SERIOUS MONEY:The mechanics of investment reveal that the commodities bubble cannot last, writes Charlie Fell.

THE NEW millennium brought an end not only to the long bull market in stocks that began in 1982 but also to the protracted bear market in commodities. Years of under-investment in the infrastructure of several commodities combined with the emergence of China and India as major consumers meant prices could only go up.

The arrival of professional investors in a hunt for additional yield in a low-return world added fuel to the fire.

Not surprisingly, commodities have recorded stellar performance in recent years and have soared higher in recent months as investors sought diversification in the face of ailing debt and equity markets, alongside increased protection against inflation fears and a weak dollar. However, the commodity bubble has hit a bump in the road and several products have endured significant setbacks.

Should investors buy on the current weakness or call time on the bull market to avoid a more serious hangover?

The market for commodities has undergone structural change in recent years and, to appreciate the outlook for returns, would-be investors need to understand the dynamics of investment.

Exposure to commodities is typically achieved via fully collateralised investment in futures contracts that are aligned to the growing number of indices that track the physicals' performance. The dependence on the futures markets is understandable given that direct physical investment is typically neither practical nor possible, while research illustrates that the correlation between industrial material prices and the returns from commodity-related stocks is relatively low.

Long-only investors have little choice but to purchase a basket of fully collateralised futures contracts to gain broad exposure to commodities and continually roll that exposure into new contracts to avoid expiries.

The mechanics of investment illustrate that the total returns earned are a function of three components - spot, collateral and roll - the understanding of which is critical before an allocation to commodities can be considered.

The spot return derives from the change in the cash price of the commodity over time.

Historically, holding physical commodities has not proved to be a good investment. Indeed, a diversified basket of commodities has generated a negative spot return of almost 2 per cent in the long run. The poor performance arises from the introduction of new supplies and production technology, resource substitution in the face of rising prices, and replacement due to innovative new technologies.

Long-term trends are well and good, but investors are far more interested in returns over short horizons. In this respect, the marked upward movement in prices over the past six years parallels the early bull market of the 1970s.

Supply scarcity, robust demand, accommodative monetary policy and a decline in the purchasing power of the dollar - the currency in which commodities are priced - have combined to propel prices ever higher. The price of a barrel of oil recently surpassed $100 for the first time, almost a century after black gold was first discovered in the Persian Gulf.

Unfortunately, the recent surge in cash prices does not appear to be supported by the underlying fundamentals and seems to reflect a feeding frenzy on the part of investors in a desperate bid to boost ailing returns. Frenzied investment and the resulting parabolic rise in prices is self-defeating and it is hard to believe commodities will be an exception.

Commodity prices typically rise during the latter stages of an economic expansion and the initial months of a recession, but as the downturn deepens prices inevitably succumb to the laws of supply and demand. Thus, spot returns are unlikely to impress through the remainder of 2008.

A bleak outlook for spot prices does not of itself negate the rationale for commodity investment due to collateral and roll returns. Long-only investment is fully collateralised, which means that long futures positions are backed dollar for dollar with cash that is invested in Treasury bills. The yield earned on collateral has accounted for more than half of historical commodity returns since 1970.

Unfortunately, the yields available on Treasury bills today suggests that collateral returns are unlikely to offset price weakness in the months ahead.

A long-only investment in commodities today cannot depend on movements in spot prices or the yield on collateral to produce respectable returns, so the roll is of crucial importance.

The roll yield, which is derived from closing a soon-to-expire futures position and going long on a more distant contract, has been a primary determinant of commodity returns through time.

This is because the term structure of futures prices has typically been in backwardation, where prices decline across the maturity spectrum of contracts. In other words, investors roll from an expensive to a cheaper contract and earn a positive carry in the process.

Commodity returns have been shown to be linearly related to backwardation, but the term structure of futures prices has undergone dramatic change in recent years for a variety of reasons, including the surge in investment demand.

Today, the futures price curve for several commodities is upward sloping, which means that roll returns are negative.

Professional investors have been enthralled by commodities in recent years and total investment has exploded from less than $10 billion (€6.36 billion) a decade ago to more than $170 billion today.

Will the commodity bubble continue? The fundamentals say no, as do the investment mechanics.