How To Win With Commodity Spreads

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• Commodity spreads have low correlations to major equity indices, offering creative portfolio diversification. Specialized commodity funds have information access unavailable to average investors.
• Arbitrage trades of agricultural commodities require a deep understanding of consumer behavior in different jurisdictions, crop cycles and global weather patterns. By untangling the complexity, investors can find high-upside opportunities.
• South African hedge fund Polar Star combines statistical modeling and fundamental analysis to identify the best entry points for trading commodity futures.

Global commodity futures are typically a hedge against inflation and volatility, and spreads offer a further strategic opportunity for portfolio diversification. Yet there’s a high barrier to entry — foreign exchange risk, low liquidity and the granular requirements of market data keep many traders boxed out unless they can find a hedge fund that’s mastered the system.

Polar Star is a commodities-focused fund based in Cape Town, South Africa. Its founders began with a proprietary trading desk at an investment bank and first recognized the arbitrage opportunities between South African-produced commodities and the U.S.-based benchmark. Since moving to a fund structure in 2009, Polar Star now has more than 740 million rand ($39.5 million) in assets under management.

“In South Africa, there’s a lot of agriculture,” explains Polar Star investment researcher Mauritz van den Worm. “You don’t have to be stuck with U.S. commodities. You can also look at, say, South African wheat versus European wheat or Black Sea wheat.”

How does it work? Finding relative value in commodity markets is an exercise in patience. In addition to quantitative analysis, it requires a careful understanding of the underlying fundamentals of supply and demand, as well as daily monitoring for price asymmetries.

According to Mauritz, most people look for value too close to the expiry date, when most market inefficiencies have already been corrected. “In reality,” he says, “opportunities present themselves better along the futures curve, a year or even 18 months out.”

Mauritz recently joined host Moritz Seibert on the inaugural episode of the Top Traders Unplugged Open Interest series to provide a fascinating behind-the-scenes look into how Polar Star leverages location arbitrage, calendar spreads and other commodities trading strategies. Here’s a page from his playbook. 

Agricultural spreads 

Geographical arbitrage capitalizes on price spreads for the same item in different locations. If you buy a vintage gold watch at an estate sale for $100 and then immediately sell it to a collector online for $200, that’s arbitrage.

In the global commodities market, these spreads might exist between gold prices on London and New York exchanges or between corn prices in Chicago and Johannesburg. If the commodity is priced differently in the two locations, a trader can theoretically buy low in the cheaper market and sell high in the more expensive location. 

But the math gets complicated. Futures contracts aren’t one-for-one equivalents in different markets. “U.S. [corn] contracts are priced in cents per bushel,” Mauritz explains, “and the South African contract is priced in South African rand per metric ton.” 

It’s not just the unit conversion that’s tricky. Even though Polar Star rarely holds a position to expiry, the arbitrage equation still needs to consider the shipping cost of the physical goods. To compare apples to apples, or maize to maize, traders need to look at similar shipments of equivalent distances and matching tonnages. 

Beyond that, prices several months out are subject to swings in the exchange rate, essentially creating an FX position on top of the commodity trade. “At the inception of the trade, we hedge out all currency risk,” Mauritz adds. The fund managers work to get all numbers to a common denominator so transactions are priced in dollars per ton. That way, the only factor influencing the trade value is the underlying commodity.

Finding the entry point

Once the calculations are complete and it’s clear one market is trading more expensively than the other, Polar Star won’t necessarily swing in to execute a spread trade. The fund managers use screening tools to assess how the current relative value compares to historical situations, but Mauritz notes that quantitative analysis is only step one.

“Many of these agricultural and other commodity spreads have spread levels that are governed by the underlying fundamentals of the commodities, or the jurisdictions under which they are produced,” Mauritz says. For example, there’s an intrinsic price support for agricultural commodities. If the price of corn drops low enough that it’s no longer profitable for farmers to grow it, they’ll plant something else, and the resulting shortage will bring the price back up.

Ultimately, it’s a question of supply and demand. If drought conditions lead to a weak crop in South Africa, export prices in other markets, such as the U.S., will rise. But in a bumper crop year, South African exports can cut into the U.S. market share, as happened in early 2023 when China diversified its grain purchasing with South African corn. Depending on which direction the scales tilt, corn futures will be valued accordingly.

“Most of the time, when you’re talking about the price of one contract being elevated compared to another, it’ll probably be in the front end of the curve,” Mauritz says. “That’s where most people are looking.”

The more interesting place to look, however, is farther out on the curve, months before there’s any certainty about weather conditions or international trade agreements. According to Mauritz, determining the future fundamentals of a crop demand more than a year in advance can identify wide price spreads with significant profit opportunities. Why? Because of the tension between producers and consumers.

The distorted curve

Sellers want to lock in profits, meaning farmers will look at far-out contract dates for financial security in the next growing season. Buyers, on the other hand, want the commodity sooner and will prefer short-term expiry dates. When sellers push the back end of the curve down and buyers push the front end of the curve up, it creates a distortion — the back end of the curve becomes relatively cheaper. Because of this, the better buying opportunity is on long-dated contracts.

“You’ll find that many times the spread — say between South African yellow maize and CBOT [Chicago] corn along your future curve — has a better opportunity in terms of what you can gain versus what you can lose, given the underlying fundamentals,” Mauritz explains. Maybe prices are dipping low for summer-dated contracts over a year out. Since droughts are more likely to happen in the summer, which would in turn drive the price up, having long exposure could be a great investment.

Host Moritz Seibert, however, raises a question. How much liquidity is in agricultural futures contracts 18 months out? “In my experience,” he notes, “it’s almost more difficult to get into the trade than it is to get out of the trade.”

Mauritz agrees and admits that he often has to patiently buy in small quantities until he reaches a full position. Polar Star makes trades through specialist brokers, and, depending on market conditions, it can take weeks or even months to see the desired volume. But the closer the contracts get to expiry, the more interest buyers have. 

“The good thing is, as the trade matures, you move into liquidity,” Mauritz explains. “If you’re involved in a position a year out on the curve, six months down the line, there will be ample liquidity. So getting out is normally very easy.”

Accounting for storage

Geography isn’t the only factor in arbitrage. Commodity spreads take other forms, too. A calendar spread compares contracts with different expiry dates, maybe one in July and one in December. A substitution spread might price arabica coffee against robusta coffee, while a processing margin spread is the credit between raw materials and finished products, such as corn versus ethanol. No matter the approach, traders need to remember a fundamental reality of agricultural commodities: Crops need storage space.

The cost of storing a commodity — plus any associated interest, delivery fees and insurance payments — is known as full carry. Hypothetically, maybe it costs 5 cents per bushel per month to store corn. In theory, then, a contract expiring 12 months out should be 60 cents higher than one expiring today to account for the monthly storage costs. It sounds simple enough, but in reality, holding costs aren’t so cut and dried.

“In terms of the South African market,” Mauritz says, “there are many different delivery points. And each delivery point has a different silo with different owners, so you need to be aware of the costs associated with each of these to get an idea of the default carry.” If a futures contract isn’t accounting for the full carry price, it creates an arbitrage opportunity.

It’s a similar process for the U.S. and Europe. Without access to data vendors or brokerages who can supply these numbers, investors are left disadvantaged, creating another barrier to entry for average traders. In order to maintain its edge, Polar Star has worked diligently to build a network of brokers with access to delivery and storage price information.

Mauritz explains that if a current curve is trading close to the full carry price but a contract dated a year out is trading above the carry cost — perhaps due to some uncertainty about next season’s crop — there’s a chance to trade the spread. “It gives you a good asymmetric opportunity,” he says.

When disaster strikes

No matter how good the model is, there are always events it can’t forecast. For agricultural commodities, perhaps no example is more relevant than the war in Ukraine. Speaking of Russia’s initial invasion in early 2022, Moritz Seibert asks, “How was trading during that period?”

Mauritz recalls it as “terribly frightening.” Euronext wheat was stuck, unable to go through the Black Sea. With no way to sell, the price dropped. Meanwhile, consumers still needed the product, so prices in the U.S. went up. “So your candle was burning at both ends,” Mauriz says, “and you couldn’t get out of the position.”

So what did Polar Star do? While other institutional investors around the world jumped out of their positions, Mauritz and his team held steady. He says, “After really focusing on and studying the fundamentals, you could see that the Ukrainian wheat wasn’t such a big part of the balance sheet and the world would actually be fine. We decided to just hold on, and, eventually, the fundamentals [of the original trade] realized.”

The takeaway? Commodity spreads have low correlations to what’s happening in other financial markets. While 2022 was a horrendous year for U.S. equities, agricultural commodities bounced back faster from the same geopolitical crisis.

“Because [commodities trading] is so different from anything else, especially in the relative value space, it lends itself to be this fantastic portfolio diversifier,” Mauritz says. At the very least, it’s one worth exploring.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.