By: Steve Smith
Before I focused on options I actually began my trading career some 25 years ago in the trading pits of the Chicago Board of Trade, trading contracts on corn, soybean and wheat futures. While these are very tangible products most of us encounter in our everyday life, the concept of “futures contracts” can be a bit more elusive.
With the election of Trump and reflationary policies he has promised, we have seen a resurgence in interest in commodity prices and and trading interest. Everything from gold and copper to oil and coffee rallied of late. Because commodities tend to be uncorrelated they are a great way for investors to diversify. For more active traders their volatility and leverage offer tremendous profit potential. Let’s take a dive into the what, why and how of commodities.
Note there are now a full slate of Exchange Traded Funds tracking commodities, such as SPDR Gold (GLD) and United States Oil Fund (USO), and while commodity equities and commodity futures can be similar, there are profound differences when one digs into the weeds. What commodity futures can provide for a diversified portfolio is also very different from what commodity equities provides for a diversified portfolio (i.e., more equity risk).
Commodity futures investing can appear to be deceptively simple, and investors can have basic misunderstandings about the asset class. For example, many investors (to include the great investors at GMO) hint at the idea investing in commodity-producing equities is “better” than investing in the underlying commodity futures. If this were true it would be great on many levels – more transparent, more liquid, more tax-efficient, and less complex.
But there is a problem – one can’t replicate commodity future trading strategies via equities because there are 2 elements of commodity futures: spot returns and roll yield return. Commodity equities and commodity futures are different animals that help investors often achieve different goals.
Observe that long-only commodity returns for the Bloomberg Commodity Index and the S&P GSCI commodity index over the period were -4.6% per year, which was a much lower return than for stocks and bonds. The chart below highlights the poor performance over the most recent decade.
The average risk premium to an equal weight commodity futures index during this out-of-sample period was 3.7% per annum, which is comparable to its long-term in-sample average of 5.23% from 1959-2004. The authors attributed much of the lower out-of-sample returns to lower collateral returns. The chart below highlights their core result, commodity futures haven’t been wonderful the past decade, but they haven’t been a tragedy either.
The Mechanics of Commodity Futures Pricing
In order to grasp where roll returns, or “roll yield,” comes from, we must first understand how futures are priced in equilibrium.
Futures price reflects three components set forth in the equation below:
F = Sp*(1+r+s-c)
The components of the equation are as follows:
The Risk-free rate, r, is embedded in the futures price due to the leverage inherent in commodity futures.
Storage costs, s, are the annualized costs to store a physical commodity.
Convenience yield, c, arises from the benefit of holding a physical commodity.
Sp is the current spot price.
F is the current future price.
Take into consideration an investor always has two options to pursue if they want to own a specific commodity at time T:
- Borrow money, buy the commodity, store it, and hold it until time T.
- Go long the future and settle the future at time T.
In short, the futures price is equal to the spot price, adjusted for the cost of borrowing, the cost of storage, and taking into account the benefit of ownership (convenience yield).
There you have it. If interest rates and storage costs are higher than convenience yields, futures have higher prices than spot (i.e., contango). If interest rates and storage costs are lower than convenience yields, futures prices are lower than spot (i.e. backwardation).
Futures are essentially an ownership of an asset in the future, secured by a loan, and another party endures the costs/benefits of ownership during the loan period.
Roll Yield and Futures Pricing
As time passes, a futures contract will converge on the spot price as the time period between the futures expiration date and the current date converge on the same value.
What does this imply about the futures curve, assuming spot prices don’t change?
Well, if futures are above spot (contango), we can expect to earn negative returns as time passes and the future’s price converges on the spot price. Similarly, if futures are below spot (backwardation), we can expect them to creep up towards the spot price as time passes. This element of return, which isn’t explicitly tied to the spot price, is often referred to as “roll yield,” or the roll returns.
Let’s take a simple example to see how futures returns can be decomposed into spot and roll returns (we are going to ignore borrowing/lending and other details for now in order to demonstrate the spot/roll concept first).
It is January 2016, and the spot price of crude oil is $55. We go long the March futures contract at $50. Note the futures curve is “backwardated,” and slopes downward.
Now let’s say it’s February 2016 and we close our March contract at $60. What are returns for futures, decomposed into spot and roll returns?
The futures return is: $60/$50-1 = 20%
The spot return is: $60/55-1 = 9%
The roll return is 11%, which is the difference between the futures and the spot returns (20%-9%=11%)
Using this approach, we can calculate spot returns, and derive roll returns for any rolled price series.
As you can see rolling creates a significant drag on performance over time.
I know this a lot of information, some of which might not matter to the typical investor, but I think it is important to have a basic understanding of the structure and price behavior of whatever assets you trade.
The key takeaways are the following:
- Commodity futures index returns are positive and significant over time.
- Interest rate adjusted carry (convenience yield – storage costs) is responsible for most of the return, arguably earning a “speculator premium.”
- Commodity spot returns drive futures volatility and these returns are positively correlated with macroeconomic states (expansion/recession), suggesting the existence of a risk premium.
- Commodity futures offer an inflation hedge and enhanced returns in “backwardated” markets, highlighting a unique portfolio diversification benefit.
Commodity futures are a unique asset class that cannot be replicated via equities, bonds, or equity/bond combos. Commodity futures stand on their own and should at least be considered by investors.