Latest / How Canadian Markets Work / Episode 67: Commodities (The Roll Cost Trap)

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Episode 67: Commodities (The Roll Cost Trap) · How Canadian Markets Work

0:00
Imagine you have this thesis. OK. You've been
0:03
looking at the global economy, you know, maybe
0:05
tracking supply chain bottlenecks, and you conclude
0:08
that the price of oil is about to climb. Right.
0:11
A fairly common macro bet. Yeah, exactly. So
0:14
you decide you want exposure to that market,
0:16
but obviously you don't want physical barrels
0:19
of crude showing up on your driveway. No, I mean,
0:22
that would certainly violate a few municipal
0:24
zoning laws, not to mention just being a complete
0:26
logistical nightmare. Right. So you take the
0:28
modern friction -free route, you log into your
0:31
brokerage account, and you buy an oil ETF. Nice
0:33
and easy. An exchange -traded fund that explicitly
0:36
states it tracks the price of oil. You buy it,
0:39
you hold it for a year, and, well, it turns out
0:41
your thesis was spot on. Oh, nice. Over that
0:44
12 -month period, the spot price of oil climbs
0:47
by 10%. Which is a very satisfying outcome for
0:51
any investor, really. Or so you would assume.
0:53
That is, until you log back into your account
0:56
to check your balance. Let me guess. The underlying
0:58
commodity went up 10%, but your ETF position
1:02
is somehow down 26%. Wow. Down 26%. Yeah. You
1:07
have literally lost a quarter of your money while
1:09
being absolutely demonstrably right about the
1:13
market. I mean, most people in that situation
1:14
would immediately assume they've been the victim
1:16
of a you know, a systemic error. Right. Or maybe
1:20
even outright fraud. Right. It feels like a scam.
1:23
And that staggering 36 -point gap between the
1:26
commodities gain and your massive loss, that
1:29
is exactly what we are dissecting today. It's
1:31
a fascinating topic. It really is. We've been
1:33
slowly working our way through this stack of
1:35
research focused on the mechanics of Canadian
1:37
markets and commodities. And all of these sources
1:40
point toward this one invisible mechanism. The
1:43
trap. Yes. Today, our mission in this Deep Dive
1:46
is to deliberately unpack what is known as the
1:49
roll cost track. We're going to explore how a
1:52
fund can do exactly what it promises in its prospectus,
1:55
you know, without any mismanagement or fraud,
1:57
and still just quietly drain your capital. To
2:00
really grasp how this mechanism works, we first
2:03
have to step back and reevaluate our fundamental
2:05
understanding of what a financial asset actually
2:07
is. Okay, lay it out for us. Because the moment
2:10
we start treating commodities like traditional
2:12
stocks or bonds, that's when we step into the
2:14
trap. We're dealing with an entirely different
2:16
species of capital here, aren't we? Exactly.
2:19
And we should probably define that structural
2:21
difference right away just because, you know,
2:24
you're likely already well versed in traditional
2:27
equities. Right. If you buy a share of a blue
2:29
chip company, you're buying a piece of a living,
2:31
breathing machine that generates revenue. Yes.
2:34
Even if the stock price goes nowhere for a decade,
2:37
that company might still be paying you a quarterly
2:40
dividend out of its free cash flow. So there's
2:42
a tangible return just for holding it. Precisely.
2:45
And if you buy a bond, you're holding a contract
2:48
that promises a regular coupon payment. There
2:51
is a mathematical heartbeat to those assets.
2:53
A heartbeat. I like that. They possess intrinsic
2:56
yield. You can run a discounted cash flow analysis
2:59
on them because they organically produce capital
3:01
over time. But commodities? Commodities, on the
3:03
other hand, are structurally barren. A barrel
3:07
of oil, a ton of copper, a bushel of wheat. They
3:11
produce absolutely zero cash flow. I sometimes
3:13
think of it like... Buying a massive incredibly
3:17
expensive statue and just putting it in your
3:19
garden. That's a good way to look at it It doesn't
3:21
do anything It just sits there slowly weathering
3:24
and not only does it fail to produce cash it
3:26
actually Actively drains your wallet which introduces
3:30
the concept of negative carry right negative
3:32
carry and this is really the critical foundational
3:35
layer of this entire trap Because the asset produces
3:39
no yield your entire return is completely dependent
3:43
on price appreciation You're just hoping someone
3:46
pays more for it later. Exactly. But in the meantime,
3:49
the physical reality of that commodity demands
3:51
constant feeding. Because, yeah, holding physical
3:54
assets requires infrastructure. Like we said,
3:57
you can't just leave crude oil in a garden. You
3:58
really can't. You need specialized storage facilities.
4:01
You have to lease space in a tank farm or charter
4:04
a supertanker. And the insurance on that? Oh.
4:06
The insurance premiums are exorbitant, especially
4:09
because the asset is highly flammable or subject
4:12
to strict environmental regulations. You have
4:14
security costs. Yep. And financing costs on the
4:18
capital tied up in the physical good itself.
4:20
So before the price of the commodity even moves
4:23
a single cent in the open market, the math is
4:26
already working against you. Heavily against
4:28
you. The physical holder is bleeding capital
4:30
every single day just to maintain custody of
4:33
the asset. Which means the financial markets
4:36
had to engineer a solution because capital is
4:39
highly efficient and it absolutely despises the
4:42
friction of negative carry. It always finds a
4:44
workaround. Always. So to allow investors to
4:48
trade the price of oil without having to personally
4:50
lease a supertanker, the market relies heavily
4:53
on derivative paper contracts. Specifically,
4:57
futures contracts. Right, futures contracts.
4:59
They allow you to gain pure exposure to the price
5:02
movements of a commodity. By doing what, exactly?
5:04
You enter into a legally -bounding agreement
5:07
to buy or sell a specific quantity of that commodity
5:10
at a predetermined price for delivery on a specific
5:13
date in the future. Okay, so this makes perfect
5:15
sense on the surface. I get the financial exposure
5:17
to the energy market, but I outsource the physical
5:20
headache of storage to someone else. That's the
5:22
idea. But I have to imagine that outsourcing
5:24
isn't free. it is fiercely expensive. And that
5:28
cost is embedded directly into the pricing of
5:32
those futures contracts. How does that show up
5:34
in the price? Because we are dealing with future
5:36
delivery, the paper price is almost never identical
5:40
to the spot price. And the spot price is just
5:43
the price you would pay if you took physical
5:45
delivery of the commodity today. Exactly. Now,
5:48
the relationship between the spot price and the
5:50
futures price typically falls into one of two
5:53
states. Our sources define the primary, you know,
5:56
normal state for storable commodities as contango.
6:00
Contango. It's a funny word, but it simply means
6:02
that the futures price is trading higher than
6:04
the current spot price. OK, higher than the spot
6:06
price. Yeah. And if we look back at the concept
6:09
of negative carry we just talked about, the reason
6:11
for this premium becomes quite logical. Let me
6:14
see if I can trace the logic here for everyone
6:17
listening. If I want oil delivered next month,
6:20
whoever currently holds that physical oil has
6:22
to pay for the storage tank. Right. And they
6:24
pay for the insurance and the security for the
6:26
next 30 days. So when they sell me the contract
6:29
for next month, they are padding the price to
6:32
cover those 30 days of negative carry. That is
6:35
the exact mechanism, yes. Okay. If the spot price
6:38
of oil today is $60, A futures contract for delivery
6:42
one month from now might be priced at, say, $62.
6:47
Got it. That $2 premium is just the physical
6:50
market demanding compensation for the friction
6:52
of time and storage. But wait, if the futures
6:55
price is usually higher than the spot price in
6:58
a contango market, who is willingly taking the
7:00
other side of that trade? What do you mean? Like,
7:02
why would anyone buy a contract at $62 if the
7:05
current price is $60? That sounds like a built
7:08
-in headwind. It is a headwind. But often, the
7:11
buyers are hedgers who need price certainty for
7:14
their business operations. Ah, OK. Like an airline.
7:17
Exactly. An airline wanting to lock in fuel costs
7:20
for the upcoming quarter. They'll pay a slight
7:23
premium for predictability. And you also have
7:25
arbitrageurs who exploit tiny inefficiencies
7:28
between the paper and physical markets. But the
7:31
key takeaway for an ETF investor is exactly what
7:33
you just pointed out. Contango creates a built
7:37
-in structural headwind. Because that $62 contract
7:40
doesn't just stay at $62 forever. It cannot.
7:44
Because time is constantly running out. Right.
7:47
As the calendar moves closer to the contract's
7:50
expiry date, the amount of time left to store
7:52
the oil diminishes. Therefore, the required storage
7:56
premium shrinks. The 30 days of storage becomes
7:59
20 days, then 10 days. Exactly. And on the exact
8:02
day the contract expires, the futures price and
8:05
the current spot price must perfectly converge.
8:08
Because at the moment of expiry, the future has
8:10
become the present. Yes. The paper is about to
8:13
turn into physical delivery. So assuming the
8:15
underlying spot price of oil stays perfectly
8:18
flat at $60 throughout the entire month, that
8:20
$62 futures contract will slowly, inevitably
8:24
drift downward until it gets $60 on expiry day.
8:27
Wow. OK, before we dig into how that mechanical
8:30
drift actively destroys a retail ETF, we should
8:33
probably briefly cover the alternate market state
8:36
just to complete the picture. Backwardation.
8:38
Right. Backwardation. Backwardation is just the
8:40
inverse of contango. It occurs when the futures
8:43
price is actually lower than the current spot
8:45
price. Which feels backward, hence the name.
8:48
Yeah. And this is typically a symptom of severe
8:51
distress in the physical market. Like a sudden
8:54
supply shock or unexpected surge in demand. Yes.
8:58
Buyers are looking at their supply chains and
9:00
they're realizing they need the commodity immediately
9:03
to keep their factories running. They can't wait
9:05
30 days. Right. They become so desperate for
9:08
physical inventory today that they're willing
9:11
to pay a massive premium on the spot market rather
9:14
than waiting for a cheaper delivery next month.
9:17
But as our sources know, while backwardation
9:19
happens during crises or shortages, contango
9:22
is the normal resting pulse for commodities that
9:25
require heady storage infrastructure. It is the
9:28
default state. And that constant contango headwind
9:30
brings us directly to the trap waiting for you,
9:33
our hypothetical. Because a retail commodity
9:36
ETF, you know, the kind you buy in a standard
9:38
brokerage account, is structurally incapable
9:40
of taking physical delivery. Right. An ETF management
9:44
firm sitting in a high -rise office does not
9:46
own an oil terminal in Cushing, Oklahoma. No,
9:48
they definitely do not. They only own the derivative
9:51
paper. Just the paper. Right. So when that near
9:53
-term contract approaches its expiration date
9:55
and the threat of physical delivery looms, the
9:59
fund has to take evasive action. They are forced
10:02
into a mandatory mechanical maneuver. Our sources
10:06
call it the roll. The roll, yes. Yeah. To maintain
10:09
their ongoing exposure to the price of oil, the
10:12
fund must sell the expiring contract just before
10:15
it matures and use that capital to purchase the
10:18
next month's contract. I want to walk through
10:20
the math of this roll very deliberately because
10:22
I think this is where the illusion shatters.
10:24
Let's do it. Let's use the numbers we just established.
10:26
The spot price of oil is $60. OK, spot is 60.
10:30
The fund is holding the near -term contract,
10:33
and because time has nearly run out, the price
10:35
of that contract has drifted down to match the
10:38
spot price. So it is sitting at $60. Right. So
10:41
the fund sells that expiring contract at $60.
10:44
They now have $60 in cash, and they need to reestablish
10:49
their position to keep tracking the market. So
10:52
they look to the next month's contract. But the
10:54
market is in normal contango. Yes. Which means
10:57
the contract for the following month is priced
11:00
at $62 because it has that 30 days of storage
11:03
premium baked into it. Exactly. So the fund takes
11:06
the $60 it just made, realizes it isn't enough,
11:10
and has to buy the new contract at $62. Wait,
11:13
wait. So they just sold an asset at $60 and immediately
11:16
bought the replacement at $62. Yes. They effectively
11:19
locked in a $2 loss just to maintain the exact
11:22
same degree of exposure to the oil market. They
11:24
did. And a $2 loss on a $62 contract is a negative
11:28
drag of roughly 3 .2%. And because these are
11:31
monthly contracts, the ETF has to execute this
11:34
role every single month. Every single month.
11:36
They are mechanically bleeding 3 .2 % 12 times
11:41
a year. Why would anyone design a financial product
11:44
that is structurally mandated to buy high and
11:47
sell low in perpetuity? It looks deeply flawed
11:49
from the outside. I mean, it sounds terrible.
11:52
But the fund managers are simply executing the
11:55
strategy outlined in their prospectus. They don't
11:58
have a choice. No. They are legally barred from
12:01
taking physical delivery. So they must roll the
12:04
contracts. The flaw is not in the architecture
12:07
of the fund. Where is it then? The fatal flaw
12:10
lies in the retail investor's assumption that
12:14
a portfolio of rolling paper contracts will perfectly
12:17
mimic the static spot price of a physical barrel
12:21
of oil. Let's look at the compounding effect
12:23
of that assumption, because the math gets terrifying
12:25
very quickly. It really does. Imagine the actual
12:28
spot price of oil doesn't move at all. It stays
12:30
completely flat at $60 for 12 consecutive months.
12:33
OK, so if the spot price is flat, but the market
12:36
remains in a steady state of contango, the fund
12:39
is eating that 3 .2 % loss every time it rolls.
12:42
Right. As those losses compound month over month,
12:45
an initial investment of $100 would erode down
12:47
to approximately $67. You lose 33 % of your capital
12:51
on a commodity that never even went down in price.
12:53
Yes. The value is just quietly incinerated by
12:57
the friction of the roll. Which brings us back
13:00
to the mystery we opened this deep dive with.
13:01
Let's apply this drag to a market where you actually
13:04
predicted the direction correctly. OK. The spot
13:07
price of oil rises 10 % over the year, moving
13:10
from $60 to $66. You feel like a genius. But
13:14
the underlying contango hasn't stopped. The ETF
13:17
is still forced to sell low and buy high every
13:21
30 days to avoid taking delivery. Wow. The continuous
13:25
drag of the roll yield completely overpowers
13:28
the 10 % appreciation in the spot price. The
13:31
math pulls the fund downward so aggressively
13:33
that the investor ends up losing 26 % of their
13:36
money. It's basically a phantom tax. That's a
13:39
great way to put it. It is entirely invisible
13:41
to someone who just watches the financial news,
13:44
sees the oil ticker flashing green, and assumes
13:46
their ETF is riding that same wave. This is the
13:49
inherent danger of treating a derivative as a
13:52
perfect substitute for physical reality. These
13:55
paper contracts are tethered to the physical
13:57
logistics of the commodity, and occasionally
13:59
that physical reality asserts itself violently.
14:02
Which leads perfectly into the two major exceptions
14:05
highlighted in our sources. where the physical
14:07
nature of the asset completely dictates the behavior
14:10
of the paper. Let's start with the ultimate stress
14:13
test. The historic oil crash in the spring of
14:16
2020. Yes. The 2020 anomaly fundamentally shocked
14:19
people who only understood oil as numbers on
14:22
a screen. For a brief chaotic window, the price
14:25
of the front month crude oil futures contract
14:27
dropped below zero. It traded deeply negative.
14:31
Deeply negative. Financial traders were literally
14:33
paying people to take oil contracts off their
14:35
hands. And this happened because, as we establish,
14:38
a futures contract is a legally binding obligation.
14:40
Right. In early 2020, the global economy basically
14:44
shut down overnight. The demand for refined fuel
14:47
evaporated, but the massive industrial machinery
14:50
of global oil production just kept pumping. Every
14:52
commercial storage tank, every pipeline, every
14:56
available vessel floating in the ocean was filled
14:59
to maximum capacity. There was no empty space
15:02
left on the grid. Wow. So as the near term futures
15:06
contracts approached expiry, the purely financial
15:09
traders, the ones operating out of hedge funds
15:12
and retail accounts, realized what was happening.
15:14
They realized they were days away from being
15:16
legally forced to accept physical delivery of
15:20
millions of barrels of crude oil. And they had
15:22
nowhere to put it. Exactly. The realization sparked
15:25
absolute panic. The negative price wasn't a glitch.
15:28
It was the financial market frantically trying
15:30
to buy its way out of a physical logistical impossibility.
15:34
It proved beyond any doubt that futures are not
15:36
merely price proxies. They are the plumbing of
15:39
the physical world rendered in paper. Beautifully
15:41
said. So that's the catastrophic exception where
15:44
physical logistics break the paper market. But
15:46
our sources also detail a positive exception.
15:49
They do. A scenario where investors completely
15:51
sidestepped the roll cost trap. And that brings
15:53
us to physically backed gold funds. Gold is fascinating
15:57
because its physical properties allow for a completely
16:00
different financial structure. We've discussed
16:02
how oil ETFs use futures because physical storage
16:06
is too complex. Right. But with a precious metal
16:08
like gold, a fund doesn't need to bother with
16:12
the futures market at all. Because when you buy
16:15
a physically backed gold ETF, the fund managers
16:17
basically take your capital, purchase actual
16:20
gold bullion, and lock it inside a high security
16:23
vault. Right. They hold the physical asset. Yeah.
16:25
Which means there are no expiring contracts.
16:28
There is no mandatory mechanical role every month.
16:31
No role. No role. And because they aren't interacting
16:34
with the futures curve, the concept of contangos
16:37
simply does not apply to their returns. They
16:39
completely bypass the phantom tax. But wait,
16:42
they still have negative carry, right? They still
16:44
have to pay for the vault and the guards and
16:45
the insurance? They do, but the critical difference
16:48
lies in the density of the value. The density?
16:50
Yeah. A billion dollars of crude oil requires
16:53
an incredibly vast, specialized, and highly regulated
16:56
infrastructure network to store. A billion dollars
17:00
of gold, on the other hand, can fit into a relatively
17:02
modest corner of a secure basement. So the negative
17:05
carry is just drastically lower. Vastly lower.
17:08
Instead of a devastating compounding roll cost,
17:10
the gold ETF investor just pays a transparent,
17:13
predictable management and storage fee, usually
17:16
a fraction of a percent annually. That makes
17:18
sense. This allows the fund to track the actual
17:21
spot price of gold with remarkable fidelity.
17:24
It's deeply ironic when you think about it. The
17:27
only way to escape the expensive, invisible traps
17:30
of the modern paper derivatives market is to
17:33
revert to the most ancient method of wealth preservation.
17:36
Which is paying someone to lock a heavy piece
17:38
of metal in a fortified room. Exactly. It's highly
17:41
effective, assuming the asset is dense enough
17:43
to warrant it. But this entire discussion about
17:46
the friction of holding physical commodities
17:48
leads to a vital, practical question for you,
17:51
the listener. It does. Knowing all of this, knowing
17:53
that ETFs bleed value and can tango and physical
17:56
storage is expensive, how should you actually
17:58
participate in a commodity cycle? Or perhaps
18:01
the sharper question is, do you even need to?
18:04
Our sources provide a very clear alternative
18:06
to the ETF trap. If you want exposure to rising
18:09
copper oil prices, but you absolutely refuse
18:13
to pay the roll cost, the traditional route is
18:16
to purchase shares in the companies that actually
18:18
extract the commodity. Ah, the producer shares.
18:21
So buying an energy company instead of an energy
18:24
ETF. Precisely. A producer share completely changes
18:27
the math. An energy company is a living business.
18:30
It pulls the oil out of the ground and sells
18:32
it into the physical market at the spot price.
18:34
It doesn't trade futures to simulate exposure.
18:37
Exactly. It generates actual cash flow and it
18:39
often returns that cash to shareholders in the
18:41
form of dividends. So you get the upside of the
18:43
commodity price and you avoid the roll trap entirely.
18:46
But you are swapping one risk for another. You
18:49
are. You are taking on deep operational risk.
18:52
The price of oil could double. But if the company's
18:55
management team makes terrible capital allocation
18:58
decisions, or if a critical piece of infrastructure
19:00
fails, or if they are just crushed by debt. The
19:03
stock price will plummet regardless of the commodity
19:06
cycle. Right. It is a profound trade -off. But
19:08
our sources make a brilliant connection here,
19:11
particularly for the Canadian investor, regarding
19:13
whether this exposure is even necessary. Yeah.
19:16
If you are building a portfolio in Canada, you
19:18
have to look closely at the structural reality
19:21
of the domestic market. The Canadian stock market.
19:23
represented by indices like the TSX composite
19:26
is heavily skewed toward two specific sectors.
19:29
Energy and materials. Energy and materials. Which
19:32
means if you hold a standard, broadly diversified
19:35
Canadian index fund in your retirement account,
19:37
you are already holding a massive concentrated
19:40
position in commodity producer shares. Wow, yeah.
19:43
You're already heavily exposed to the global
19:45
cycles of oil, natural gas, and industrial metals.
19:48
Furthermore, just consider the nature of your
19:50
own human capital. If you live and work in Canada,
19:54
your income is inextricably linked to the cycle.
19:57
Deeply linked. If you reside in a resource -intensive
19:59
province, the health of your local economy, the
20:03
stability of your housing market, and quite possibly
20:05
your direct job security, all rise and fall with
20:08
the price of those commodities. So if your career
20:11
is tied to the Canadian economy and your primary
20:13
retirement fund is already saturated with energy
20:16
and mining companies, actively going out and
20:18
buying an oil ETF is not diversifying your portfolio.
20:22
It is the exact opposite of diversification.
20:24
You are layering redundant bets on top of an
20:27
already concentrated risk profile. You are basically
20:30
tripling down on a bet you didn't even realize
20:32
you were making. and you are paying that massive
20:35
invisible role cost just for the privilege of
20:37
doing so. It really forces you to reconsider
20:40
what diversification actually means. You might
20:43
think you are adding a sophisticated new asset
20:46
class to your dashboard, but you are just amplifying
20:48
your exposure to the exact same physical vulnerabilities.
20:52
Which is why taking the time to understand the
20:54
deep mechanical plumbing of these financial instruments
20:57
is so vital. It really is. Once you internalize
21:00
the fact that a commodity is just a physical
21:03
object that requires costly storage and that
21:05
paper markets simply pass those storage costs
21:08
onto the investor, the mystery of the collapsing
21:11
ETF completely evaporates. The fund isn't a broken
21:15
machine. It is functioning flawlessly. It's just
21:18
designed to quietly transfer the friction of
21:21
the physical world onto the balance sheet of
21:23
the paper holder. A harsh but deeply necessary
21:26
lesson in market mechanics. Very true. As we
21:29
wrap up this deep dive, I want to leave you with
21:30
a final, somewhat unsettling thought to ponder
21:33
on your own. OK, let's hear it. We established
21:35
today that the derivatives market, this vast
21:38
ocean of paper contracts, operates as an enormous
21:41
speculative layer built on top of the physical
21:43
supply of these commodities. Yes. And in many
21:46
markets, the total notional value of those paper
21:48
contracts vastly outnumbers the actual physical
21:51
supply of the commodity that currently exists
21:54
in the world. And as the 2020 oil anomaly demonstrates
21:58
those paper contracts remain legally binding
22:02
obligations for physical delivery. So imagine
22:04
the mechanics of a severe systemic crisis. What
22:07
happens if the holders of those paper contracts
22:10
suddenly lose faith in the financial system's
22:13
ability to settle trades in cash? Oh, wow. What
22:15
if, driven by panic or counterparty distrust,
22:19
every single entity holding a paper claim decides
22:22
they want the actual physical asset instead?
22:25
A simultaneous demand for physical settlement
22:27
across the board. A global run on the commodity
22:30
banks. What happens to the financial system when
22:33
a paper market suddenly demands a physical reality
22:35
that simply does not exist in sufficient quantities
22:38
to satisfy the claims? That is a terrifying thought.
22:41
It's something to mull over the next time you
22:43
look at a simple blinking price ticker on your
22:45
screen. Thank you for joining us for this deep
22:47
dive. It has been a pleasure unpacking these
22:49
mechanisms with you. Keep questioning the plumbing
22:51
beneath the numbers. Until next time.