In What Circumstances Is It Useful to Examine Whether the Futures Curve Is

EDHEC-Risk - In what circumstances is it useful to examine whether the futures curve is ... Page 1 of 2 Commodities - June 03, 2016 In what circumstances is it useful to examine whether the futures curve is in backwardation or in contango? By Hilary Till, Research Associate, EDHEC-Risk Institute, and Principal, Premia Capital Management, LLC Examining whether a futures curve is in contango or backwardation can be useful in three circumstances. •Over sufficiently long time horizons, a clear relationship between a futures market’s returns and its futures curve shape is clearly observable. • And further, in choosing amongst commodity futures contracts for long-term investing, the curve shape has been found to be a key differentiator amongst commodity markets. • Lastly, in the crude oil futures markets, over sufficiently long time horizons, the curve shape is a very useful toggle for determining whether one should continue with structural positions in crude oil futures contracts, especially when combined with examining the oil market’s spare capacity situation. Regarding the last point, using the curve shape as a toggle to decide whether to be invested in crude oil futures contracts, we have found that as long as crude oil futures contracts were in backwardation and that there is sufficient spare capacity then in that state-of-the-world, the monthly returns on such an investment have been about 2% per month and have been positively skewed. In addition this strategy has historically produced a collar-like payoff profile on crude oil. Returning to the original question on when has it been useful (at least historically) to examine the futures curve shape, we have not found curve shape, by itself, to be a useful indicator in the very short term. Let’s look at the current relevance of curve shape. Let’s say that the current state-of-the- world is one where Saudi Arabia is pursuing a market-share strategy like in 1986. Would have a curve shape toggle been useful in 1986? The answer is yes. If one passively held WTI futures contracts in 1986, then one would have lost -25.5% at that time. Correspondingly, if one only held WTI futures contracts if the contract was backwardated at the close of the previous day, then the losses were significantly lower at -8.8%. In 2014, the curve toggle also would have helped oil futures investors. Starting in July 2014, the Brent futures contract went into contango pretty much continuously through the rest of 2014. If a trader or investor had elected to only buy and roll Brent futures contracts when the contract was backwardated at the close of the previous day, then that trader’s returns would have been quite different from the returns of a passive investor in Brent contracts: these returns would have been slightly positive rather than down by over 40%. http://www.edhec-risk.com/latest_news/featured_analysis/RISKArticle.2016-06-03.5603/ris... 6/6/2016 EDHEC-Risk - In what circumstances is it useful to examine whether the futures curve is ... Page 2 of 2 Now in our own work in analyzing crude oil, we do not solely examine curve shape, which URL is a reflection of the current inventory situation. We also examine OPEC spare capacity, for which is, in effect, below-ground inventories since this is crude oil that can be brought into production quickly. Over time, we may also include North American drilled, but this uncompleted wells, as de facto spare capacity, as well. document: http://www.edhec-risk.com/latest_news/featured_analysis/RISKArticle.2016-06- 03.5603 Hyperlinks in this document: http://www.edhec-risk.com/latest_news/featured_analysis/RISKArticle.2016-06-03.5603/ris... 6/6/2016.

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