Agricultural Market Curve Shape

Corn, Wheat and Soybeans

Corn curve shape:

2007 contango then lower

2008 contango then lower

2009 contango then higher

2010 backwardation then higher

2011 backwardation then higher

2012 backwardation then ?

 

Corn is evenly split between contango and backwardation with two contangos followed by declines and two backwardations followed by gains. This market, so far, is the only market yet to show roll yield.

 

Wheat curve shape:

2007 backwardation and contango then lower

2008 contango then lower

2009 contango then higher

2010 contango then higher

2011 contango then higher

2012 contango and backwardation then ?

Out of four contango years, three were higher. Out of two partial backwardation years, one is lower and one is unknown. Again, wheat shows no clear pattern except for contango showing higher prices which contradicts the premise of bullish backwardation. 

 

Soybean curve shape:

2007 mixed then lower

2008 contango then higher to unchanged

2009 backwardation then higher

2010 contango then lower

2011 mixed/flat then higher 

Soybeans show some negative roll yield but not much.  Contango markets were split higher and lower as were mixed markets and backwardation was lower.   

Corn and soybeans are the only markets reviewed, so far, to show any indication of roll yield.  For the periods shown, corn appears to have roll yield and soybeans barely shows the same while roll yield does not appear in wheat markets. 

 

Softs Curve Shape: Coffee, Sugar and Cocoa 

The following markets, again, show no clear long-term pattern of lower prices following contango.

 

 

Coffee futures curves:

2007 contango then lower

2008 contango then higher

2009 contango then higher

2010 backwardation then lower

2011 contango then lower

2012 contango then ? 

ICE coffee was contango four out of five years and split evenly lower and higher.  2010 was in backwardation and, contrary to theory, was lower.  Coffee shows no indication of negative  roll yield.

 

Sugar futures curves:

2007 contango then unchanged to higher

2008 contango and backwardation then higher

2009 steeply contango then sharply higher

2010 steeper contango then lower barely lower and higher

2011 backwardated then lower

2012 contango then ?

The interesting sugar curves show markets in stress (2009-2010) yet still no signs of negative roll yield.  Three contango years were followed by mostly higher, higher and sharply higher markets.  The backwardation year was lower and the mixed years were mostly higher.  Again, sugar shows few signs of negative roll yield.

 

 

 Cocoa Futures Curves:

2007 backwardated and contango then higher

2008 contango then sharply higher

2009 contango and backwardated then lower

2010 contango then lower

2011 contango then higher

2012 backwardated and contango then ? 

Cocoa was sharply bullish from 2007 to 2009 and then sharply bearish to 2012.  The three contango years were split higher, higher and lower.  The partly backwardated years were also split higher and lower.  I see no discernible pattern in cocoa. 

The remaining markets, cotton and frozen concentrated orange juice follow. 

 

 

 Cotton curves show the following:

2007 contango then lower

2008 contango then higher

2009 contango then sharply higher

2010 backwardated then lower

2011 backwardated then lower

2012 contango then ? 

Those following cotton may remember the extreme stress the market experienced due to flooding in Pakistan which accounts for the extreme pricing of 2010.  Yet, even in spite of such extreme “positive roll yield”, cotton was lower as of the subsequent year end.  Of the three contango years, the market was split lower, higher and higher.  The remaining backwated year the market was lower.  While on a wild ride, cotton shows no signs of roll yield, negative or otherwise.   

Finally, the last market in the VistaCTA basket, frozen concentrated orange juice is shown next.

 

 

Here we go again:

2007 contango then sharply lower

2008 contango then sharply higher

2009 contango then higher

2010 contango then lower

2011 backwardation then lower

2012 contango then ? 

OJ shows four years of contango with three subsequently higher and one lower. The 2010 backwardation was followed by lower price.  I just don’t see that one data point validates a theory refuted by handfuls of counter datapoints.  Again, there appears little evidence of negative roll yield in oj. 

To sum up: only two markets, corn and soybeans, out of the five ags in the VistaCTA commodity basket show any signs of negative roll yield, and those signs are specious, at best.   

The results of energy, metals and, now, ags, show very little evidence for long-term negative roll yield effects, i.e. bullish backwardation signals or bearish contango signals.  Curve shape, in general, may just be another characteristic of commodity market forward curves that has no predictive value for long-term commodity investors.   

I did not address the seasonal characteristics of many commodity markets.  Such are clearly shown in the forward curves of natural gas, heating oil and gasoline as well, more subtly, in those of some agricultural markets.  In fact, the inflections of a few mixed curves coincide with old crop/new crop designations.  Such designations may occur over shorter periods than those used for this study.  A review of shorter term curve shape effects may modify our results and may be more applicable to shorter-term investors.

Metals Curve Shape

This will be a quick look at metals which are the quintessential “cost of carry” contango markets.  Gold and silver are the definition of non-perishable commodities and nearly always in contango.  Copper futures curves are almost always in contango as the supply chain may be subject to episodes of sudden shortages.

Following is a chart of the year-end forward curves for the Comex Gold futures contract

 

All gold futures curves are contango and each year gold prices rose.  On 12/13/2012, gold was in steep contango and next year’s gold price is unknown. Gold has been one of the most bullish commodity markets of the last ten years and, at the same time is always in contango.  .  Gold is the textbook case that refutes the argument of bearish contango.

Silver follows closely in gold’s footsteps and is sometimes called the “poor man’s gold” since silver’s price level is so much lower. 

Silver, which has some industrial use, is again in contango except for the anomalous far back months of the Dec 2011 and 2012 curves.  And again, contango appears to show no relation to future declines. 

Copper, a truly industrial metal, is subject to occasional unexpected supply shocks, mainly from strikes in copper producing regions.  Under such conditions we would expect to see the futures curve in backwardation.  Supply interruptions can be moderated by large inventories.  The cost of carrying large inventory is relatively low in today’s zero rate world.  Rising rates may bring backwardation back to copper markets.  Looking at the copper curves we note:

2007 contango and backward then much lower price in 2008

2008 contango then much higher in 2009

2009 contango then higher in 2010

2010 backwardation then lower in 2011

2011 contango and backward then higher in 2012

2012 contango and backward then ?

I just don’t see the pattern of contango followed by lower prices or the converse.  Again, generalized curve shape has no predictive value in copper or any other metal futures contract.    

The Rest of Energy Contango

In the prior post, crude oil forward curve shape did not appear to have any ability to predict future return and thereby refuted a popular assertion that “backwardation is bullish” or, conversely, “contango is bearish”.

This post will look at the balance of the energy sector futures: heating oil, natural gas and the reformulated gasoline contracts.  As with crude oil, let’s look at the forward curves on the last day of the prior five years (12/31/2007 to 12/31/2011) and the curve as of our current reference date, 12/13/2012.

Below are the forward curves for the NYMEX No. 2 Heating  Oil futures contract.  Note the undulating effects of seasonality from winter demand.

For example, the leftmost blue curve, showing  the 12/31/07 trade date, has spot at $2.6531 per gallon, Feb08 at $2.6444 and so on out to the Nov10 contract at $2.4436.  In short, the 2007 futures curve is in downward sloping backwardation.  According to conventional wisdom, the backwardated curve is an indicator of higher prices.  A quick look at the year-end 2008 heating curve shows heating oil $1 lower.

 

While 2008 is definitely NOT a typical year, quick looks at the other years shows poor results using curve shape as a predictor, summarized below:

2007 backwardation then sharply lower in 2008

2008 contango then sharply higher in 2009

2009 contango then higher in 2010

2010 contango then higher in 2011

2011 backwardated then higher in 2012

2012 backwardated then ? 

Heating Oil Conclusion: Curve Shape is NOT a predictor of future returns.  

To round out the energy complex, note the following curve charts and corresponding conclusions:

 

 

All Natural Gas futures curves were contango and then all lower!

RBOB 2007 backwardated then sharply lower in 2008

2008 contango then higher 2009

2009 contango then higher 2010

2010 backwardated then higher 2011

2011 backwardated then higher 2012

2012 backwardated then ? 

Conclusion: Throughout the entire energy complex curve shape does not appear to be a predictor of future returns.

Next post will consider the metals and agricultural markets and then look at commodity index rolls, in general.

 

State of Contango

Contango or normal forward curves are alive and well in most commodity markets. As of this writing (the Dec 13 2012 close) the commodities in the VistaCTA commodity basket have the following curve shape characteristics:  

Crude- bump then backwardated

Heating oil- backwardated

Natural gas- sharply backwardated

RBOB gasoline- backwardated

Corn- sharply backwardated

Wheat- normal to flat to slightly backwardated (mostly flat)

Soybeans- backwardated

Gold- contango

Silver- contango

Copper- contango then back down

Coffee- contango

Sugar- contango

Cocoa- mostly contango

Cotton- contango

Frozen Concentrated Orange Juice- contango  

Of the fifteen names in the basket, eight are contango and seven are primarily backwardated.  The question remains, does this mean anything?  Many commodity analysts maintain that contango is a bearish or negative indicator for long investors.  Many ETF and commodity index providers also point to “negative roll yield” (i.e. the presence of contango) to account for the dismal performance of some commodity indexes and ETFs.  Likewise, inverted market curves are claimed to be bullish for long investors.  

Let’s test this assertion.  In the next few posts I’ll review the predictive value of curve shape name by name in the VistaCTA basket.   

WTI Crude Oil Forward Curves

Let’s first consider the NYMEX WTI crude oil futures contract.  There are many ways to do this but a simple way is to look at the futures curves on the last day of the year for the past five years and see if one year’s curve shape can predict the next year’s performance.

The chart below shows the crude oil forward curves on the last day of the year for five years (2007 to 2011) and the forward curve as of the 12/13/2012 close. (I am using “forward curve” and “futures curve” interchangeably here, although, technically, there is a difference.)  The vertical y-axis shows price per barrel and the x-axis shows the contract expiration month.  For instance, the bottom red curve, for the 12/31/2008 trade date, starts at $40.59 per barrel for the March 2009 contract and ends at $74.32 per barrel for the October 2014 contract. 

Aside from the crazy 2008 extreme contango year, 2007 was sharply backwardated; 2010, 2011 and 2012 were generally backwardated, as well.  Did this backwardation predict anything, let alone predict a future bull market?  Looking at the curves note the following:

2007 backwardation then sharply lower in 2008

2008 contango then sharply higher in 2009

2009 contango then higher in 2010

2010 backwardation then higher in 2011

2011 backwardation then lower in 2012

2012 backwardation then ? 

The results show that in the three backwardated years, the markets ended higher, lower and higher.  In the two years of contango, the markets were both higher.  If nothing else, the forward curves indicate that, since 2007, contango is NOT bearish, at least in WTI crude oil.   

Crude Oil Conclusion: Curve Shape is NOT a predictor of future returns.

The Myth of Roll Yield

The basic premise of this myth is that contango buyers lose money and backwardation buyers make money.More generally: curve shape is destiny! (Italics denotes it’s wrong.)

                                                                          

Before going any further, I cannot say how many times this myth is repeated; most recently today online (Indexuniverse.com), in industry and academic research but then again, I cannot say how many times this is dead wrong! NO NO NO, there is NO (and cannot BE) any such thing as roll yield, negative or otherwise.  Simply put, rolling is not a yield event, so it cannot create yield of any kind. Secondly, the theory is misunderstood.

First, it’s not a yield event. 

Let’s do the math.

Suppose, today, you are long the Jan 2013 crude oil contract at an $85.22 cost, roll out at $88.28 and roll into the Dec 2013 contract at $91.84. What is your roll yield, ahem, return? Here’s what your roll numbers are:

Jan crude: sell price 88.28 – 85.22 cost = $3.03 profit

Dec crude: sell price unknown – 91.84 cost = ???

Ok, you bought the Dec, and you paid 4% more for it than the Jan, well, so what.  All you did was establish a new basis with your roll and you have no idea where you will be selling it and what your “roll yield” is.  That’s the simple falsehood of “roll yield”.

Now to the theory.

Does the higher Dec price mean you will lose money? No.

Does the higher Dec price have anything to do with the Jan price? Well maybe and maybe not and that takes us to Arbitrage Theory.

Arbitrage theory says that the Jan price plus the cost of carry should equal the Dec price.  There should be no difference between taking delivery now and paying carrying costs versus paying for future delivery.  If there was a difference, you could make riskless arbitrage profits either way. That is theory.  In fact, spreads depend on much more than cost of carry (which deserves another post). Anyway, cost of carry is not the idea behind roll yield.

The idea behind roll yield is “convergence to spot”.  

This says that the futures price necessarily converges to the spot price over time. It seems simple, buying and holding a back month contract will eventually become a front month contract with the front month price.  So, what IS wrong with this theory? People who talk about roll yield miss the important distinction that futures prices converge to the EXPECTED spot and not today’s observable spot. 

Example:

Today’s Spot Price = Jan contract price = $88.28

Today’s Futures Price = Dec contract price = $91.84
Spot price expected on the last trading date of the Dec contract = ?

It is a wild and baseless trading maneuver to ASSUME that the expected spot will have any relation to today’s spot. You cannot use today’s spot to make an assumption about tomorrow’s spot or next month’s or next year’s!  If you try it, you will be wrong and, therein, since so many seem to (you’ll be amazed by a  “roll yield” google search), there is a potential source of market inefficiency and return!

Finally, empirical data do not support the “contango means losses” and “backwardation means gains” theory.  In fact, the most bullish markets of the last twenty years, gold and silver, are ALWAYS in contango. Backwardation was a part of certain energy markets but not so much today.   Backwardation may be a short term market aberration due to an unexpected supply interruption (crop failure) or markets with high shutdown costs (like natural gas fired power plants). 

So why so much belief in the myth?  I can only speculate that some commodity players with very poor performance seem to use contango, over and over again, as an excuse for their poor performance rather than their flawed decisions. This is just a speculation.  

Contango Basics

Commodities trade through “futures contracts” that specify commodity quality and contract delivery date.  Prices plotted on a graph are called the futures curve.  For example, as of November 19^th, barchart.com shows coffee trading at the following prices:

Contract	Price per pound
Dec 2012 coffee	$1.4995
March 2013 coffee	$1.5555
May 2013 coffee	$1.5830
July 2013 coffee	$1.5990
Sep 2013 coffee	$1.6280
December 2013 coffee	$1.6645
March 2014 coffee	$1.6875

And so on… up to September 2015!

Plotted on a graph we get CONTANGO!

Since this is an upward sloping curve (i.e. prices rise with delivery dates) this is called a CONTANGOfutures curve.  This may also be called a “cost of carry” or normal curve because the price at each delivery date supposedly includes the actual costs of storage (cost of capital, warehousing, handling, insurance, spoilage, etc.). So the implied cost of carry for a pound of coffee between December 2012 and March 2013 is 5.6 cents (=$1.5555 minus $1.4995).  It’s “normal” because one would expect the cost of buying today plus 3 month storage should equal the price of buying for delivery in three months. Note that cost-of-carry is not the same for every three month period!

Some curves are downward sloping:

This is called the oddly named BACKWARDATION futures curve. It is “backwardated” because the prices are backwards!  The price of a bushel of soybeans goes down with increased time to delivery.  For instance, the January delivery price is $14 per bushel.  In July, it is nearer to $13.50. 

How to explain this?  In fact, storage costs did not go away.  They’re still in there at maybe 1, 2 or 3 cents  per month per bushel. But there are other factors that go into today’s futures price and these other factors may be so important that they dwarf storage costs.  The soybean crop was so devastated by this summer’s excessive heat and drought that there is a shortage of available soybeans. Buyers who need beans may be caught short and may have to pay up to get their immediate needs met right now.  In fact, though, soybean prices have fallen sharply as the after drought shortage fears have turned out not as bad as expected, as shown in the March Soybean chart below.

Chart used with permission, courtesy of Barchart.com’s Advanced Commodity Service.

Just for comparison, note that March Coffee is also sharply lower:

Chart used with permission, courtesy of Barchart.com’s Advanced Commodity Service.

So, there you have it.  On the same day, two markets, both sharply lower with one in contango and one in backwardation! More to come...

Medium Term Commodity Market Outlook System

I use a fairly basic technical trading system (for my non-index program) that monitors commodity markets and calls them bullish, bearish or neutral. It's probably not much better than asking a 4 year old "which direction is this chart going?" but then having a four year old is a fairly sophisticated thing.
This morning, the outlook called crude neutral from short. Hmmm, and then by midday the market broke two dollars lower! Peace may be breaking out in Gaza.
The outlook, as with many systems, may best be used as a contrary indicator when it has extreme readings.  We started November all bearish and today it is mixed. Good job on unintended consequences.
Another note: last night for the first time in November my benchmark, the VistaCTA commodity basket, closed above its Oct31 close.  It's always nice to have an up month. We'll see how long that lasts.
Tomorrow is the day before Thanksgiving, one of the best days of the year to trade, especially on the close. Gobble, gobble. Happy Turkey Day!

Contango Myths and Misconceptions

First real post. These are some of what I think to be major misconceptions in commodity markets, some repetitive and presented in no particular order:

Roll yield exists, negative or otherwise.

Rolling futures in contango will result in a loss.

Investors will lose money if a market is in “contango”. 

Investors will profit if a market is in “backwardation”.

Losses or gains are incurred within an index by rolling from one contract to another.

Commodity futures prices converge to spot over time.

Over the long term, commodity prices are “mean reverting”.

Spot indexes are appropriate benchmarks for investment. 

Spot returns equal the return achieved from purchasing physical commodities.

Investors should choose hedge fund managers to make money in commodity markets.

Investors should choose commodity ETFs to make money in commodity markets.

Cost of carry means you start at a loss.

Commodity traders differ from traders in bonds and stocks.

Commodity traders are not buy and hold traders.

Commodity traders are not biased to the long side. 

Commodity sources of return are spot, collateral and roll yield. 

Negative roll yield is the reason for legacy commodity index underperformance. 

Commodities are leveraged investments. 

Commercial traders are short, non-commercials use trend following strategies.

Commercials make money, non-commercials lose money. 

Commodity trading volume confirms price.

Long only is a positive momentum strategy.

Legacy commodity indices are meaningful benchmarks.

Commodity indexes are bad.

Newly hatched “third generation” commodity indexes are better than the old ones.

Continuation data is valid.

Many academic studies don’t have serious data issues and flawed results.

Historical legacy index data is meaningful.

Legacy commodity indexes are not negative momentum strategies.
Negative roll yield hurts UNG.

Test Post

Here we go.  Despite the name, this will be everything on commodity investment portfolios, not commodity trading but INVESTING in commodities, commodity indexing, commodity forward curves and yes CONTANGO and backwardation-especially the fruity and juicy parts.  The first post when it happens will be a brain dump, kinda, of what I know or think I know about commodities-commodity myths and fallacies.  This will be followed up by details, evidence and musings whenever they may happen.  We'll see how this goes.