Commodity investors can capitalise on seasonal trends
Spotting annual patterns can help investors profit from seasonal fluctuations in demand for commodities
While markets around the world tend to be impacted by similar forces, seasonal factors in commodities can vary dramatically from market to market.
Because of this, demand for commodities fluctuate at different times of the year. Distinguishing these trends enables investors to potentially capitalise on the strength of a commodity at a certain point in the year. Likewise, investors might avoid the pitfalls of weaker periods and even take advantage of seasonal declines through shorting.
While equity seasonality is driven by flows of investment capital, seasonality in commodity markets is driven by changes in the production and consumption of the underlying commodity throughout the year.
In the northern hemisphere, peak demand for natural gas occurs in winter when demand is high for home heating, with a smaller spike in the summer when natural gas is used in power generation to meet air conditioning demand.
Petrol, meanwhile, has its peak demand period in the summer when consumers drive to cottages and other holiday destinations.
Although gold has been generally strong throughout the year, it tends to perform strongest in autumn, driven by an increase in jewellery demand for the wedding season in India.
Seasonality is driven more by the supply side. Weather conditions that impact both the quantity and quality of harvests have a major impact.
Based on their average monthly performance, investors can compare a number of active investment strategies that go long and short at different times of the year against a traditional strategy of buying and holding certain instruments. With these approaches in mind, the following conclusions can be made:
While it has traditionally been thought that returns and risk move together, performance testing shows that trading actively and switching sides throughout the year tends to increase returns and/or reduce risk in commodity markets.
Investors can measure the trade-off of risk and reward in a particular strategy by dividing its profits by the standard deviation of its returns. Active strategies are most effective in petrol and natural gas markets and generate a strong increase in return relative to risk.
The one exception is gold, where the active strategy reduced risk slightly but also lowered returns. This highlights the strength of the bull market during the past decade, but also indicates that gold pricing is influenced by many factors besides seasonality in commodity demand, such as its role as a store of value, currency and defensive haven.
Based on these points, it is interesting to note how seasonal swings in the demand of commodities will play out during the rest of 2012. After a rough finish to 2011, which saw major declines in three of the last four months of the year, commodities tried to rebound at the start of the year. But declines have resumed in the past three months, driven by continued weakness in precious metals. Meanwhile, fears sparked by the financial turmoil in Europe and slowing economies in China and the US have knocked down the price of energy and base metals.