Skip to main content

Inventory Level Analysis -- more gains in store for oil?

Having recently invested in the PowerShares DB Oil Index ETF(DBO), the following statement caught my interest today:

"New work published by Gary B. Gorton of Wharton, 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."

Clearly, the average investor would find it difficult to know with any accuracy what the inventory levels are for most commodities. Gorton and colleagues have determined that investors can infer inventory levels from futures- and spot-pricing data.

Here is the background as Gorton and his associates describe it:

"The new work looks at the key role played by inventories -- commodities stored for future sale. Inventories serve as buffers against fluctuations in supply, and the Theory of Storage says that when inventories are low, spot prices are more volatile, since commodity buyers cannot be certain of sufficient supplies.

Futures markets provide insurance against future price volatility. So, when low inventories heighten the risk of price volatility, the cost of this insurance can be expected to rise. That translates into bigger returns for the contract holders who take on these bigger risks."

To investigate the premise, they looked at three types of portfolios comprised of 31 commodities over the time period from 1969 through 2006. One portfolio was based on high-inventories, one was based on low inventories and one was a simple index composed of equal amounts of each commodity. The high-inventory portfolio returned 4.62%, the equal weight portfolio returned 8.98% and the low-inventory portfolio returned 13.34%.

So how identify those commodities with low inventory? Investors can look at the difference between the spot price today and futures prices. When inventories fall, the spot price rises because supply is low relative to demand. The futures price may rise as well but not so much, because traders believe inventories will gradually be replenished before the contracted delivery dates arrive. As a result, the gap between spot and futures prices widens. The wider the gap, the the higher the potential return

Gorton and his colleagues looked at holding a basket of the commodities with the best indicated returns based on the difference between spot and futures prices. What if we looked at one commodity, crude oil, example.

As of 11/1, the spot price of crude oil was $93.49. The December contract is the same. But starting with the January contract, the futures prices begin to decline. By April, it's under $90. Futures prices continue to decline for each month's contract by roughly $.60 per month.

So it appears we don't have a major gap between crude oil spot and futures prices but it appears there may be enough of a gap to support prices in the current vicinity. Heating oil and natural gas show very small gaps.

Looking at wheat and corn, the gap is in the opposite direction, indicating high inventories. Similarly, metals are not displaying futures prices that indicate inventories are tight.

Using this approach, it appears that oil is the place to be if you feel the need to invest in the commodity markets.

Sources: The Inventory Code: New Ways Investors Can Cash In on Volatile Commodities, futures prices courtesy of Barchart.com

Disclosure: author is long DBO

Comments

Popular posts from this blog

Brazil - in a bubble or on a roll?

A couple of years ago, no one recognized the real estate bubble even though it was under everyone's nose. Now, analysts and bloggers are seeing bubbles everywhere they look. One of them, they say is in Brazil whose Bovespa stock market index has doubled in the last 12 months. Does the bubble accusation hold water? I don't think so and here are 7 reasons why Brazil is by no means a bubble economy: Exports have held up over the past year thanks to demand from China for Brazil's soya exports and iron ore. This was helped by the the Brazilian government's drive to improve trade links with Asia and Africa. Export diversification, spurred by a more active trade policy and increased focus on "south-south" trade under current president Lula, helped mitigate the decline in demand from OECD (Organization for Economic Co-operation and Development) countries A "sensible" economic framework has been in place since the 1990's. This has included inflation

Thursday Bounce: Trend Busters, Swing Signals and Trend Leaders for July 9, 2009

This is a quick post to announce that we have published Thursday's Trend Leaders, Swing Signals and Trend Busters at Alert HQ . All are based on daily data. Today we have the following: 72 Swing Signals -- A couple of days ago we had 35 signals, today we have twice as many. Happily, we now have 65 BUY signals, a mere 4 SELL Signals plus 3 Strong BUYs. Whoo-hoo! 56 Trend Leaders , all in strong up-trends according to Aroon, MACD and DMI. There are 18 new stocks that made today's list and 60 that fell off Tuesday's list. 48 Trend Busters of which 5 are BUY signals and 43 are SELL signals The view from Alert HQ -- Talk about mixed signals. If you look at our Swing Signals list you would think the market was in the middle of a big bounce. BUY signals are swamping the SELL signals and we even have a few Strong BUYs. Yes, there's a good sprinkling of tech stocks and tech ETFs but the distribution is pretty broad-based with a good number of different sectors represented, eve

Trade Radar gets another update

Some of our data sources changed again and it impacted our ability to load fundamental/financial data. In response, we are rolling out a new version of the software: 7.1.24 The data sourcing issues are fixed and some dead links in the Chart menu were removed. So whether you are a registered user or someone engaged in the free trial, head over to our update page and download the latest version. The update page is here:   https://tradingstockalerts.com/software/downloadpatch Contact us if you have questions or identify any new issues.