CFA Series - Commodity Pricing

Commodity futures

The difference between gold and oil is the usage of each and their storage costs. Backwardation very seldom arises in money commodities like gold or silver. This is because it costs a large amount of money to store oil, whereas gold costs next to nothing to stash somewhere as a function of its value. Instead, every barrel of oil that is extracted is done so for the purpose of consumption. The cost of storing oil on speculation or on arbitrage is just too huge to make it a profitable activity unless there were an absolute huge positive premium between near and far month contracts

Commodity Futures Pricing

Total return = Spot return + Roll return + Collateral return + Rebalancing return

·         The spot return is simply the price appreciation in the spot price, which is based on immediate delivery, of the commodity.

The spot price is influenced by fundamental factors that are unpredictable.

·         As an investor in futures contracts has to roll contracts he has to deal with contango and backwardation. If the term structure is in backwardation the roll yield is positive whereas it is negative when the term structure is in contango. (Renew the contract, convenience yield)

·         Collateral return is the return accruing to any margin held against a futures position and which is normally the U.S. T-bill rate. (Oil can be used as collateral to earn interest on Tbill) => return on cash used as margin to take long derivatives exposure.

·         Rebalancing return is the incremental return earned by a rebalanced portfolio. The underlying source of the diversification is the rebalancing.

Negative Price of Oil futures

Contango (Spot more Cheap than Future) is the situation where the price of a commodity for future delivery is higher than the actual spot price. It is a term to describe an upward sloping forward curve.

A market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.

If commodity markets are in contango. This means the roll yield on commodity indices is negative. An investor would need to buy the commodity index above the current spot level when it's time to roll the contract.

Backwardation (Spot more Bullish than Future) is the opposite of contango. In this state, near prices become higher than far (i.e., future) prices because consumers prefer to have the commodity sooner rather than later.

A market that is steeply backwardated often indicates a perception of a current shortage in the underlying commodity.

Under rational expectations, The futures price should lie above the spot price

If the storage cost of a commodity is high, its futures market is likely to be in backwardation.

When the market is in backwardation, the roll yield will be positive  for a long investor. The long investor can buy the commodity below the current spot level from a hedger.

Thoughts on applying theory to markets

Oil is traditionally known as a strategic resource. Wars were fought by the US to gain possession and control about oil reserves, and the denomination of oil in USD led to the widespread use of USD as a petrodollar. Due to the sharp drop in demand of oil (shutdown of global supply chains and lockdowns) and supply dump by the major suppliers, Prices of oil dropped dramatically to the point whereby the cost of storage of physical oil exceeds the price of the underlying. The Co-tango situation is due to limited storage capacity / facilities.

It will be interesting to see if major countries such as China / US / Russia will snap up this extra volume by incurring near term price losses just to increase their reserves of this finite resource. As a know-nothing investor, I am willing to sit in the sidelines to watch the whole scenario play out.

Portfolio Allocation for May
 The oil market is not the only one presenting market anomalies. The stock market is even nuttier to the levels of running parallels with Jim Cramer. The US stock market seem to be racing upwards in stiff competition with the escalating US infections rate and unemployment rate. As the US stock market seem to be not reflecting market reality, and the SG and HK stock markets correlates their rise and fall with the US, I shall stay on the sidelines for now.

I shall stick to my <maximum one buy trade per month> stock allocation until there are significant discounts to my watch-list. Sell in May and go away may become a self fulfilling prophecy for many traders out there, and I need to brace for the impact.