthermore, the Dow Jones-UBS indices have constraints on individual commodities and commodity group weightings, thus ensuring an element of control as to the exposure of the index value to the movement of any one commodity or commodity group. 3

4 The Basics of Commodities Another aspect of these indices is that they are often quoted as excess return or total return indices. An index that tracks the return generated by rolling the future contract is known as an excess return index. However, excess return indices do not take into account that an investor having futures exposure would usually be holding the notional amount in cash. Total return indices look to adjust for this by calculating the value of the index as the excess return plus an interest amount (usually based on the interest paid on shortdated US government treasury bills). Most index tracking investments relate to the total return indices as these are often the best index proxies to a fully committed cash investment with continuous exposure to a commodity. Figure 1 DOW JONES-UBS COMMODITY INDEX TOTAL RETURN SM S&P GSCI TOTAL RETURN INDEX Number of commodity groups Index calculation Arithmetic Arithmetic Weighting method 2 / 3 liquidity, 1 / 3 production, 15% cap and 2% floor for single commodities, 33% cap per commodity group * Production and liquidity Launch date * As of annual rebalancing. Sources: Dow Jones-UBS as of 31/10/2011, S&P as of 31/08/2011. Figure 2 Commodity Group % Weight in Dow Jones-UBS % Weight in S&P GSCI Commodity Index Total Return sm Index Total Return Energy Agriculture Industrial Metals Precious Metals Livestock Sources: Dow Jones-UBS as of 31/10/2011, S&P as of 31/08/

5 What is the roll yield? Usually the price of a futures contract will not be the same as the current market price of the physical commodity (the spot price). However, it can be said that over time, as a futures contract moves towards its expiry date, the price of any given futures contract will converge towards the spot price. In fact, on expiration of the 1 month futures contract, the value of the contract will actually be that commodity s spot price. Thus an investor investing in an index which rolls a futures contract, i.e. buying a future, holding it for some time and then selling it, will experience either a profit or a loss even if the spot price of the commodity has remained unchanged. The return generated by the rolling of the future is known as the roll yield. The roll yield can be negative or positive: Negative Roll Yield If the spot price is lower than the futures contract price, then all else being equal, the futures price will decrease over time, towards the spot price. In this scenario, the roll yield will be negative, and an index, or an investor, will experience a negative return. Over time the roll yield can lead to significant divergence, either positive or negative, between the return of the indices and the price of a physical investment in the commodity. Negative roll yields could adversely affect the value of a Commodity Index. Positive Roll Yield If the spot price is higher than the futures contract price, then all else being equal, the futures price will increase over time, towards the spot price. In this scenario, the roll yield will be positive, and an index, or an investor, will experience a positive return. For example, a 5-year index investment would have 60 monthly roll yield contributions. 5

6 The Basics of Commodities Negative Roll Yield Example: Figure 3 shows the price structure of futures contracts for a sample commodity. In this example the futures market is trading in Contango. Contango markets are those in which the prices of contracts are higher in the distant delivery months than in the nearer delivery months. It shows that in respect of today: the spot price for a commodity is $10 the price of the 1 month futures contract (Contract A) is $20 the price of the 2 month futures contract (Contract B) is $30 However, in a month s time, Contract A will have reached its expiry date, i.e. the price of Contract A will be the prevailing spot price. Similarly, Contract B will now have 1 month to expiry and be the prevailing current 1 month futures contract. If we assume that there has been no change at all in price structure of the sample commodity, then its state after 1 month will be illustrated by Figure 4: the spot price or price for Contract A for a commodity is $10 the price of the 1 month futures contract (Contract B) is $20 Figure 3 Illustrative pricing of a commodity today Figure 4 Illustrative pricing of a commodity after 1 month $30 Contract B $30 $20 Contract A $20 Contract B Price $10 Current Spot Price Price $10 Current Spot Price = Contract A Current Date 1 month 2 month Current Date 1 month 2 month Thus an investor with $1,000, who wanted to maintain a continuous exposure to the commodity, would follow a strategy of initially buying the 1 month futures contract and just before that contract s expiry, roll it into the next 1 month futures contract. In our example, an investor would buy 50 Contract A today and pay $20. After 1 month, the investor would roll out of Contract A into Contract B. In other words, sell 50 Contract A at $10 and spend the proceeds to buy 25 Contract B. The table below shows the value of the investor s position. Date Contract Number of Contracts Price Value of Investor s Position Today Contract A 50 $20 $1,000 After 1 Month Just before roll Contract A 50 $10 $500 After 1 Month Just after roll Contract B 25 $20 $500 Although there has been no price movement, the investor has experienced a negative roll yield as Contract A has converged from the futures price of $20 to $10. The investor has lost $500. 6

7 Positive Roll Yield Example: Figure 5 shows the price structure of futures contracts for a sample commodity. In this example the futures market is trading in Backwardation. Backwardation markets are those in which the prices are lower in the distant delivery months than in the nearer delivery months. It shows that in respect of today: the spot price for a commodity is $30 the price of the 1 month futures contract (Contract A) is $20 the price of the 2 month futures contract (Contract B) is $10 However, in a month s time, Contract A will have reached its expiry date, i.e. the price of Contract A will be the prevailing spot price. Similarly, Contract B will now have 1 month to expiry and be the prevailing current 1 month futures contract. If we assume that there has been no change at all in price structure of the sample commodity, then its state after 1 month will be illustrated by Figure 6: the spot price or price for Contract A for a commodity is $30 the price of the 1 month futures contract (Contract B) is $20 Figure 5 Illustrative pricing of a commodity today Figure 6 Illustrative pricing of a commodity after 1 month $30 Current Spot Price $30 Current Spot Price = Contract A $20 Contract A $20 Contract B Price $10 Contract B Price $10 Current Date 1 month 2 month Current Date 1 month 2 month Thus an investor with $1,000, who wanted to maintain a continuous exposure to the commodity, would follow a strategy of initially buying the 1 month futures contract and just before that contract s expiry, roll it into the next 1 month futures contract. In our example, an investor would buy 50 Contract A today and pay $20. After 1 month, the investor would roll out of Contract A into Contract B. In other words, sell 50 Contract A at $30 and spend the proceeds to buy 75 Contract B. The table below shows the value of the investor s position. Date Contract Number of Contracts Price Value of Investor s Position Today Contract A 50 $20 $1,000 After 1 Month Just before roll Contract A 50 $30 $1,500 After 1 Month Just after roll Contract B 75 $20 $1,500 Although there has been no price movement, the investor has experienced a positive roll yield as Contract A has converged from the futures price of $20 to $30. The investor has made $500. 7

8 The Basics of Commodities Why invest in commodities? An investor may have a positive view on a commodity or commodities in general, and this may be reason enough to invest. However, there are two other reasons to consider commodities, particularly as part of a portfolio allocation. Diversification When thinking about building a diversified portfolio, it is important to remember the old adage, don t put all your eggs in one basket. Diversification is not only about the number of investments in your portfolio, it is also about the relationships among those investments. For example, adding one more technology share to a portfolio comprising only 15 other technology shares is not a particularly diversifying move. If the technology sector faces a downturn, the portfolio value will decrease no matter how many different technology shares are in it. One approach used by financial advisors is to build a portfolio whose individual elements tend not to move in lockstep in response to changing market conditions, so there are built-in buffers if certain asset classes, sectors, or styles should suffer. You should consult your qualified investment advisor for further guidance in relation to such investment strategies. Figure 7 Commodity prices and prices for shares and bonds usually respond differently to changes in market and economic conditions. The difference in how they respond to these global events and the timing of those responses can provide commodities with valuable benefits when combined with other financial assets. While diversification may not necessarily protect against market risk, the historically low correlation between commodities and financial assets means that commodities may perform well in neutral or negative years for shares and bonds. As such, commodities, while historically volatile in terms of their returns, in these circumstances, can lower the overall volatility of a diversified portfolio. However, it is important to remember that diversification is not a panacea for risk. For example, in periods of particular financial stress, such as the height of the credit crunch, most financial assets, including some commodities fell in value simultaneously. Index Correlations Correlation Coefficient S&P GSCI index Total return DJ-UBS Commodity Index Total Return sm Year 1 Year 2 Year 3 Year 4 Year 5 Year 1 Year 2 Year 3 Year 4 Year 5 S&P GSCI Index Total Return DJ-UBS Commodity Index Total Return SM S&P GSCI Crude Oil Index Total Return S&P 500 Index Barclays Capital U.S. Aggregate Index MSCI EAFE Index Sources: UBS, Standard & Poor s, Barclays Capital, MSCI Inc., Bloomberg (01/11/ /10/2011), based on dailly returns. Year 1 refers to 01/11/ /10/2007. Year 2 refers to 01/11/ /10/2008. Year 3 refers to 01/11/ /10/2009. Year 4 refers to 01/11/ /10/2010. Year 5 refers to 01/11/ /10/2011. Any data on actual or simulated past performance, modelling or back-testing contained herein is no indication as to future performance. Assets that have an inverse relationship, or move in exact opposite directions, will have a correlation of -1, while those that move in the same direction in tandem will have a correlation of +1. A correlation of 0 implies that there is no relationship. Commodities have historically had a low correlation with the performance of stocks and bonds. 8

9 Inflation Protection Though shares and bonds typically perform poorly during times of inflation, commodities tend to perform well because they are closely linked to rising prices in essential goods. Looking back at inflation and the performance of shares, bonds and commodities from , stocks and bonds have generally moved in the opposite direction from inflation while commodities moved in the same direction. As a result, some investors may use commodities as part of an inflation hedging strategy. Commodities are increasingly considered a part of many investors portfolio. However, commodity investment carries risk and particular circumstances may undermine the diversification and inflation hedge benefit. When considering investing in commodities or when building a portfolio an investor should consult with their qualified financial advisor for further guidance in relation to such investment strategies. Although it could be said that commodities have historically been a good inflation hedge, particularly in periods when commodity price rises were at the root of the inflation, this will not always be the case. Inflation may be a result of other factors, or impact commodity prices differently to the general price change, as such other asset classes may be a more suitable investment. Figure 8 Index total returns 300% PERFORMANCE IN % 200% 100% 0% NoV 06 NoV 07 NoV 08 NoV 10 NoV 09 NoV 11 Dow Jones-UBS Commodity Index Total Return SM S&P GSCI Crude Oil Index Total Return Barclays Capital U.S. Aggregate Index MSCI EAFE Index S&P GSCI Index Total Return S&P 500 Index Sources: S&P, Dow Jones, UBS Securities LLC, Barclays Capital, MSCI Inc., Bloomberg (11/ /2011), based on monthly returns. Index returns are for illustrative purposes only and do not represent actual ipath ETN performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and cannot be invested in directly. Any data on actual or simulated past performance, modelling or back-testing contained herein is no indication as to future performance. For current index and ipath ETN performance, go to 9

10 The Basics of Commodities What are some of the risk factors that should be considered? The performance of commodities and commodity indices are unpredictable. Commodity prices are inherently volatile and may be affected by numerous factors including liquidity, supply and demand, market activity, regulatory intervention, civil action, natural disaster and other geopolitical circumstances. You should regard commodity linked products as high risk. A physical investment in commodity is exposed to the cost of carry. Some investment products are linked to a physical investment in the underlying commodity. An investor should consider the performance impact of the cost of holding such physical assets, i.e. the cost of carry, such as the cost of the transportation, storage and in many cases potential for spoilage. An investment in commodities referencing a commodity index may be subject to additional risks. Although investments using commodity indices are popular particularly because of their ease of use, there are a number of risks an investor should consider. Commodity indices are subject to a roll yield. Many commodity investments will be referenced to commodity indices. As mentioned earlier, these investments are likely to be subject to a roll yield effect. This effect may be positive or negative and can lead to significant divergence, either positive or negative, between the return of the indices and the price of a physical investment in the commodity. Commodity indices may reference illiquid futures contracts. Indices are based on rolling futures contracts. The liquidity of these futures contracts will impact their price. As a result, the prices for such futures contracts may differ significantly from underlying commodity prices. A commodity index sponsor may change the commodity index. Commodity index sponsors reserve the right to adjust the composition or calculation methodology and may suspend or cancel the commodity index. This may have a negative impact on the performance of any investment linked to such an index. A commodity index may be substituted in certain circumstances. Investments linked to commodity indices will usually have the right to substitute the index in certain circumstances. Such action may negatively affect the value and performance of the investment. Furthermore, the investments are not guaranteed by an exchange and they do not confer any ownership of any exchange traded contracts. Why invest in commodities instead of commodity producers? Investing in shares of commodity producers has been seen as a substitute to investing directly in commodities. However, the performance of the shares of commodity producers and the underlying commodities may diverge significantly. For example, investing in an oil company will usually not give direct exposure to the movement of oil prices. The reasons for this is that an equity stake in a company exposes the investor to a number of other factors, such as specific financial and operational risk of the company, e.g. a company may be highly levered, or it may be more focused on the distribution of the commodity than in its manufacture. Furthermore, many commodity companies hedge the price of the commodity they are exposed to, e.g. to lock in a particular profit margin. The chart in Figure 9 shows the annual returns of a hypothetical investment in oil directly, as represented by the S&P GSCI Crude Oil Total Return Index, and exposure to the stocks of oil companies, as represented by the Dow Jones U.S. Oil & Gas Index. As you can see, historically these two indices have not moved in lockstep and may have moved in different directions. Figure 9 Annual Returns for Oil and Oil & Gas Companies ANNUAL RETURNS (%) YEAR dow Jones U.S. oil & Gas Index (oil company stocks) S&P GSCI Crude oil Index Total Return (oil) Index returns are for illustrative purposes only and do not represent actual ipath ETN performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index. Any data on actual or simulated past performance, modelling or back-testing contained herein is no indication as to future performance. For current index and ipath ETN performance, go to 10

11 How to invest in commodities? There are many ways of investing in commodities, but below is a brief summary of some common strategies for gaining commodity asset class exposure. Direct investment: While providing pure asset class exposure, owning physical commodities outright typically entails high transportation and storage costs and is not cost effective or practical for most investors. Futures contracts: Managed futures eliminate the transportation and storage costs but are best suited for institutional investors with the resources to meet investment minimums and manage derivatives contracts. Commodity funds: Commodity funds provide a viable alternative for the individual investor, usually offering broad based commodity exposure with relatively low investment minimums. However, some of the funds may not be regulated in the relevant jurisdiction and may not be appropriate for a less sophisticated investor. Exchange traded products: A range of exchange traded commodity products is available. These are often in the form of exchange traded notes or certificates. They provide an effective and easy to use investment, although the investor may be exposed to the issuer s credit risk. Please note that you should not invest in any commodity related investment unless you understand the risks involved of such investments (taking independent professional advice as you deem appropriate), and you are capable of assuming such risks. Barclays has issued (ETNs) designed to provide investors with a new way to access difficultto-reach markets. ipath ETNs provide investors with convenient access to the returns of key implied volatility and commodity indices (less an investor fee), and may be one of the most convenient and cost effective means yet of gaining exposure. Please consult your financial adviser before considering an investment in ipath ETNs. An investment in ipath ETNs involves risks, including possible loss of principal. In addition, ipath ETNs do not pay any coupon or dividends. For a description of the main risks involved, please refer to the Basics of ipath ETNs document available on the ipath website, and also see the Risk Factors noted in the applicable prospectus for the product in question. Please refer to ipath exchange traded notes (ETNs) ipath commodity etns Ticker Symbol Annual Fee* ISin ipath Dow Jones-UBS Commodity Index Total Return SM ETN DJUB GY / DJUB LN 0.75% DE000BC1C7J1 ipath S&P GSCI Index Total Return ETN SPGS GY / SPGS LN 0.75% DE000BC1DBG1 ipath S&P GSCI Agriculture Index Total Return ETN AGGS GY / AGGS LN 0.75% DE000BC1DBJ5 ipath S&P GSCI Energy Index Total Return ETN NRGY GY / NRGY LN 0.75% DE000BC1DBH9 ipath S&P GSCI Grains Index Total Return ETN SEED GY / SEED LN 0.75% DE000BC1DBK3 ipath S&P GSCI Industrial Metals Index Total Return ETN IMET GY / IMET LN 0.75% DE000BC1C7K9 ipath S&P GSCI Livestock Index Total Return ETN MOOO GY / MOOO LN 0.75% DE000BC1DBM9 ipath S&P GSCI Precious Metals Index Total Return ETN PMET GY / PMET LN 0.75% DE000BC1C7L7 ipath S&P GSCI Softs Index Total Return ETN SOFT GY / SOFT LN 0.75% DE000BC1DBL1 * The investor fee is the Annual Fee times the applicable closing indicative value times the applicable daily index factor, calculated on a daily basis in the following manner: The investor fee on the inception date will equal zero. On each subsequent calendar day until maturity or early redemption, the investor fee will be equal to the Annual Fee times the closing indicative value on the immediately preceding calendar day times the daily index factor on that day (or, if such day is not an index business day, one) divided by 365. Find Your ipath 11

12 DISCLAIMER THIS DOCUMENT IS AN INDICATIVE SUMMARY OF THE PRODUCT. It has been prepared by Barclays Capital, the investment banking division of Barclays Bank PLC ( Barclays ). It is subject to change. THE PROSPECTUS AND FINAL TERMS FOR ALL RELEVANT ETNs ARE AVAILABLE ON THE WEBSITE THIS DOCUMENT IS FOR INFORMATION PURPOSES ONLY AND IS NOT BINDING. Barclays is not offering to sell or seeking offers to buy the Products described in this document. Any transaction requires Barclays subsequent formal agreement which will be set out in binding transaction documents and which is subject to internal approvals. THIS DOCUMENT DOES NOT AND CANNOT DISCLOSE ALL POSSIBLE RISKS RELATING TO THE PRODUCT. Before investing, you must satisfy yourself that you fully understand the Product and the risks of investing in it. YOU SHOULD OBTAIN INDEPENDENT PROFESSIONAL ADVICE BEFORE INVESTING IN THE PRODUCT. Barclays is not your advisor or fiduciary. In any resulting transaction, Barclays will act as principal. It is not advising or recommending investment in the Product or making any representations as to suitability. Barclays is not responsible for the accuracy or completeness of information stated to be obtained or derived from third party sources or statistical services. Dow Jones, DJ UBS, Dow Jones-UBS Commodity Index SM, DJUBSCI SM and Dow Jones-UBS Commodity Index Total Return SM are servicemarks of Dow Jones & Company, Inc. ( Dow Jones ) and UBS AG ( UBS AG ), as the case may be, and have been licensed for use for certain purposes by Barclays Bank PLC. The Securities based on the Dow Jones-UBS Commodity Index Total Return SM are not sponsored, endorsed, sold or promoted by Dow Jones, UBS AG, UBS Securities LLC ( UBS Securities ), or any of their respective subsidiaries or affiliates and none of Dow Jones, UBS AG, UBS Securities, or any of their respective subsidiaries or affiliates makes any representation regarding the advisability of investing in such Securities. Standard & Poor s, S&P GSCI, S&P GSCI, S&P GSCI Index, S&P GSCI Index Total Return and S&P GSCI Commodity Index are trademarks or service marks of The McGraw- Hill Companies, Inc and have been licensed for use by Barclays Bank PLC in connection with the Securities. The S&P GSCI Index, the S&P GSCI Index Total Return, the S&P GSCI Energy Index Total Return, and S&P GSCI Commodity Index are not owned, endorsed, or approved by or associated with Goldman Sachs & Co. or its affiliated companies. The Securities are not sponsored, endorsed, sold or promoted by Standard & Poor s, a division of the McGraw-Hill Companies, Inc. or any of its affiliates ( Standard & Poor s). Standard & Poor s does not make any representation or warranty, express or implied, to the owners of the Securities or any member of the public regarding the advisability of investing in securities generally or in the Securities particularly or the ability of the S&P GSCI Index or any of its subindices to track general commodity market performance. If you on-sell any Product described herein, you will comply with all applicable regulations, and to the extent required you will fully disclose any fees or commissions received or paid by you in connection with such Product. YOU ARE RESPONSIBLE FOR COMPLYING WITH ANY APPLICABLE LAWS AND REGULATIONS IF YOU OFFER, SELL, RESELL OR DELIVER THE PRODUCT OR DISTRIBUTE ANY OFFERING MATERIAL RELATING TO SUCH PRODUCT TO THE PUBLIC IN ANY JURISDICTION. Barclays is authorised and regulated by the UK Financial Services Authority and a member of the London Stock Exchange. Barclays Bank PLC is registered in England No Registered Office: 1 Churchill Place, London E14 5HP. Copyright Barclays Bank PLC, 2011 (all rights reserved). No part of this document may be reproduced, distributed or transmitted without Barclays written permission. Find Your ipath