The difficult and painful commodity world

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The commodity complex continues to hurt many investors directly and indirectly. We have written about commodities and the issues with many of the products in the past and most recently about the indirect pain in the high yield market with regard to Oil and Gas exploration companies.

Broad based commodity funds and ETFs have lost 13% or more over the last year in a very tough environment for many commodities such as oil, gold, wheat and base metals such as aluminum. Among other reasons, basic oversupply and lower demand have driven prices down. The Powershares ETF DBC which represents futures contracts in major commodities such as Oil, Gold, Wheat and Aluminum is down and has not provided the inflation protection or the diversification benefits that many advisers have hoped for.

We decided to take a look at the underlying commodities to determine if the futures curves in each are in a state of contango or backwardation. As a review, contango is not an enviable state while backwardation allows for the potential to profit. The key question is whether or not the manager or instrument used has the ability to navigate the futures curve adeptly.

It is important as wealth can be eroded by buying contracts that are part of a futures curve that is in contango and after examining some of the curves for energy and gold at least, there is reason to be concerned as at least a few of these areas display contango.

We recommend that your investment committee take a serious look at the methodology that your ETF or active mutual fund manager employs as a poor process can cause wealth destroying damage. If you would like some assistance in this due diligence project, Zenith would be happy to help out and provide our insight.


Tom Koehler, CIO


Lower oil can hurt

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The precipitous decline in oil over the last few months is not news and is really a matter of higher supply with lower demand. Some believe this imbalance will continue for some time. This is up for debate but the market inter connectivity is very much alive and continues to be painful for investors in a number of asset classes.

Brent Crude is down approximately 27% from its June high. While that is seemingly good for consumers, the speed and ferocity is truly a worry as the deflation fears are here and are leaving the Federal Reserve with a tougher time with interest rate policy.

The ETF (XLE) is down over 20% in the same time frame as the large energy producers equity valuations have been hit very hard. They have fared well however vs the smaller energy exploration companies whose balance sheet and credit quality is not as robust.

XOP is the SPDR ETF that represents a large portion of the oil exploration companies and is down from June peak 32%. That is the equity and depending on your high yield bond fund, there may be additional pain. Some of these companies at the lower end of the credit spectrum issued bonds at or near par(1oo centS/$) and are trading in ranges from 55cents to 70 cent on the dollar.

As equity is at risk of losing all value, these bonds can default and leave the investors with little to no residual value. They were sold most likely with optimistic scenarios to warrant the par pricing but reality has set  in.

A broad based investment in commodities has not helped either as they are down close to or over 20% from peak as well.  They say a strong dollar is partly to blame but diversification away from the dollar has been the asset allocation advice for a long time. Now markets are converging against that thesis. It is time to delve in the intricacies of the models.

We suggest that you hold a conference call with each of your managers to determine their risk profile with respect to their positions and how they plan to maneuver this treacherous environment.

As always, we are happy to help with that discussion preparation to aid in the market and manager due diligence.



Tom Koehler, CIO