everything we wanted to know about spot prices and

EVERYTHING WE WANTED TO KNOW ABOUT

SPOT PRICES AND WERE DUMB ENOUGH TO ASK

Investors looking to the ETF and ETN markets to find simple commodity exposures, such as spot prices, often find an array of trading strategies all of which involve complex performance tradeoffs.

Everything We Wanted to Know About Spot Prices and Were Dumb Enough To Ask

Investors and traders in commodities funds confront a number of unique challenges with respect to evaluating and managing their positions. Unlike traditional securities such as corporate stocks and bonds, commodities-linked funds are complicated by the physical nature of their underlying markets. While equity and bond investors can see market moves translate directly into securities

price changes, the realities of tankers, silos and pipelines complicate the story for the commodities investor. Even though commodity ETFs and ETNs present the financial investor with a tradable share at a simple price, the funds generally cannot defy the physical complications and limitations of their underlying markets.

Among the first questions a prospective ETF or ETN investor should ask are:

cc What are my investing objectives?

cc What price or index does my ETF or ETN seek to target?

cc Will that targeted price have adequate responsiveness to commodities markets?

cc How might my fund’s targeted index deviate from general price movements in the related commodity?

Generally, commodity-linked ETFs and ETNs are limited to buying, holding and rolling specific futures contracts in order to create their exposures. While ETF and ETN market conventions may suggest that there are no measurement alternatives to rolled futures based prices, the real answer is more involved.

Investors looking to the ETF and ETN markets to find simple commodity exposures, such as spot prices, often

find an array of trading strategies all of which involve complex performance tradeoffs.

In the following discussion, we do not advocate for one ETF or ETN over another, and we do not advocate for trading in futures or other markets; but we do advocate using price levels obtained across multiple markets to measure and assess the effectiveness of an ETF or ETN in achieving an investor’s portfolio objectives.

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For convenience and clarity, all markets standardize the manner in which prices are quoted and reported. Price standardization makes trading easier, and it assists in consistent and accurate performance measurements. For example, the markets for stocks, bonds, and currencies are almost always quoted and reported as spot prices, and trade settlement is electronic, speedy, and highly standardized.

The term “spot price” is typically used to describe the normal or “regular way” cash price for a security or commodity. For domestic equities and corporate bonds, spot prices reflect a “T+3” settlement indicating that the cash and the related securities will change hands three exchange days after the trade date. In other markets such as the U.S. Treasury market or the foreign exchange market, quoted prices reflect “T+1” and “T+2” settlements respectively.

When one leaves the world of computerized book-entry securities, the question of “what is spot?” gets considerably more complex – spot prices for commodities involve a number of parameters including delivery points, grade specifications, forward dates and other technical particulars relating to moving and storing the physical commodity. While spot prices are produced and published for many of the commodities underlying investable ETFs and ETNs, the impracticalities of accessing spot commodity prices generally relegates ETFs and ETNs to utilizing the futures markets.

Unlike typical securities markets where spot or cash prices indicate near-immediate settlement, spot or cash prices in commodities such as crude oil involve material logistics relating to transportation and storage. For example, spot trades in crude oil can take 45 to 60 days to settle, and even the physical settlement of WTI crude oil futures contracts can occur more than 40 days after the trading of a futures contract ceases – as such, what is generally considered spot crude prices actually have a degree of “forwardness” to them and oil futures are really a futures contract over a forward contract rather than a futures contract over a “true spot” commodity. Traditional commodities-linked ETFs and ETNs embed these complexities.

What are Spot Prices?

While spot prices are produced and published for many of the commodities underlying investable ETFs and ETNs, the impracticalities of accessing spot commodity prices generally relegates ETFs and ETNs to utilizing the futures markets.

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Because of the need to avoid physical commodities, financial investors and their funds usually limit their exposures to trading in futures markets.

What Do Most Financial Investors and Funds Do?

Much of the complication around commodities prices for the financial investor results from the fact that financial investors want (and generally need) to avoid all aspects of physical delivery – while financial investors want the best, most responsive price exposure to the subject commodity, they typically need to avoid all of the logistics of physical delivery and storage.

Because of the need to avoid physical commodities, financial investors and their funds usually limit their exposures to trading in futures markets. However, futures trading does not really escape the complexities in the physical commodities:

cc many futures contracts expire into physical delivery

cc prices along the futures curves imbed the varying economics of the physical markets such as delivery and storage costs

cc expirations force funds to maintain a carefully balanced regime of maintaining market exposure while avoiding the logistics of futures expirations

cc financial investors can become trapped into trading futures contracts at pre-defined and sometimes suboptimal times

In practice, futures based commodity funds purchase, hold, and then sell futures contracts prior to stated expiry – and then repeat the process in a continuing cycle. What should be apparent in this futures trading cycle is

that such a fund is not transacting at spot prices in any part of the cycle, but rather the fund is always buying contracts with longer expiries than it is selling. A less obvious consequence from this cycle of futures trading is that funds are repeatedly required to find a trader on “the other side” of their commodity in the futures market (e.g. a long WTI crude oil fund requires a seller(s) of crude WTI futures) with little to no discretion in timing or execution. Further, it is important to realize that the rolling of futures contracts further complicates matters by requiring the participation and engagement of both futures buyers and futures sellers at the same time – buyers for the contracts approaching expiry, and sellers for the next contract.

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For the financial investor or fund, owning commodities futures contracts has two direct consequences; first, futures contracts must be sold prior to expiry, and second, in order to maintain market exposure, the sales proceeds must be used to purchase new longer-dated, futures contracts.

For the financial investor or fund, owning commodities futures contracts has two direct consequences; first, futures contracts must be sold prior to expiry, and second, in order to maintain market exposure, the sales proceeds must be used to purchase new longer-dated, futures contracts. Basic financial theory suggests that the net cost or benefit associated with these buys-and-sells should be limited to forward commodity price components such as transaction costs, storage costs, convenience yields, and interest rates. However, where financial investors are either required to (or happen to) telegraph the dates and times of the execution of their roundtrip transactions, there is a risk that futures market operators will pre-position their books in anticipation of these roundtrip transactions and raise the cost of execution to the financial investors.

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While some investors trade commodities-linked ETFs and ETNs specifically for the complexities associated with the futures markets, other investors, if given the opportunity, would forgo futures contract complexities for more direct spot price alignment. While investible ETF or ETN opportunities which either isolate spot movements or materially minimize futures trading effects may be a long time in coming, it is still instructive to look at alternative metrics in an attempt to assess what’s actually being gained or lost during the futures rolling process relative to a theoretical spot exposure.

For example in a market where the complexities or inefficiencies of accessing a particular return component through futures trading is too high, investors may opt out of the commodities space altogether and into corporate equity market proxies – for example, investors may choose oil producer stocks for energy related exposures or mining company stocks for metals related exposures. The tradeoffs involved in pursuing commodities exposures through corporate equities is beyond the scope of this discussion, but it is likely that there are instances in which it may be a reasonable approach.

In light of the fact that there is a range of alternatives relating to acquiring a commodities exposure, including forgoing the exposure all together, it makes sense to attempt to measure the return consequences from an ETF or ETN’s access strategy by making reference to an alternative measure.

Criteria for good alternate measures include accuracy, transparency, and technical tractability. For the financial investor, the technical tractability of an index is its ability to measure or follow percentage changes – that is, details such as the numerical levels of an index are unimportant, but an index’s ability to accurately measure daily and intra-day rates of change is critical.

Despite the high-energy blogging and journalism around commodities-linked ETF and ETN investing (including the well-trod futures roll complications), it is surprising that alternative measures rarely make an appearance in the debate. While today, it may be necessary to throw-in the towel and accept a rolled-futures strategy in order to invest in crude oil, it still makes sense to attempt to estimate how much of the performance of a fund is directly related to oil price movements and how much of the performance is impacted by futures rolling and other secondary effects (e.g. transaction costs). As outlined below, alternative measures of price movements come in the form of cash based prices and variations on futures price series.

There are at least three categories of commodities spot prices which are candidates for this alternative measure. The three categories of spot prices listed below are editorial spot prices, producer spot prices, and S&P® GSCI® spot prices. Most of the following discussion is directed at WTI crude oil prices, but the principles can be applied to other commodities.

Are There Any Alternative Metrics to Measure Commodities Returns?

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1. Editorial Prices on Energy Commodities

There are a number of market data providers who produce and publish spot commodity prices. These spot price data providers include Platts, Argus Media, and Thomson Reuters. While their methods and related disclosure vary, these prices are typically described as “price assessments” determined by “editors” using a variety of inputs including voluntarily reported cash transactions.

Of particular note, the Thomson Reuters editorial prices are published by the U.S. federal government with complete historical detail on the U.S. Energy Information Administration website (www.eia.gov). Further, the Thomson Reuters spot price data is widely used by researchers in scholarly and governmental policy papers.

As of the date of this paper, none of these editorial prices have been used by the ETF or ETN marketplace. Among the reasons for marked absence of editorial prices in securities markets may include a bias relating to self-reported prices and selective transaction reporting, thin reporting volumes, and a lack of full transparency on the overall price assessment process.

2. Producer Spot Market Prices on Energy Commodities

A number of energy companies including producers and refiners publish spot prices. In particular, Shell Trading, Phillips66, Conoco, Union76, and Suncor publish daily spot crude oil prices for differing grades and delivery points. Energy companies produce comprehensive price reports often including more than 10 quoted delivery points and corresponding gravity adjustments.

The energy company prices are typically disclaimed that they are for informational purposes only, and as such, they also have not found their way into the ETN or ETF marketplace as a WTI crude oil price reference. Shell Trading includes the following informational narrative with its price reports:

“Effective 7:00 AM of the effective date(s) indicated, subject to change without notice, Shell Trading (US) Company (STUSCO) posts the following prices per barrel of 42 U.S. gallons of merchantable crude oil and condensate of 7.5 pounds RVP or less for the grade and area shown. The prices shown are also subject to the gravity adjustment schedule published by STUSCO. The prices are for informational purposes only and do not constitute an offer.”

3. S&P ® GSCI® Spot Indices

The index provider S&P Dow Jones Indices is well known for its wide range of indices across many markets including equities, fixed income, commodities and real estate. In commodities, the S&P GSCI series is one of the major index series and it is widely used in the commodities-linked ETF and ETN marketplace. As described in the detailed methodology on the S&P Dow Jones Indices website

continued...

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(us.spindices.com), the S&P GSCI index values and returns are based on the prices of specified futures contracts.

While the S&P GSCI series is widely followed, what is less well known is that S&P Dow Jones Indices produces a “spot” series of indices which not only include the broad S&P GSCI Commodity Index, but also the sub-components - included in those published sub-components are spot prices for WTI crude oil, Brent crude oil, natural gas, and a range of metals. Similar to other S&P Dow Jones indices, the spot series are based on price changes in related futures contract price changes. However, unlike their excess return (“ER”) index series and total return (“TR”) index series, the spot series does not incorporate interest on collateral or the premium or discount obtained by rolling positions forward as they approach delivery – because the spot indices eliminate many of the second order return components of the futures contracts (i.e. those elements of the futures returns not directly related to commodity price changes), they may be a good candidate for proxying cash/spot returns. Levels for the S&P GSCI spot indices can be found at us.spindices.com/performance-overview/commodities/sp-gsci.

Despite their minimal publicity, the spot indices and the related methodology are detailed in the S&P GSCI Methodology handbook located on the S&P Dow Jones Indices website under the documents link. Unlike the other two types of prices (editorial and producer spot prices), this index series is based on the daily price changes of the futures contracts prescribed by the methodology. While its reliance on futures prices may seem a step removed from cash prices, this series may have an advantage relating to volumes, objectivity and accessibility.

It is illustrative to pull all three types of index sources together, along with front futures contract price changes to examine for closeness of results.

If one makes the leap that editorial and producer spot prices are a reasonable proxy for cash/spot crude oil, and if those prices closely correspond to futures based indices, the futures based prices may be highly usable as a cash/spot proxy. As previously highlighted, the following numerical analysis is only applied to WTI crude oil prices, but the principles may be applied to other commodity indices.

The common thread across all three categories is that there is no impact from futures rolls captured in the values.

As used below, CL1 and CL2 refer to the continuous front and the continuous next WTI crude oil futures contract price indices respectively. As such CL1 and CL2 are that front or next futures contract at each respective observation point without regard to rolls or trading around an expiry.

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continued...

The following table presents the 2008, 2011, and 2013 daily return correlations of the Thomson Reuters WTI spot prices (eia.gov symbol “RWTC”), Shell Trading WTI spot prices (“SHELL”), S&P GSCI Crude Oil Spot (Reuters symbol “.SPGSCL”), and the front WTI crude oil futures contract (“CL1”).1 In order to avoid burying the reader in data, the examined years were limited to 2008, 2011, and 2013. The years were selected from recent history based on the volatility of their daily returns. 2008 represents a high volatility year and 2013 represents a low volatility year, with annualized daily return volatilities of approximately 62% and 18% respectively. 2011 is representative of a mid-volatility year with an annualized daily return volatility of approximately 34% which is a value close to the average daily return price volatility since the beginning of 2008.

Referring to Table 1 below, the daily return correlations across all indices for most of the periods examined are in excess of 0.97; an exception is the second half of 2008 where the crude oil price levels fell by over 75% and where correlations values range from 0.837 to 0.999. The data for each year is presented and summarized in two parts: Q1-through-Q2 and Q3-through-Q4.

2008 was one of the most dynamic years for crude oil prices in recent history – the first half of 2008 saw a rally of roughly 50%, only to be followed by a sell-off in the second half of the year of over 75%. As measured by the front futures contract, the high and low price levels for 2008 were approximately $145 and $33 respectively. Further, 2008 was characterized by a mix of upward sloping futures curves (“contango”) and downward sloping futures curves (“backwardation”).

What the Data Suggest

1.Running correlations on futures versus non-futures prices may introduce some element of bias or inconsistency due to the fact that a single or constant futures contract changes with respect to its expiry from one daily observation to the next. For the simplified analysis conducted herein, the effect of non-stationary futures measurement is acknowledged but appears immaterial.

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RWTC SHELL .SPGSCL CL1 RWTC SHELL .SPGSCL CL1RWTC 1.00000 RWTC 1.00000SHELL 0.98968 1.00000 SHELL 0.83737 1.00000

.SPGSCL 0.99394 0.99149 1.00000 .SPGSCL 0.87007 0.85694 1.00000CL1 0.99018 0.99983 0.99209 1.00000 CL1 0.84388 0.99963 0.86050 1.00000

2008 WTI CRUDE OIL DAILY RETURN CORRELATIONSQ3 through Q4Q1 through Q2



Q1 through Q22011 WTI CRUDE OIL DAILY RETURN CORRELATIONS

Q3 through Q4



2013 WTI CRUDE OIL DAILY RETURN CORRELATIONSQ1 through Q2 Q3 through Q4

TABLE 1

Sources: Thomson Reuters, Shell Trading, and AccuShares for calculations

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Correlations, like those depicted above, are one indication of the relationship between the relative returns, however correlations can cause miscues in comparative statistics.

Among other considerations relating to return correlations are: (i) correlation results can be heavily influenced by outlier observations, (ii) correlations assume a perfectly coincidental relationship between the data – that is there must be a period to period relationship rather than any kind of lagged, leading, or catch-up relationship, and (iii) because correlations measure relative movement around the respective average values, they will not capture absent or divergent trends between the indices.

To compliment the correlation analysis above, Table 2 below examines how well the daily change in futures prices predicts producer spot prices (as measured by “SHELL”) month-by-month over of the examined years. The calculations are run monthly from the 15th to the 15th, and the daily price returns from front-month futures contracts are applied to beginning-of-period producer prices in order to predict the period-end producer price. Table 2 reports the average monthly percentage error resulting from using front-month futures price returns to project the producer spot prices, and the analysis was conducted in half-year periods (Q1/Q2 and Q3/Q4) consistent with the daily return correlation analysis above.

TABLE 2Source: Thomson Reuters and AccuShares for calculations

Looking at both 2011 and 2013, the average cumulative difference between front-month futures return predicted spots and the monthly actual producer price spots is immaterial with no apparent directional bias. In contrast, 2008 indicates that front-month futures contract price returns underestimated producer prices during the first half of 2008 and overestimated producer prices during the second half of 2008. However, considering that the average financial investor is probably more interested in capturing absolute moves on an index rather than relative moves between indices, the approximately 1.4% undershoot (-0.24% times 6 months) in a market where the price of WTI crude moved 50% and approximately 5% overshoot (0.84% times 6 months) when it moved 75% are likely immaterial in an investor’s overall portfolio experience.

2008 2011 2013Q1 & Q2 -0.24% -0.01% 0.04%Q3 & Q4 0.84% 0.01% 0.00%

monthly SHELL prices implied by CL1 daily price returnsAVERAGE % ERROR IN PREDICTED PRODUCER PRICES

How Well Do the Daily Futures Predict WTI Crude Spot Market Prices

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Factoring in Futures Contract Rolls

In comparison to the relatively small amounts of over- and under- measurement of the futures contract as it relates to index measurement, futures rolls can introduce material effects in financial investor experience. It is generally well understood that the process of rolling futures in an ETF or ETN introduce either a benefit or cost when compared to a non-rolled spot measure; a relative benefit (for a “long side” fund) is expected when the rolled contracts are “in backwardation” (the longer-dated contract carries a lower price than the shorter-dated or expiring contract) and a relative cost (for a “long side” fund) is expected when the rolled contracts are “in contango” (the longer-dated contract carries a higher price than the shorter-dated or expiring contract). A “short-side” fund (or short position in a “long-side” fund) has the opposite relationship with respect to shapes of the futures curve.

Table 3 below presents the results of rolling from the front to the next WTI crude oil futures contract (monthly) over the penultimate 10 trading days of each contract where the “average” and “median” values include all of the penultimate 10 trading days and where the “best” and “worst” include only the single best day (lowest cost/highest benefit) or the single worst day (highest cost/lowest benefit) respectively – “best” and “worst” presume that the fund manager picks either the single best or worst single day within the penultimate 10 trading days to execute the entire roll. The last trading day of each contract was omitted from the analysis to avoid outlier effects common on the last day of contract trading.

The results in Table 3 are based on futures closing prices and do not include bid/offers or other transactions costs. Positive values indicate a cost to rolling futures contracts for a long-side fund.

TABLE 3

Source: Thomson Reuters and AccuShares for calculations

Average Median Best Worst2008 7.18% 6.36% -0.57% 16.37%2009 38.06% 37.92% 20.41% 53.17%2010 13.15% 12.88% 9.11% 17.97%2011 8.60% 8.57% 6.60% 10.79%2012 4.80% 4.84% 4.10% 5.38%2013 1.75% 1.80% -0.21% 3.39%

% C ost/B e ne fit [ (C L 2 - C L 1) / C L 1 ]Annua liz e d W T I C rude Oil F uture s C ontra ct F ront-to-Ne x t R oll

based on the penultimate 10 trading days of the front contract each month

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Further, when we consider the entire 6 year period from 2008 to 2013, if we remove the effect of outlier years by using median values, the median annual WTI crude oil return for the period was just over 7.5% and the median futures roll costs were over 5.5% – so for the median case, futures roll costs are indicated at almost 75% of the gross index return. The monthly best and worst roll outcomes range from a monthly benefit of just over 1.0% (3/08) to a cost of over 14% (1/09) for long-side funds.

Away from the cost or benefit attributable to futures rolls, the variance across periods and potential variance within periods is high and challenging for tactical position taking.

Because many investors will establish both long and short positions in a commodity across a market cycle, there is considerable risk that a fund’s futures rolls will frustrate achieving the tactical return. If only the less volatile years of 2011 through 2013 are considered, a one standard deviation annualized cost-or-benefit range is approximately minus 2.8% to positive 12.4% – a large range by almost all standards.

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Some Conclusions

1. The daily price returns of front futures contracts may be an accurate spot price indicator

For those investors seeking to access the primary or “first order” changes in WTI crude oil, these data indicate that daily percentage changes in front futures contracts may be an accurate and reliable proxy for movements in the spot price (as measured by “SHELL” and “RWTC”). A suggested implication for portfolio management is that an oil fund’s efficiency at delivering effective spot crude exposure can be benchmarked against running daily changes in front futures contract prices without the effect of collateral, expiries and rolls.

In the correlations and predictive estimates above, no adjustments were made for the non-stationary term/maturity of the continuous front futures contract (CL1). From observation to observation in both the correlation and predictive measures, the price movement in the front futures contract is used unadjusted despite the fact that the continuous front futures contract both: (a) shortens by one day until trading ceases for that specific month, and then (b) lengthens by approximately one month as the “next contract” becomes the front contract (CL2 becomes CL1) – and the cycle repeats.

The data examined show support for a highly simplified parallel shift model futures curves characterized by equal responsiveness across the term structure of futures prices – at least with respect to the front month contract. Movements in spot appear to be reasonably mimicked throughout the front month contract expiration and vice versa. The effects from localized curve shape effects, including day-to-day decay, appear relatively minor in the data examined.

2. In conventional ETFs and ETNs, the decision to participate in crude oil or other commodities should be accompanied with a view on how curve shape will impact futures rolls

Table 3 above is an illustration of how volatile the cost of roll yields can be; many investors have typically conceded (depending upon the years and the history examined) that the cost of rolls in a crude oil fund is typically between 5% and 10% per year; that is, a long fund is running into a 5%-to-10% headwind before positive gains are realized.

The results over the examined years show a number of results outside the 5%-to-10% window. Further there are some periods, such as the first quarter of 2009, where WTI crude oil rose by over 10% during the quarter, but the costs of rolling futures over that quarter (measured consistent with Table 3) exceeded

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27% – a directionally correct trade in actuality would have resulted in a loss of roughly 17%. During the first quarter of 2009, the average percentage contango (as measured by the difference of CL2 and CL1 divided by CL1) was almost 8% – so during that quarter, extending expiries by only 1 month cost a fund approximately 8%. Managing expirations can cost a fund a great deal more than is generated by the index.

Given that investors use crude oil exposure for many purposes including getting long in certain market conditions and getting short in other market conditions, it is important for investors to be cognizant of the various market conditions which will frustrate their achieving a tactical commodity return objective.

3. Check your ETFs and ETNs not only against their targeted index, but also other indices

Investors are regularly encouraged to monitor their ETFs and ETNs for tracking error in relation to the targeted indices. As demonstrated above, it is often illustrative to go beyond the narrow limits of what’s currently tradable in the ETF market and to identify other markets or other prices which may be more aligned with an investor’s goals. For example, while it’s common for an investor to want long or short exposure to a commodity it’s probably less common for that same investor to actually want a complex futures roll strategy return – although that’s what the ETF and ETN markets typically offer.

Further, investors should appreciate that a sponsor’s selection of a fund’s targeted index may be guided more by convenience or availability rather than optimal application. For example, different funds buy and hold different futures contracts and they may roll those futures according to different schedules – all of these structural details should be taken into account in fund selection.

As investors navigate the ETF and ETN landscape, investors should: (i) look outside the boundaries and limitations of the ETF and ETN market when measuring the exposures they expect and require, and (ii) carefully consider how the operational mechanics of any particular index or related fund may introduce return concessions which frustrate effective tactical trading or longer term investing.

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everything we wanted to know about spot prices and

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