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.