CRB Index Revised

Adam Hamilton
Archives
Jul 8, 2005

Just as the NASDAQ stock index became the most widely followed benchmark of the mighty 1990s tech bull, in the last several years the CRB commodities index has become the reference metric of choice for today's powerful secular commodities bull.

Like all financial indexes, the CRB is not a static measuring rod but is constantly evolving. Constructing and maintaining an index designed to track a complex sector is quite challenging. Over years and decades component choice, weightings, and calculation methodologies gradually change as index custodians strive to keep their index relevant and useful.

While not widely known to mainstream investors, hardcore students of the markets are well aware that static indexes simply do not exist. The NASDAQ 100 is a perfect example. Since it topped in March 2000, an incredible 81 companies have been kicked out of the index. The NASDAQ 100 of today is a vastly different beast than the creature that tracked the elite tech stocks during last decade's boom.

Love it or hate it, the CRB Index is periodically revised as well. The latest revision, which is already generating controversy in some contrarian circles, is due to start trading on July 12th. It marks the most radical departure from existing CRB construction in the storied history of the index. After much study and thought, I would like to address this coming CRB revision and its impact on commodities investors.

The venerable CRB Index was originally launched in 1957, and for decades since it has been the world's premier commodities index. Interestingly, since then it has already been revised nine times before! Today's fringe perception that the CRB has been and should stay static is as inherently flawed as the short-sighted belief that political borders around the world are set in stone. History easily guts both fallacies.

While having a changing yardstick creates obvious problems of comparability, not having one leads to obsolescence and irrelevance. For example, of the 28 commodities included in the original CRB of 1957, there are quite a few that just aren't really relevant at all to our modern economy. Can you imagine if rye, potatoes, onions, hides, and lard were still in the CRB today? It would be laughed out of the markets! Lard?!?

And the other side of this coin is the original CRB also lacked essential commodities for today's economy. Believe it or not, there was not a single energy component in the original CRB! No crude oil, no natural gas, nothing. Precious metals were also nonexistent. Silver and platinum were first added in the 1971 revision. Gold first made the index in 1983, nearly a decade after it became legal to own again in the States. And crude oil, which makes the world go around today, also made its debut in 1983.

So as distasteful as a changing benchmark can seem at first glance, change is essential. Not even the most jaded and cynical contrarian would argue that the CRB would be superior today if it still had lard instead of crude oil. Indexes are a work in progress, period. Twenty years from now the CRB will need other commodities that may not even have risen to prominence yet, like uranium or hydrogen perhaps.

The CRB originally encompassed 28 commodities, and it continued to have 27 or 28 for its first six revisions running to 1983. In 1987 the list was pared to 21 where it remained until its most recent major revision in 1995. In 1995 it was further sliced down to the now familiar CRB 17 commodities. From 1995 to today, interestingly, was the single longest period of time sans revision in the CRB's history. The average time between revisions was only 4 years or so historically.

So after a decade without updating, I certainly agree the CRB is ripe for evolving once again. While the present CRB's component list isn't too bad, its component weighting and geometric calculation methodology leave much to be desired. Here is how the CRB is presently calculated as reported in a recent essay concluding unfortunately that today's CRB was not a particularly useful trading tool

"Individual commodities are arithmetically averaged across their various futures contracts that expire in the coming six months. After this operation is done for all 17 commodities, all 17 simple average prices are then geometrically averaged. All the individual simple average commodity prices are multiplied and then the 17th root is taken, yielding a geometric average across all components."

"Finally this geometric average result obtained from the 17th root is divided by a 1967 base-year average for commodities prices and multiplied by 100. The end result of these dual averages over time in individual commodities and across all commodities is a stalwart index that is the most resistant to component volatility out of any other major index that I have ever studied."

In addition to being overly smoothed and devoid of volatility due to its geometric averaging, the current CRB's equal weighting is not a valid reflection of reality. Over the last decade all of the CRB 17 have been equally weighted. Thus a relatively obscure commodity like orange juice is considered just as important as crude oil in today's CRB. Obviously this is silly. A great index should reasonably accurately reflect the economic realities of the underlying sector that it strives to measure.

In light of its increasingly evident obsolescence, the CRB's current custodian Reuters teamed up with Jefferies Financial Products, which provides commodities-related products to institutional investors, to radically update the CRB Index for the tenth time since it was launched nearly a half-century ago. When it goes live next week it will officially be known as the Reuters/Jefferies CRB Index, or R/J CRB. Overall the changes seem to be excellent steps forward.

The most obvious change to the CRB will be the addition of three new commodities (and the elimination of one existing one) for a net gain of two components. The famous CRB 17 will now be the CRB 19. The traditional equal weighting of the CRB will be thrown out as well, and good riddance to it. In the new CRB crude oil will be weighted as 23x more important than orange juice, a vastly more accurate portrayal of reality than equality has been.

The CRB's traditional geometric averaging is also being eliminated, promising a more fluid and volatile index that better tracks the true behavior of commodities during this secular commodities bull. By its very mathematical nature geometric averaging effectively continually rebalanced the index, decreasing exposure to rising commodities and increasing exposure to declining commodities. The new arithmetic averaging with monthly rebalancing ought to maintain uniform exposure and increase the CRB's consistency over time.

New R/J CRB futures will be launched too. These will have a contract multiplier of $200 times the CRB, greatly reduced from $500 times in the existing CRB contracts. These smaller contracts will make the CRB futures much easier to trade for small speculators and should dramatically increase liquidity. Overall the coming CRB changes seem logical and good for the commodities bull, enabling it to be more easily tracked and traded.

With the high-level strategic summary out of the way, we can dig into the actual tactical CRB changes. While some changes will no doubt irritate certain constituencies like orange-juice producers and pig farmers, I think most contrarians will agree that the new CRB is generally a vast improvement over the existing one.

In the graphic below, today's CRB is represented by the left pie chart while the new CRB is rendered on the right. Pie slices with colors are common between both CRB indexes, while white slices indicate commodities dropped and/or added. The commodities listed in the center show the increase or decrease in weight in this tenth major CRB revision. In addition, CRB sub-sector weightings and changes are highlighted above and below the pie charts.

The CRB of the past decade had 17 equally-weighted component commodities, which equals out to 5.9% or so for each individual component. The new CRB's 19 component commodities are much more intelligently weighted. The biggest by far, and rightfully so, is crude oil at a massive 23% of the new CRB index. Total petroleum products will now run 33% compared to less than 12% in the current CRB.

Crude oil is absolutely the King of Commodities today. It forms the foundation of our extensive global trade and hence the entire world economy. Virtually everything we consume in the first world is transported via oil-powered ships, trains, airplanes, and trucks. Without oil, the incredibly intricate global logistics network on which we so heavily rely today would grind to a halt. We would be thrust back into the Steam Age before flight and global trade would implode. Oil's supreme importance is unassailable.

The new CRB brings back unleaded gasoline as well, a great decision. Unleaded gas was originally inducted into the CRB in the 1992 revision and then inexplicably booted in the 1995 revision. Yet gas is the crude oil distillate that most affects first-world consumers. Every ride we take consumes gasoline and everything we buy includes a component of gas costs incurred to transport it from where it is produced to where we purchase it. As far as impacting everyday life, no other commodity is so ubiquitous and far reaching.

The new CRB's 33% weighting for crude oil and its key distillates is also now in line with other commodities indexes. The CRB's main competitor is the Goldman Sachs Commodities Index, which was running an utterly massive 64% petroleum weighting at the end April. The Dow Jones AIG Commodities Index had 21% exposure to petroleum at the same time. Far more so than today's paltry sub-12% weighting, the new CRB's petroleum emphasis captures the essence of today's world trade and better compares to other leading indexes.

Overall, when natural gas is included, the new CRB's energy exposure rises 21% to 39% from the existing iteration's 18% or so. I have pondered this heavy energy emphasis a lot in recent weeks and continue to conclude that it can only be good. A great index reflects the relative importance of its components in the underlying world economy, and in today's world nothing else even comes close to having the broad impact of energy.

In order to add energy exposure, the new CRB had to cut exposure in the other four traditional CRB groups of grains, meats, tropicals, and metals. In general the net effect of these cuts is good, as the costs of these commodities are usually small relative to the total dollars an average first-world consumer spends on commodities in a typical year.

The CRB grains were cut nearly 5% to 13% in the new index. Weightings of corn and soybeans actually rose slightly from the CRB, while wheat was cut dramatically to 1%. I am not aware of the specific Reuters/Jefferies rationale behind the wheat cut, but by weighting it at 1% they consider it a "Group IV" commodity. Group IV commodities are all weighted at 1% and are designed to help further the overall diversification and broad representation of the index.

The CRB meats fell nearly 5% as well, to 7%. Live cattle make up the bulk of this exposure at 6% in the new CRB while lean hogs are only running 1% now. As an American this intuitively makes sense to me. I don't know the exact figures, but with our deep cultural affinity for steaks and hamburgers I am sure vastly more beef is consumed in the States than pork. Since the new CRB wants to better reflect the underlying commodities economy, it makes sense to weight widely consumed commodities higher.

Thankfully the new CRB cuts tropicals exposure by 8% or so to 21%. While this is still higher than I would like to see as a first-world contrarian investor and speculator, it is a vast improvement. Tropicals include sugar, cotton, coffee, cocoa, and orange juice. While no doubt extremely important in the countries that rely on these commodities as their major exports, I can't help but feel that they just aren't that important in our modern world.

Relative to our total personal expenditures in a given year, cotton, cocoa, and orange juice are probably trivial. Indeed orange juice weighs in at just 1% in the new CRB, a huge improvement over the old CRB's nearly 6%, while the other tropicals are now running 5% each. We probably consume a good amount of coffee and sugar, but again as a percentage of our total expenditures these have to be fairly small per capita.

If I was nominated Supreme CRB Custodian I would reduce the weight of tropicals even further, probably to the 10% to 15% range. I would then reallocate the excess tropicals' weighting back to the CRB metals. Metals are crucial in the heavy manufacturing necessary to bring other nations up to first-world standards of living and they also provide the easiest and most leveraged way to ride this secular commodities bull.

Unfortunately CRB metals were also reduced in prominence in the new CRB, down about 4% to 20% even. Most of the component changes occurred in the metals realm as well. The new CRB adds aluminum at 6% and nickel at 1% while dropping platinum entirely. The weighting of silver is also drastically reduced to 1%. Out of all the changes in the new CRB, those in the metals are the ones I find most questionable. We can further subdivide these metals into industrial metals and precious metals.

The old CRB only had copper as its sole industrial metal, weighing in at under 6%. Copper is a very important metal in manufacturing and its weight was slightly increased in the new CRB. With the addition of aluminum and nickel, the industrial-metal weight in the new CRB is 13%, over double the existing CRB's. All three metals have extensive industrial applications and each find their way into our lives via the goods we buy in an astonishing variety of ways.

All contrarian rancor that I have seen directed at the new CRB swirls around its serious reduction in weighting of the precious metals. In the old CRB gold, silver, and platinum commanded an impressive 18% or so of the index. In the new CRB with platinum unceremoniously booted and silver sliced down to a mere 1%, precious metals only comprise 7% of the new CRB. There are a variety of perspectives from which to illuminate this drastic change.

Now I am a contrarian investor who has spent the last six years of my life studying and trading our new secular commodities bull, often via precious-metals vehicles. I love precious metals as they are one of the easiest, safest, and most leveraged ways to ride this powerful commodities bull. I have been blessed with great wins bull to date in gold and silver and the stocks of companies that mine them, so I definitely have a special affinity for the precious metals.

But playing devil's advocate, it is not hard to understand why the CRB custodians consider them less important relative to the entire commodities economy. Gold, platinum, and silver each have a variety of highly specialized industrial uses where they excel without equal, but as a percentage of final manufactured product costs they are usually trivial. Industrial demand for each, while important, is utterly dwarfed by total-dollar demand for energy and food commodities.

While platinum was kicked out and silver's influence greatly reduced, the weighting of gold actually rises slightly in the new CRB. Gold trades highly liquid futures contracts that are heavily used by investors and speculators to play the unfolding commodities bull and the new CRB custodians duly acknowledged this by giving it their highest 6% weighting (not counting the special exception of crude oil).

After studying everything publicly released about the new CRB I certainly do not get the impression that its custodians are anti-gold at all. On the contrary, in their new weighting scheme they gave gold a priority position equal to natural gas, soybeans, and copper among others, their premier weighting level.

And silver, as exciting as it is for speculators, really does have a trivially small market. From a broad commodities-economy standpoint silver's reduced weighting is certainly justifiable. Contrarian speculators like me will love silver forever due to its extreme volatility and lightning-fast rallies, but even we acknowledge that relative to the overall economy silver really isn't that important on a dollar basis in the grand scheme of things.

And while I am certainly sympathetic to claims that the new CRB is partially designed to draw attention away from precious metals, if true that may actually be a plus. If entities like central banks are actively trying to retard or cap gold or silver, they are happy when there is less investor attention captured by it. If the CRB eventually becomes as popular as the NASDAQ did last decade, the lighter emphasis on gold and silver together in the new CRB may help keep the precious metals lower on the popular radar.

Thus the metals could theoretically rise higher and faster without dragging the CRB too high or unleashing torrents of central bank selling. And the longer that precious metals escape mainstream attention, the more we contrarians can accumulate at rock-bottom prices and the higher the ultimate bubble top will be driven when the public rushes in at the mania stage. The metals markets are all very small compared to total investment capital and the later that the mainstream "discovers" gold and silver the more spectacular the resulting neo-gold rush will truly be.

So although I personally would have weighted the precious metals more heavily in the new CRB and cannibalized the still over-represented tropicals to make the room, overall the new CRB looks logical and sound. It is a vast improvement over the existing CRB in almost all regards and will be a great tool to measure the next decade of our awesome secular commodities bull.

I think it will be wonderful for investors and speculators too, far more responsive to commodities prices. Reuters and Jefferies did a historical study of how the CRB would look since 1994 if this 10th revision had already been in place. While the existing CRB was only up about 1.3x over this period, the new CRB would have risen about 2.7x since 1994! Thus the new CRB will be more than twice as responsive as the old geometrically smoothed one we are all used to. And nothing draws new capital to commodities faster than rising benchmark indexes!

In light of this analysis, I believe the new CRB is a very positive commodities bull development. We'll be blessed with a more responsive, more exciting, and more realistic index that will help entice new capital into the ongoing commodities bull. While change always brings challenges in comparability, the vast majority of these CRB changes are moving in the right direction.

At Zeal we continue to believe that the new secular commodities bull will offer the greatest opportunities for earning legendary profits in the coming decade. We will continue to zealously study the commodities markets and look for elite stocks of commodities producers in which to invest capital. As the new CRB data starts pouring in we will continue analyzing it and even build new trading tools based on it if possible. Please join us today so you don't miss out on the vast opportunities that the new CRB could help unleash in the years ahead!

The bottom line is indexes are born to change, not to remain static forever. If the CRB hadn't changed since 1957, it would have no energy or precious-metals components today and would still follow anachronisms like hides and lard. Change keeps the CRB relevant as commodities wax and wane in importance across the seas of time.

It is also important to keep in mind that the CRB is not designed to be, and was never intended to be, a precious-metals dominated index. The extreme investment leverage attainable in precious metals is due to the fact that they are very small markets relative to total investment capital floating around. The new PM weightings are reasonable and logical in light of the PMs' modest footprint in the overall commodities economy. As an outspoken PM zealot I do not find these new weightings terribly troubling at all.

The new CRB should make for a much more exciting and dynamic index attracting in more capital to our secular bull. And that is what we always want, mainstream investors following in the leading vanguard of contrarians and driving up our existing investments dramatically.

Adam Hamilton, CPA
July 8, 2005

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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