Swedroe: Oil Isn’t Doomed To ‘Contango’

A contangoed oil futures curve may be called ‘normal,’ but that doesn’t mean backwardation can’t persist.

The Wall Street Journal reported that, as of June 10, speculators (emphasis mine) held a near-record bet worth $35.7 billion that oil prices would rise on the New York Mercantile Exchange.

In the debate about whether investors should consider including a portfolio allocation to commodities, one of the main arguments against doing so has been the huge amount of cash flowing into commodities over the past decade. The influx has rendered past data irrelevant because this increased demand virtually doomed commodity futures contracts to trade in large contango.

When contango exists, commodity funds have to sell contracts at low near-month prices and buy into costly further-month contracts. That can cause the returns of a fund to trail the returns of spot prices by large amounts. And while this may have been the case in recent years, the situation began to change in the second half of 2013.

Defying prognosticators who argued that all the capital flowing into commodities would lead to persistent contango, oil futures have been in persistent backwardation for quite some time. For example, on Oct. 30, 2013, the closing price for light sweet crude oil for delivery in December 2013 was $97.77; while the price for delivery in December 2014 was $91.92, the price for delivery in December 2015 was $86.23.

As I write this in mid-June 2014, the spot price for light sweet crude was about $107, as was the July 2014 contract. But the January 2015 contract was trading at about $100.65. That backwardation presents investors in oil futures—and those in broad-based, diversified commodities funds—with a strong tail wind in terms of returns.

You might be curious how oil futures can be in backwardation when there is so much investment demand. The authors of the paper “Scarcity, Risk Premiums, and the Pricing of Commodity Futures: The Case of Crude Oil Contracts,” published in the summer 2013 edition of The Journal of Alternative Investments, sought the answer to that question. They found that the premiums and discounts of commodity futures are directly related to the physical scarcity of commodities.

The authors proposed a breakdown of spot and futures prices into two parts: A “scarcity price” component and a “quasi-asset price” component that separates the risk premiums related to net hedging pressure from the scarcity of commodities. They found that inventories play an important role in determining futures prices.

The authors explain that the “ambiguity about the relevant model for pricing commodity futures arises from the hybrid role of commodities as assets and consumption goods, in terms of use, storability; that availability storage operators’ risk aversion increases with the size of their inventories; and that their net hedging pressure increases the risk premium on futures. This implies that futures prices should be low if inventories are high.

They then write that “inventories are also carried for productive purposes; for example, to smooth supply or demand shocks over time or to decrease the probability of stock-outs. Under this perspective, there should be a high-risk premium at low (as opposed to high) inventory levels, which is not caused by net hedging motives, but by economic costs directly related to scarcity or stock-out risks.”

The authors conclude that what is called the “convenience yield” depends “on the level of inventories and reflect expectations about the availability of commodities, sometimes called the “immediacy” of a market or “scarcity” of a commodity, e.g., inventories have a productive value because they can be used to meet unexpected demand without adjusting production schedules, or to reduce stock-out risks. The productive value of inventories is high if storage levels are low. Therefore, low inventories imply high convenience yields, and vice versa.”

They hypothesized that “in the presence of fluctuating inventories, the hedging pressure related premium should increase with larger inventories, while a scarcity related premium should decrease.”

By examining historical evidence related to crude oil futures—evidence chosen for the length of the data available on prices and inventories—they found that the coefficients related to scarcity are all negative and statistically significant at the 95 percent confidence level, except for the longest maturity. This result supports their hypothesis that scarcity has the highest impact on the contracts with immediately delivery and is much less important for the longest maturities.

The findings are important for investors in commodities futures because they demonstrate that even in the face of increased investor demand, futures are not doomed to persistent contango. The reason is that the level of inventory also influences futures prices. And because inventories fluctuate over time, that characteristic of the futures market isn’t constant.

We now know that the persistent demand for commodities futures for their diversification or hedging benefits doesn’t doom the futures to persistent contango, and thus strong head winds.

On the other hand, the evidence demonstrates that commodities tend to perform best when the futures are in backwardation, as they are now. This doesn’t in any way guarantee profits; it just makes a favorable outcome more likely. Likewise, contango doesn’t guarantee losses, but it does make a less favorable outcome more likely.

Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.