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  1. 1. Commodities Research 2 June 2006 Deutsche Bank@ Global Markets Research DBLCI-OY: Technology To Tackle Term Structure Dynamics Commodities Special A holder of inventories in a particular commodity • The sources of returns for any commodity generates a convenience yield, which is defined as index are a function of not only the spot the flow of services and benefits that accrues to an price, but, also the shape of the term owner of a physical commodity but not to an owner of structure and hence the roll yield. a contract for future delivery of the commodity 2. This • The changing nature of term structures can come in the form of having a secure supply of raw across the entire commodity complex over materials and hence eliminating the costs associated the past few years has meant that the with stock-outs. traditional approach employed by The convenience yield is therefore related to the commodity indices, namely rolling futures amount of available inventory relative to current contracts on a pre-defined schedule (e.g. consumption. Consequently those markets where monthly) has, in our view, become an available inventory is ample such as gold the inferior strategy for passive long only convenience yield is low and the term structure is commodity index investing. solely a function of interest rate and warehousing • To tackle the dynamic nature of commodity costs and consequently upward sloping. While forward curves we have designed a new set industrial metal markets have typically been of commodity index products, called the characterised by ample inventories and hence a low Deutsche Bank Liquid Commodities Indices convenience yield, over the past three years Optimum Yield, or DBLCI-OY. inventories on the London Metal Exchange have • The DBLCI-OY indices are designed so that declined rapidly. rather than selecting the futures contract on a pre-defined scheduled they roll into the This has meant that the convenience yield has futures contract that either maximises the increased over this period as consumers of industrial positive roll yield in backwardated term metals becoming increasing concerned towards the structures or minimises the negative roll physical availability of commodities such as copper yield in contangoed markets. and zinc. This has led term structures in this part of the commodity complex to flip from contango to Historically energy forward curves have been backwardation. In the grains complex, as global downward sloping or in backwardation while metal inventories decline we would expect a similar change and agricultural forward curves have traditionally been in the term structure from contango to backwardation. upward sloping or in contango. These differing term structures can be explained by the Theory of Storage This changing pattern in commodity term structures and the existence of the convenience yield such that has important implications for commodity index the relationship between the forward and spot price investing. We have noted for some time that the for a specific commodity is defined as: engine room of performance in a commodity index has traditionally derived from the positive roll yield Formula (1) generated in the energy sector due to the tendency Forward price = Spot price + Interest Rate + for forward curves in this part of the commodity Storage Costs - Convenience Yield complex to be downward sloping. However, the appearance of contango in the crude oil term structure Formula 1 relies on the fact tha t by storing rather than over the past two years has meant the benefits of selling the commodity, one surrenders the spot price rolling down the curve and a positive roll yield have but incurs interest rate and warehousing costs. disappeared and have been replaced by rolling up the However, offsetting these costs are the benefits curve and picking up a negative roll yield. accruing from holding inventory, or what is called the convenience yield¹. IMPORTANT: All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Independent, third-party research (IR) on certain companies covered by DBSI's research is available to customers of DBSI in the United States at no cost. Customers can access this IR at, or call 1-877-208-6300 to request that a copy of the IR be sent to them. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN THE BACK OF THIS REPORT
  2. 2. Deutsche Bank@ Commodities Special 2 June 2006 This change has been dramatic in terms of returns The DBLCI-OY employs a rule-based approach when it performance. We find that between 1988 and 2004 'rolls' from one futures contract to another for each the roll return in the DB crude oil index has amounted commodity in the index³. Rather than select the new to 9.0% per annum. However, in 2005 the roll yield future based on a pre-defined schedule (e.g. monthly on the DB crude oil index stood at -22% due to the for energy and annually for metals and agriculture) the appearance and persistence of contango in the front index rolls to that future which generates the part of the WTI term structure. maximum implied roll yield from the list of tradable futures which expire in the next thirteen months. The The shift in changing term structures across the index consequently aims to maximise the potential roll commodity sectors poses challenges for traditional benefits in backwardated markets and minimise the commodity index investing. In terms of the Dow losses from rolling up the curve in contagoed markets. Jones-AIG and the Goldman Sachs Commodity Index they adopt a pre-defined rolling strategy whereby We find that from December 1988 to May 2006 the futures contracts are rolled monthly for every futures DBLCI-OY index has historically tended to outperform contract in the commodity index. the DBLCI index, Figure 2. The annualised return over this period rises from 9.20% to 9.72% as well as In comparison the Deutsche Bank Liquid Commodity raising the Sharpe ratio from 0.49 to 0.63. We find Index (DBLCI) and the DBLCI-Mean Reversion roll the that the energy indices benefit most from the WTI and heating oil futures contracts monthly and the optimum yield technology. The DBLCI-OY WTI crude aluminium, gold, corn and wheat futures contracts oil (CL) index has an overall annual out-performance annually. This strategy was employed to exploit the over DBLCI CL of 3.33%. Furthermore the DBLCI-OY tendency for energy futures’ curves to be downward CL index has exhibited a lower volatility when sloping and metal and agricultural futures contracts to compared to the DBLCI CL index giving it a be upward sloping. significantly higher Sharpe ratio. However, given the shifting pattern in commodity term structures over the past few years we believe Michael Lewis, (44 20) 7545 2166 this mechanistic approach to futures rolling every month and employed by the Dow Jones-AIG and GSCI commodity indices as well as the approach by References: the DBLCI can be enhanced. In this regard we have 1. The Theory of the Price of Storage, Working created the Deutsche Bank Liquid Commodities (1949) Indices -Optimum Yield (DBLCI-OY). 2. Brennan and Schwartz (1985) 3. For full details of the DBLCI-OY index Calculation & Rules see the DBIQ Index Guide: DBLCI Optimum Yield Commodity Indices report published on 26 May 2006 and available at Figure 2: DBLCI-OY and DBLCI Excess Return Index Statistics (December 1988-May 2006) Monthly Return Analysis Annualised Return Data Avg. Annualised Sharpe Monthly No. +ve % of +ve Return Volatility Ratio Return Months Months 15 Years 10 Years 5 Years 3 Years DBLCI-OY 9.72% 15.32% 0.63 0.86% 111 53.11% 9.46% 11.86% 21.66% 37.65% DBLCI 9.20% 18.93% 0.49 0.89% 112 53.59% 8.15% 9.40% 15.31% 27.01% DBLCI-OY CL 19.61% 20.83% 0.94 2.15% 161 77.03% 23.11% 36.60% 34.38% 56.69% DBLCI CL 16.28% 31.70% 0.51 1.69% 124 59.33% 12.88% 16.78% 20.79% 37.69% DBLCI-OY HO 14.05% 24.79% 0.57 1.32% 124 59.33% 13.84% 20.44% 31.78% 56.81% DBLCI HO 10.93% 31.52% 0.35 1.29% 117 55.98% 7.88% 13.00% 19.55% 36.40% DBLCI-OY C -7.54% 17.79% -0.42 -0.50% 103 49.28% -8.05% -13.36% -8.87% -9.57% DBLCI C -7.41% 18.16% -0.41 -0.48% 102 48.80% -7.58% -12.93% -7.85% -8.55% DBLCI-OY GC -1.59% 12.55% -0.13 -0.07% 90 43.06% 0.49% 1.90% 17.54% 21.49% DBLCI GC -1.43% 12.55% -0.11 -0.05% 91 43.54% 0.68% 2.04% 17.64% 21.65% DBLCI-OY MAL 2.91% 14.57% 0.20 0.57% 48 46.60% 13.02% 30.03% DBLCI MAL 2.67% 15.84% 0.17 0.52% 48 46.60% 13.05% 29.75% DBLCI-OY W -4.75% 19.06% -0.25 -0.26% 98 46.89% -3.21% -12.90% -1.08% 3.79% DBLCI W -2.76% 19.98% -0.14 -0.07% 104 49.76% -1.13% -12.27% -0.46% 0.58% Source: DB Global Markets Research, Returns between 02- Dec-1988 (03-Sep-1997 for DBLCI -OY MAL and DBLCI MAL) and 01-May-2006 This data does not include transaction costs. 2 Global Markets Research
  3. 3. 2 June 2006 Commodities Special Deutsche Bank@ CERTIFICATION The views expressed in this report accurately reflect the views of the undersigned lead analyst about the subject issuer. In addition, the undersigned has not and will not receive any compensation for providing a specific recommendation or view in this report. Michael Lewis DISCLAIMER The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively "Deutsche Bank"). The information herein is believed by Deutsche Bank to be reliable, but Deutsche Bank makes no representation as to the accuracy or completeness of such information. Important Information Regarding Our Independence. The research analyst principally responsible for the preparation of this report receives compensation that is based upon, among other factors, Deutsche Bank’s overall investment banking revenues. Deutsche Bank may engage in securities transactions in a manner inconsistent with this research report, and with respect to securities covered by this report, will sell to or buy from customers on a principal basis. Disclosures of conflicts of interest, if any, are discussed at the end of the text of this report or on the Deutsche Bank website at Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate, or if research on the subject company is withdrawn. Prices and availability of financial instruments also are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own investment decisions using their own independent advisors as they believe necessary and based upon their specific financial situations and investment objectives. If a financial instrument is denominated in a currency other than an investor’s currency, a change in exchange rates may adversely affect the price or value of, or the income derived from, the financial instrument, and such investor effectively assumes currency risk. In addition, income from an investment may fluctuate and the price or value of financial instruments described in this report, either directly or indirectly, may rise or fall. Furthermore, past performance is not necessarily indicative of future results. Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor’s home jurisdiction. In the U.S. this report is approved and/or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In the United Kingdom this report is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Singapore by Deutsche Bank AG, Singapore Branch, and in Japan by Deutsche Bank AG Tokyo. Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank’s prior written consent. Please cite source when quoting. Copyright© 2006 Deutsche Bank AG REV041003 Global Markets Resea rch 3