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Sunday, February 12, 2017

Futures: Part 1 :Roll and decay

Contango, Futures roll, Backwardation and Futures vs present prices is a large topic. Hence I am going to try and do it piecemeal.
Here goes.
Futures represent delivery of a certain product that is very specifically defined by the exchanges in terms of grade, location and quality on a certain date (date range).The buyer agrees to buy and the seller agrees to sell it. Another price is the Spot price which is the “current” price for the same item.
Many factors impact the futures price for the closest month vs the futures price of other months. A few of them are
1)    Storage Costs for the commodity
2)    Expected changes in supply and demand in the future
3)    Storage limitations
4)    Interest rates
5)    Short term disruptions in supply and demand.
6)    Harvest times for Ags (Corn, Soybean, Rough RIce etc.)
7)    Potential current or future substitute availability
8)    Producer and Consumer hedging
9)    Central bank manipulation (just kidding J)

Let’s look at a simple fictitious curve of oil from May 2017 to February 2018. Assume currently it is March 2017 and May 2017 is the first available contract, which trades at $45. The cost of storing 1 barrel of oil for 1 month is $1. In the perfect example, the only thing influencing the price of oil is the cost of storage. Hence each month is higher than the next by about $1. 

Let’s say you were a big time speculator and you had $54,000,000 to invest. You look at the curve and decide to buy 1,200 contracts of WTI (1,200 X $45 X 1,000 Barrels per contract) = $54,000,000. We are going to ignore the small commissions. Also because you hate to take leverage, you have the entire amount in cash in your account. Now you are the proud owner of 1,200,000 barrels of oil to be delivered in May.

As the end of the futures contract comes about, (late April), you look at the futures curve and lo and behold, the curve has not moved one bit in this ideal example.  You know you obviously don’t want delivery, so you sell your May contracts and buy June contracts. However when you do this, you just get 1174 contracts for the same amount as the price is higher ($54,000,000/46/1000 barrels).

The Futures curve stays perfectly flat as all of OPEC is frozen in time. Every month you roll your futures forward. By the time you own February 2018 futures, you own 1,000 contracts at $54 vs the initial 1,200 at $45.

Let’s stop here for a minute. During our little exercise spanning 9 months….the price went from $45 to $54, a nice 20% increase. You made 0%. So we see the first example of rolling hurting your returns. The reason is that when you started speculating $54 “was baked into the futures” . In fact you would have done just as badly, if you bought 1,000 contracts of the Feb 2018 futures right at the beginning and held them.

You are feeling pretty silly now, but life throws another curve ball. Just as you are about to roll again, a huge amount of oil is sold from the strategic petroleum reserve unexpectedly. The price drops to $45 within seconds. So here is the other way you lose. You started off with the price at $45 and ended with the price at $45. In an ideal world you should have not lost anything. But you are going to be down 16.67% on your investment as now your $54,000,000 investment is worth $45,000,000.  

To be continued……

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