Animal Spirits Podcast - Talk Your Book: Investing in Commodities

Episode Date: March 2, 2020

On this week's Talk Your Book Michael and Ben talk all things commodities with Yale's Geert Rouwenhorst and John Love from USCF Investments. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by USCF Investments. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rittholds wealth management may maintain positions in the securities discussed in this podcast. On today's show, we spoke with John Love of USCF investments, as well as

Garrett Rowanhurst of the Yale School of Management. And we spoke all about commodities and Geert's research and primarily crude oil and how investors can get exposure to it through an ETF. I liked this chat because we had a good balance between someone who straddles the fund world and the academic world and and someone who's just in the fund world. And Geert came prepared with a lot of data and stats and papers because he's written a lot about this. So I thought that his background did this was interesting because he's got a new paper out that he was talking about.

It's called the Commodities Future Risk Premium, where he looked at futures of commodities going back to 1871. So it was like 1871 to 2018. When did he publish that? So it was just published in September 2019, it looks like. It's on SSRN. Was that an update to one that he did previously? He's written a lot on commodities in the past.

This is a new one. I think he went further back than he. I think in the past he'd gone back to the 50s or 60s maybe. But he said he found 230 commodities futures that traded between 1871 and 2018. A lot of them are no longer available. But apparently, and he mentioned this on our talk, that it was actually not that hard to find some of these old commodity futures. But I thought one of the more interesting aspects of this was, so we talked specifically about the USO ETF. And USO stands for United States oil. So it tries to track the future's price for the

oil. And this was kind of a good myth-busting one for me, because I think I've written about this fund in the past about how it does not, if you see the price of oil on the news or on Yahoo Finance or one of these places where they show the per CNBC, where they show what the price of Brent crude is doing or whatever that day, there is no way, unless you take delivery of that of a barrel of oil, that you can get that exact price. And even if you could, you'd have to pay to store that somewhere, buy the barrel, I guess, something. So...

Wait, can I do a bit of an actually? Sure. I thought that this actually does track it fairly well on a day-to-day basis. But if you're looking at like six-month or one-year returns, that's when there can be a bit of a spread. Okay. Yes, because that's the cost of... It's just like a little bit over time that builds up.

So tracking it perfectly is impossible to do because you're not going to actually have 30 barrels of oil in your backyard, unlike you who has gold bars buried under your mattress. So you look at the difference between the returns to those and you think, well, this is crazy. Why can't they do it? And he gave a, they both give a very good explanation on the podcast about why this is the case in explaining the difference between futures and then that price that you see. So we spoke to the conversation about the people that are using this. And I forget where the exact shakedown laid, but I feel like this has been out there so much. that most investors probably have some sort of understanding of what they're getting themselves

into. And I don't mean that to sit in a bedway, only to say that this is not the spot price, because to your point, the only way that you get exposure to the spot price is by taking delivery. And of course, there's all sorts of fees involved with that. So what they were saying was that any sort of differential that you experience on the downside, think of that as a storage cost. Right. And we've talked about this in the past, how commodities generally make for a better tactical investment than buy and hold. I think gear. maybe tries to make the point that it could be a buy-in-hold of by diversified. So he wrote this facts and fantasies about commodities futures in 2005 with Gary Gordon. And he talked about

how fully collateralized commodities futures have historically offered the same return in sharp ratios of equities. While the risk premium is essentially the same, they're negative correlated with equity returns and bond returns, which sounds great. I will say there was a paper by Claude Irb and Cam Harvey. Cam Harvey, who was on a compound a couple months ago, talking about the inverted yield curve, which is, I think, a signal that he more or less put on the map, they wrote a paper called the Strategic and Tactical Value of Commodities Futures, and they questioned some of these things. So I guess there's a little bit of a fight in the academic circle, so this kind of reminds me of the Anchorman News teams fighting it

out over commodities futures a little bit. But Geert made it, he made a strong case for it with us. I still don't know if I totally agree that it hasn't been completely changed by the number of speculators, but his point was, yes, there's more speculators, but there's also more hedgers. Well, he said the ratio, because I asked that question, he said the ratio of hedgers to speculators has actually not changed. So I just assumed that it did. He's like, no, actually, that's not true. So I thought that was interesting. But I think here's where I come down in this debate. I think I would tend to agree that commodities are best used tactically. So I would imagine for most people, that means some sort of trend following signals. But I can fully support the idea behind

the permanent portfolio. So some variation of stocks, bonds, cash commodities, you know, in whatever derivation you want in terms of waiting. Here's the problem. And I guess you could say the same thing with stocks. So let's say bonds have had a really rough decade. Well, maybe that's recency bias because it's not as if stocks don't have rough decades. As a matter of fact, in 2009, that was a loss decade for stocks. So again, maybe this is just recentcy bias on my part. That being said, I feel like anything that deviates too far from what's quote unquote normal or commonly accepted asset allocation is difficult for a lot of people to stick with mentally emotionally, even if all of the mathematical arguments for lower, better diversification, higher sharp

ratios, all of those sort of things I get intuitively academically. But in the real world, I think it just is not as easy as it might seem. Negative correlation works better in a portfolio optimizer than it does in real life sometimes if you don't understand how this stuff works. And even if the returns are lower than the risk premium, you could return. return on, get on stocks, having that negative correlation with this massive boom bust mentality in nature of commodities, actually, with all that volatility, if you use it as like a rebalancing bonus, it probably could add something to your portfolio. It's just, again, how many people are willing to stick with it. Well, so that's the thing. If you, if you put this

into a portfolio over 20 year period and you never look at it, I can make the case that it would outperform a portfolio of traditional just stocks and bonds. Like, I could definitely make that case based on what you just said, even if the returns are lower. which, you know, maybe they will be, maybe they won't be. But again, we don't live in 20-year periods. We live in the real world. And it's just, you just got to be aware of what you're getting yourself into. So here is our conversation with Geert, Rowanhurst, and John Love. I hope you enjoy it. We are sitting here with John Love, president and CEO of USCF investments, and Geert, Professor of Finance at the Yale School of Management. He is also a partner at Summerhaven Investment

management. John Geert, thank you so much for being on the show today. heaven us. So, Geert, you wrote a very influential paper called Facts and Fantasies about Commodity Futures. Let's start there. What were some of your key findings? So it was 2004 and people were interested in taking exposure to commodities as an asset, but had no idea what the risk and return properties of the asset class were. So together with a colleague at Wharton at the time, Gary Corton, we wrote a white paper and tried to document long-term historical returns. on a diversified portfolio of commodity of future. So you take exposure not to just a single commodity.

It includes oil, energy, metals, agricultural, anyway, just a broad-based portfolio. And we found that the return that investors historically had earned was in many ways similar to equities in terms of long-term average returns, in terms of volatility, but surprisingly had very little correlation to stock market or to the bond market, for that matter.

So it means that if you were to add commodity futures to our portfolio, you get a lot of diversification. So your risk of your portfolio would go down, but you basically would maintain your return. And I think that's something that many investors would like. So how far did you go back? Where did you get this data and how reliable do you think it is? At the time, we went back to 1959, which was about a 45-year history at the time, which is a substantially long history. And I think we really focused on all futures that had been available for investment since that time.

So it really covered the whole broad market. So that was real data. It was real data. And it was sort of collected by people through the exchanges. So it was all very good data. So I think these results were pretty reliable. And how many commodities are we talking about here to give people in a sense of what diversified means in this space? At that time, we probably looked at a sample of about 40 commodities.

More recently, we've really taken that effort a step further, and we have gone back to really the origin of futures trading in the United States, and we've basically collected data all the way to the 1870s, which is very close to the inception of futures trading in the United States. Did the risk and return parameters match from 1871 to 1959 from 1950 to today? In many ways, it did. The purpose of that study was primarily to focus on a relatively narrow question. So I think the reaction to the facts and fantasy study was really just people were kind of pretty surprised. And I think it was pretty easily accepted that commodities had a positive inflation beta. They helped you in times of inflation. It was also pretty easily accepted that commodities would diversify your portfolio. I think what was harder to understand why commodities had a risk

premium. So why you would actually earn an equity like a return. So given the challenging period, challenging last five years for commodities, I think that thesis has come under a little pressure. So what we have done in this long-term study is really just focus on this return-generating behavior of commodities. And surprise, surprise, the returns that you would have earned between 1870 and sort of the 1960s when we started our facts and fantasy study, they were actually as good or even better than we had originally documented in our paper. You mentioned the last five years have been tough for commodities. the biggest reason the inflation piece, or are there other factors that play here that have made

commodities kind of a drag on portfolios? I think there's really two reasons, and they're not completely independent. One is that indeed inflationary expectations has been adjusted down, and clearly just as commodities are being helped in inflationary periods, they will suffer during periods where inflation is basically adjusted downwards. I think the second piece is that is actually the dollar. We've seen some dollar strength, and if you think of commodities, prices is being set in a global world market, in the common currency, then if the currency that we're measuring things in the dollar, if that's appreciating, then we'll actually put a downward pressure on commodity prices in dollar terms.

So I think both of these factors have had a negative influence on commodity prices. Is there any impact of technology over the longer term where we would think that technology is almost this deflationary force? And people say that maybe the invention of the Internet is deflationary. And obviously maybe that doesn't impact commodity. prices per se, but is technology a factor in that? So it is potentially a factor in the setting of spot prices. I mean, just technological progress has, I think, put a downward pressure on commodity spot prices. We can go back to the early days of aluminum trading when aluminum prices were

really high and they have only come down because of the invention of electricity. In same way, crop yields have increased for corn and soybeans and that has put a downward pressure on those prices. It's been easier to manufacture them? Easier to manufacture at lower costs. So to the extent, as economists say, price equals marginal costs. Marginal costs have gone down, prices go down. But here's the rub. We're actually not investing in spot prices.

We're investing in futures. And somehow futures is sort of a bet in the spot price. And it will typically take into account that spot prices might be expected to fall. So the argument is a little bit more tricky to think about the things in future's terms and in terms of spot prices. So it's been sort of a perfect storm in a bad way against commodities in terms. terms of we haven't even discussed oversupply of oil, which we'll get to. I'm surprised that prior to 2004, this was somehow a revelation. Maybe I'm being naive, but commodities are a giant market. Nobody had

studied the risk and return parameters? Well, the answer is, yes, people had done this. But what people had done is looked at individual commodities over relatively short periods of time. So it's a little bit asking yourself, so do stocks have a risk premium? And you're looking at 10 years of date on IBM. So there's lots of volatility that will mask the measurement of risk premiums. So what you really need to do in order to measure these premiums is take portfolios of stocks and long time periods. That's when these premiums sort of manifest themselves. Let's talk about portfolios. So if fully collateralized commodity futures do in fact offer the same return and sharp of equities and are negatively correlated with stocks and bonds, as your paper suggests, then what are the

implications for investors constructing diversified portfolios? Well, if you actually put these numbers in an optimizer. You get allocations where you say, let's put half your money in commodities, half in equities. Forget about bonds. People are not going to do that, obviously. But I think another take on this would be to say the optimal allocation of commodities is probably not zero. We can confidently say that. And that's still where many people are. And so I think the broader message of the research is to say, how confident are you really that you want to put all your risk in your portfolio in the equity bucket, which many investors have, considering. considering especially where the market is trading these days, maybe it's a good time to take

advantage of the low in commodities and sort of spread your money around a little bit more. You mentioned the difference between understanding futures versus spot. Maybe you could take a step back and just walk the audience through what those differences are in terms of the prices that they're seeing that go across the ticker versus what the futures market is actually doing in commodities. So I think on a day-to-day basis, futures and spot prices are very highly correlated. So they move pretty much in lockstep. But I think what the futures market does, it takes into account expected movements in the spot.

Just as stock prices take into account expectations about dividends, futures prices take into account expectations about spot prices. So to the extent that spot price movements are predictable, they actually don't really are a source of return to a futures investor. So it is really just where the futures price at today is set relative to the expected spot price tomorrow, that's the expected return that investors can expect to earn. And what's the spot price? The spot price is the price that the commodity trades for in the physical market.

So, in other words, you can't invest in the spot price unless you are buying oils and putting them in your backyard. So basically, that's another good point. Spot investing is basically impractable for any investor. So when you see the price of oil go up by 10%, it doesn't mean that you as an investor can actually earn 10%. You earn something that is less than 10%. And if you actually held physical oil, really what you would need to, what you would get as an

investor is the spot price appreciation minus storage cost. That storage cost is usually people easily forget about when they see oil prices move around, but it's actually something that manifests itself in the futures. So when you actually look at the futures return, it will implicitly subtract that cost of storage and that sometimes that is called contango or under a variety of names, how it manifests itself. But that's one of the reasons that when people actually invest in futures-based ETFs, they don't always exactly get the appreciation in the spot price. But they actually, what they really get is the appreciation of spot price net of storage. Which is a good lead

into a product like USO, which tracks price of oil, and why people would see this difference between the spot price they're seeing that's shown on the news versus the return they're getting in that ETF. You can talk a little bit about why that is using this idea to jump off Sure. I mean, a great way to illustrate the points Geert just made is to look at U.S.O and to look at the spot price of oil. Over the years, as Geert said, on a daily basis, if oil's up 1%, U.S.O is most likely going to be up about 1%, maybe 9.9 basis points, maybe 101, but it's going to be very close to what crude did on a particular day. But if we were in this condition called contango, which is where the futures curve is actually upward sloping, so the spot price is, say, $50, and the future, is slightly above that. And as you go out in time, maybe the second month future is 51. The third month is 52. That's what we call contango when the futures curve is rising. It looks like a

yield curve. It looks like a yield curve. That's a very good way to look at it. And the opposite of that is called backwardation. That's when the futures price gets cheaper as you go out on the curve. So you could start at $50, go down to $49, 48, and so forth. So the way this plays out is that when you're investing in futures, and especially if you want the highest beta to the spot that you can get on a daily basis, then you want to be in the front month contract. If you say buy the front month contract at $50 and you're having to roll every month to the next month, what you might be doing is say buying at $50, rolling to the $51 contract. And what happens over the next 30 days is that contract approaches expiration, it drops towards the spot price. So you kind of have this deterioration

of the price. I'm assuming the spot price doesn't change that it stays right at 50. So Contango can be a headwind against your return. It doesn't mean that you can't make money. It just means it's one factor that could potentially eat away at that over time. And then backwardation is the opposite. It's actually kind of like a roll yield, or it's called a roll yield, either direction. It can be positive or negative. You get paid for that. You get paid for that. You get paid to hold the future. So even if the spot price is $50, when it's in backwardation, you're actually rolling down to a $49 contract, which will then appreciate it up to spot over the course of the month. And then you repeatedly do that. That's kind of it in a nutshell, and I can give you some examples.

There's a lot that goes on behind the scenes of running a fund like this that a lot of the investors probably don't even realize. Correct. Yeah, how does that work inside of the ETF wrapper? What is actually going on? So what we're doing is we're trying to replicate as close as we can what an investor would actually experience by practically investing in crude oil. As Geert said, that means investing in futures contracts. It's not practical to go out and buy barrels of oil. And even if you do, you're always going to have the cost of storage.

and maybe insurance and maybe transportation if you're moving it somewhere. So it's practical to invest in things like gold, things like that, but it's a little challenging when you look at a commodity like crude oil. So one thing I would, I guess, draw people's attention to is that's what we're trying to do is we're trying to replicate that practical experience. But if you are an individual investor and you're investing in futures contracts, you've really got to pay attention of that position. You've got to roll it in time because if it expires, you suddenly are the owner of physical crude oil, which you either have to trade in the OTC market or take delivery of... Ben learned that lesson the hard way. So hopefully not a swimming pool full of oil, but it's definitely

something that you have to watch. The other things you have to do is you can trade futures on margin. A smart investor will not get too overextended, but we fully collateralize the ETF. So if you want to invest $100 in oil, there's $100 of cash or treasuries in the funds. So there's no leverage. Exactly. But if you're an individual investor, you might put up, say, 10% of that cost, and you've got to monitor that and deal with margin calls, things like that. So those are some of the things we're dealing with is roles in margin and meeting margin. So I understand that it's hard to track the flows of ETS, but how do you think people are using this? I'm sure there's a wide range in terms of being tactical. It's a core holding. Talk about where this fits in a portfolio.

Sure. Well, I think if you're looking at a single commodity ETF, then I think most people look at that tactically. I mean, just like if you are trading a single stock like Amazon or something like that, you've got to be a little more focused on it. It's not just like investing in a broad fund where you can say, hey, I want an allocation to X, Y, or Z, and this is going to be it. And I'm just going to put that in my retirement portfolio and let it go. You can do that with a broad commodity fund, but with a single commodity like U.S. like oil or natural gas or something like that. that you have to be a little more focused on that. So I think people do use it tactically because of that contango and backwardation factor, which we'm happy to talk about more. But it's something you want to be cognizant of as you're looking at that position and know where it's going. So basically, the longer you hold it, the more likely there is that you're going to see

decay. Potentially or more likely you'll see the benefit of a positive role yield if you've got that downward sloping curve. So, and I'll get into that in a second. I think just stepping back from all the technicalities, let's realize why these products were great innovations. So if you, in the olden days, wanted to take exposure to oil, there's really only two ways you could do it. You could try to own physical oils, completely impractical for investors. The other is you would maybe buy a stock in an oil producer. Then you get more than the price risk of commodities. You also get management risk, all kinds of other things, risk of oil spills, all these types of things. So what the innovation allowed,

investors to do is basically trade physical oil minus storage costs in the four, just like you would trade a stock. Purely, it's almost like a barrel of oil that automatically would subtract the cost of storage from its return. And you could do that with enormous liquid, but data liquidity and in large volumes. And I think that's really why this product has been so successful and had sort of appeal. So I think I agree with John that for a single commodity, probably you would make this, you would take this exposure for tactical reasons. But if you want to commit sort of more broadly to the asset class and take advantage of the diversification, then actually there are long-term benefits to doing this. Speaking in terms of trying to be tactical, what are the

things that have been impacting the price of oil over the past decade or so? We talked earlier before we started taping about in June 2008, the price of oil hit $150. We're still obviously well all that, even though oil was up pretty decently last year. What are some of the things that are impacting that? Right now, everything. I mean, it's kind of funny. I mean, there's times you can say that it's one specific factor or another, but we've really been jumping around from week to week to different factors that are having more of an impact than another. I mean, if it's right now today in the last couple of days, it's clearly fears on the demand growth side with what's going on with China and the coronavirus that's spreading. So we're in the early

stages of that and we'll have to see how it plays out. But that demand growth is really critical right now. We have supply and demand fairly closely aligned. As you know, a few years ago, we had a glut of inventory in the United States and globally. Let's come down somewhat. We're about 80% down from the peak in terms of stockpiles. But supply, especially in the U.S. and starting to occur in other countries, has grown dramatically. We just hit 13 million barrels a day of U.S. production. And that's probably going to grow a little bit more this year. So OPEC has been trying to hold the line by cutting production. They've been more committed than they have ever been before in a cutting regime

to keeping their production level down or their delivery level down. But U.S. supply and non-OPEC supply keeps growing. So with that happening, demand growth is really essential. And so anything that threatens that like this virus is consequential. It's almost comical. I mean, we went from last week where we finally signed. the trade one trade deal with China. And there was some enthusiasm in the market that, okay, we're going to get some demand growth back online. And it was literally within a matter of days,

the virus rose to be a kind of counter to that saying that this might affect demand growth. So there's a lot of things at play right now. So outside of the macro factors like that, that could be a news event, what are sort of the fundamentals that people need to look at when they're thinking about commodities in terms of hoping for better performers in the future? Well, generally, obviously, supply demand. I mean, economics 101, something is expensive. It's going to encourage people to produce more of it. Something gets cheap. They're going to shut in production that will kind of rebalance the market. But you're always kind of bouncing back and forth between those extremes. So supply demand needs to be looked at inventories. The most reliable signals looking at U.S. inventories. Like I said, we're down about 20 percent from the highs of, I think we hit 535 million barrels in 2017. We're down to about 440 barrels, million barrels of supply or of inventory sitting in stockpiles in the U.S. right now. So that's come down a bit, and a lot of that's due to what OPEC has done.

Meanwhile, like I said, production has gone up. So you want to keep an eye on what OPEC is doing. That's a big factor. It's not as big a factor as it used to be because of non-OPEC supply. They used to be able to control the market. Now they can only kind of steer it one direction or another with announcements and policy and things like that, but not nearly to the extent that they could. we could talk about geopolitical events. I think that was something on the agenda as well. That's

another thing altogether. There's a lot. And you said what affects oil? It's everything. I think Howard Marks once said there is nothing intelligent that could be said about the price of oil. Something along the line. So, Professor, I'd be curious, have you done any sort of regression analysis to see, like, what is actually driving oil? Because it seems like it is the most sensitive commodity, maybe natural gas even more so. But like, there are so many forces at play. If you could just say, okay, it's this. What moves the price? Well, it's ultimately, it's demand and supply shocks relative to inventories. The thing is that the production of oil can only take place along a certain sort of steady path. There's an optimal rate at which you extract oil from the ground.

And while we can speed it up maybe a little bit or slow it down a little bit, that's basically the supply is essentially inelastic. So since we can't speed it up or slow it down, we have to kind of hold buffer stocks above ground inventories in order to deal with any short-term increases on demand and supply. And when these inventories are getting low, then the ability for the market to absorb any unexpected news is being diminished. So the volatility research has shown really stems from periods when inventories are drawn down and stuff happens, either positive or negative. That drives the volatility. And that's actually. actually, for an investor, that's actually also the time your expected returns are high.

I mean, commodity markets are really no different from equity markets in the sense that we think there's a relationship between risk and return. And when risk goes up, returns go up. And so it's not necessarily, the directional return is also good, but your expected return is higher in high volatility scenarios and a low volatility scenario. So calmness is not a friend of the commodity investors. Disruptions and chaos. If investors are setting long-term expectations for some of the commodities, obviously that's kind of where they differ in the fact that you're not banking on cash flows or income streams or dividend yield. So how do you set expectations? Or is the expectation that you have this one economic environment inflation kind of protected to this part of

your portfolio? Is that more the idea? I think there's two ways to think about this. I think maybe the easiest thing that I find is that ask yourself, what is the role of futures markets to begin with in the economy. And basically, hedgers use it to lock in prices and reduce risk. Who are hedgers? Hedgers are going to be oil producers. They could be farmers. They could be airlines who actually use the commodity as an input. And so these are people who basically either buy or sell large quantities of a commodity and like to lock in prices and basically buy insurance. So that's basically one side of the market. The other side of the market is investors who are going to basically provide an insurance. So it turns out that, and we can go back 100 years to find

that same setup in markets, that people are hedge or hedgers are typically short in the market because these are typically the people who produce the commodities and basically buy the insurance. And when they lock in prices by going short, they do so at a discount. They actually accept a lower price than the current market price or the expected future price because they're actually buying insurance. So that discount, that discount is the premium that investors earn by going long. So it's a long story, but that's really the source of the expected return. So that makes good sense. I wonder structurally, over time, you had the hedgers, now you have the speculators and the giant funds. How does the sort of math change when you have so many more speculators

willing to provide more insurance? Like, how does that change the potential dynamics? Well, if we first have to make sure that that's true, it's true there's more speculators in the market. but there's actually also more hedger than the market. So when these speculators came to the market and say, I'm willing to provide insurance, then the hedgeer said, well, maybe I want to buy more insurance. So in some sense, when you look at how the markets have developed, they actually have organically grown.

And the CFTC every week publishes reports about the composition of market participants. And what you find is that actually the proportions of hedgers to speculators has been remarkably constant and stable, despite the fact that somehow the press gives you an idea that there's so many more speculators. But the flip side of it is who takes the other side of that market? And it turns out the number of hedgers have increased too. Pye has gotten bigger for everyone you're saying. That's correct.

That's interesting. So what drives the price between the supply and the demand? Is it on the financial side? Is it the buyers and sells the futures or is it the consumers of the product? Where do you see that balance? I think it ultimately it's the spot market that nails down that price. because ultimately it's the futures price that as a futures contract goes towards aspiration and sort of maturity, basically it converges to the spot price.

So it's ultimately, those the markets get tied down by the physical market. So it's ultimately the fundamentals of physical demand and supply that determine the outcomes of futures. Interesting. Yeah. We see a scenario where for some reason the next 20 to 30 years continues to be this period of low inflation, interest rates stay low. We never really get this huge kick up. Is this a forecast? No, just throwing it out there. Scenario analysis. Growth stays low.

Does that potentially a poor environment for commodities reaching out that long, or is there other factors at play there? So remember that futures investors look at the spot market and incorporate all these expectations, your expectations when they set the futures price. So I think the key piece that's relevant from what you're saying in your description, your assumptions is that the market is going to be low growth and there's going to be a relatively low increase in demand of commodities. But it looks like you described it as a pretty stable world. So in a stable world, Ben's an optimist. Ben's an optimist. I'm just throwing it out there. I'm not saying that's going to happen. So let's stick with that for now. So in a world where there's not a lot

of uncertainty. I guess the risk is low and I would think the expected return is low. But there will always be surprises. On average, we may think that the world is stable, but there will always be a strike somewhere. There'll be some bad weather and some other places. And so I think that will basically keep commodity markets alive and fuel people's interest. Well, I think one of the things that is often missed when you're talking about this is that it is a piece of a portfolio and it can have benefits above and beyond outperforming stocks or bonds, for that matter. There can be benefits, rebalancing benefits, diversification benefits, even if it does continue to have returns that don't match your stocks.

I'll tell you, if I could go back and talk to my 25-year-old self, and well, obviously, with hindsight, I'd tell myself to invest in Amazon. But, I mean, the smart thing to do is to put together a diversified portfolio. And unless you're a professional trader, you're monitoring this every day. And even then, got to be right, which is the odds are you're going to be right sometimes. You're going to be wrong sometimes. The antidote to that is to have a diversified portfolio. And we view commodities as kind of that first alternative after stocks and bonds,

obviously you have real estate, you have many other things you can go to. And I think people should have a well-rounded portfolio. Look at emerging markets and things like that. But there may be things that over the last X number of years haven't done great. That doesn't mean over the next five, 10, 20 years, they're not going to have a tremendous impact at different times. We don't know necessarily when those times are going to come. So we view commodities as a really critical component of any well-rounded portfolio. If you're ignoring commodities, you're ignoring a source of differentiated returns that you can't replace in hindsight. So, all right, let's just stick with that for a moment.

We know that commodities have been one of the worst performing asset classes over the last decade, even though I was surprised to learn that oil was the best asset class in 2019, up 32 percent, something like that? I did not know that. So is it possible that there's a sort of investor's fallacy going on to think that, oh, because returns have been so bad, they're going to be good? What do we think the past means for the future? I think it's very difficult with anything to predict.

the future, what's going to happen tomorrow next year based on recent past. I think the key thing to do is to look at really the long-term research like Geert has done in which he and his partners have recently expanded. This is fundamentally how the economy works. This is fundamentally how these asset classes work and how they relate and look at that. Trying to pick, well, this is going to be the number one asset class next year or in the top three. Waste of time. It's a waste of time. Now, I will say that, yeah, I mean, this decade has been incredibly changed. challenging for commodities. You've had a runaway stock market. You've had low interest rates and you've had commodities basically running fairly flat to down depending on the commodity. And it's been a

challenging time. But that is, I think, one of the key things to look at, again, long term is that is in no way normal. A lot of times if you go back 30, 40 years, commodities and equities kind of dance around each other. Sometimes one's the best asset class. Sometimes it's another. But you don't really have these gigantic divergences like we've had in the last 10 years. So I don't know when exactly that changes, but I think that it's run quite a long time. And I would be queasy about not having exposure. I'm sure you've seen the chart of the S&P relative to commodities. And I think there's a bit of a chart crime going on. I don't think that's using total return. But the point remains. Stocks have done much better than commodities for a long, long time. And that probably doesn't

last forever. Well, a long time. A long time would be going back to 1870s. And there are They're actually kind of on top of each other over that since 1870s. Too shat. Short a long period is 10 years, right? And indeed, the stocks have done much better since. But if we just go back, let's go back to the beginning of that period around the financial crisis. I mean, I remember the newspaper saying there was a lost decade for equities. So did everybody at that point say, oh, this is a great opportunity.

Let's rebalance my portfolio, sell some bonds and buy some more stock. No, no. People extrapolate returns. Guilteous charged. And they chase returns, right? So maybe if you learned the lessons from that period, maybe this is a good time to rebalance. Great stuff. So you spoke earlier about potential periods of contanglement backwardation.

So backwardation is beneficial for USO. What causes these forces and what's more common? It depends. Before we launched USO, actually backwardation, the oil market had principally been in backwardation since futures were launched in 1983, and that's consistent with Geert's research on commodities in general. We did enter a period where because of expanding supplies, expanding inventories, we had high contango for a number of years. We're in actually petroleum futures are in backwardation right now and have been kind of dancing a little bit between contango and backwardation over the last couple of years.

But mostly they've been in backwardation. And I don't think you can say that one's more common than the other, just that you have regimes where it might be a contango regime, it might be a backwardation regime. And I think the critical thing to do is kind of look at how do commodities perform in these regimes. So I said a minute ago, contango doesn't mean you're going to have a negative return. Backwardation doesn't mean you're going to have a positive return. One's a headwind. One is a tailwind. Relative to spot price.

Relative to spot price. Exactly. So if the spot price is moving up and it moves up dramatically and you've got contango of 10, 20 cents, maybe even 50 cents, it's not that important. It's one factor. You're also earning income on the collateral in the portfolio that could off. set that contango. So that's another important thing to consider. But we looked at the data for just oil futures going back to just 1997, so about 22 years of oil future data. What was interesting is that we have another product, ticker is USL. What it does is invest in the front 12 months.

So we were curious, if you're in a contango period or a backwardation period, how do these products do versus each other? And when you basically invest in the front 12 months as opposed to the front month only, you kind of spread out that contango. The current usually is steepest near the front, whichever direction it's going, and it kind of flattens out as you go further. So you can kind of mitigate that contango effect, or obviously you'd mitigate the backwardation benefit if it was going the other way. But what we found is that basically over this time period, when markets and backwardation, by far investing in the front 12 months makes a difference versus just investing in the front month. When you're in a contango period,

that's where it makes a difference. When you're at a backwardation period, they're more aligned. And also, one thing to point out is that regardless of whether you're in a backwardation or contango period, the front month future is going to pop the most when something happens. So something like recent attacks in Saudi Arabia, the issues with Iran that we've had over the last couple of weeks, that'll move the front month a little more than the back of the curve. So if you're looking at short-term volatility, you want to look at the front of the curve. So it's sort of like the opposite of bonds. Exactly. So if you're looking at being in a position longer and you're in a contango regime, then maybe you want to spread that out either by

investing in the future strip more than just the front month contract or by looking at a broad basket of commodities. So if I can take the longer view of this, since 1870s, looking over across more than 200 different commodities that traded at various points in time, in the average period or the average time period, commodities were in contango. Contango is actually, but traders call that the normal market. It's the normal situation because contango is a way in which future traders basically pay storage costs. So over this period, since 1870s, when the average market was in Contango, and there was sort of a headwind, using John's words, investors earned a premium over cash of about

6% per annum. So without knowing anything about backwardation in contango, if you just basically passively had allocated over that period, you'd got 6% over cash. I think most investors would think of that as a pretty attractive investment. So there's a premium in the futures contract market. There's just a risk premium. The long investors have earned historically, and that's without knowing anything about backwardation and contango.

So at some level, I think we can get to do a very technical discussion about where this backwardation and cantanko come from, how would it work and the slope. And at some basic level, I don't think necessarily that knowledge is essential for people to familiar with in order to make an allocation to this. ass class. So during the Iranian bombing, crude spiked, I don't know, 4%, whatever it was. It seemed to give it back fairly quickly, which is just always amazing to me. But what does that mean? That is a very fascinating thing that's going on right now, is the geopolitical wildfires that have occurred over the last year. There's been a number of different flashpoints. The most significant

one, aside from the killing of Soleimani a few weeks ago, was the attack on the Saudi infrastructure in September. That spiked the price 16%. Since futures started trading in 1983, prices have only moved that much in either direction about five or six times. So that was a really incredible event. Traders were in the market over the weekend. People were very concerned about what's going to happen in their portfolios. Historically, an event like that is going to have a major shift on the market. And what we saw is in both of these major incidents, within a few weeks of the attack on the Saudi infrastructure, things were kind of back to normal. What does that mean? Basically, this 16% spike in prices jumped up there in a single day.

day, and then we started to come back down. Soleimani, same thing. With that first day, four or five percent, and then the very next day we were giving it back on oversupply concerns and demand growth concerns. And so what it means that the thing that's driving that is just the fact that U.S. has significantly ramped up production, that we have more oil in the world, we're able to withstand these impacts. I mean, it's surprised even me because historically, something like that, just like you said, I mean, it's pretty amazing to give it back that quickly. Certainly, we saw tensions subside. We saw if tensions got bigger than I think you would have seen the price continued to go up. But it does recover these days more quickly than it did before.

It seems to go back to where it was before. Very unusual. Actually, Ben and I were talking on a podcast recently. When this happens and you see these spikes in the futures market, who is pressing the buttons? Who is actually doing the trading? It's across the board. It's the hedgers, speculators. It's everybody out. They're kind of trying to figure out where's the new equilibrium given this new information. So Chevron and Exxon have full-time hedgers. that are just responsible for, hey, if this happens, dude, the X-O-G-Z? Absolutely. Sometimes the spikes occur without any trading volume.

The markets could be closed. When they open, they just open at a higher price. So there's gap. They literally gap. It's not one set of traders are pushing up the price, trade after trade. It's just the price just jumps. It's the Dukes. Yeah, exactly.

Exactly. Well, it's actually, it can be a benefit for people. So when you have this jump like you did with the Soleimani assassination, you have, producers able to lock in a higher price, they're able to hedge, and basically lock in a higher price for future delivery, and then they can extend their debt a little bit, do things like that. So it can be healthy in that direction. It can hurt other people. So there are people looking for these moments, and like you said, there's full-time hedgers with their finger on the trigger ready to go. Great. Anything else here? So I would say if I piqued your interest

in my research, then you can go to social science researchnetwork.com, SSRN.com. and you search for the commodity risk premium, 1871 through 2019, and you'll find my paper, and there's lots of details about the historical performance of commodity futures markets. We'll make that really easy for the listeners. It'll be all on our show notes on the podcast, on the blog. So thank you very much, Geert. Thank you very much, John. This is great.

Thanks, guys. Thank you again to USCF investments and to John and Geert for coming on. I actually learned a lot about commodities futures in that, that I probably, didn't really know as much about beforehand. So this was a good learning one for me. So thanks again. Give us a shout, Animal Spiritspot at gmail.com, and we'll talk to you next time.