Long Crude Futures – Can You Really Reduce Roll Costs?
The Attain Capital blog can’t be beat as a great source of information and education on the futures industry and trading. I never fail to learn something reading it.
In How to Play a Bounce in Oil (Hint: Not $USO), though, the description of the “roll costs” of a long-term long futures position didn’t quite hit the mark. This being the case, the suggestion of buying a far-out futures contract and rolling it less frequently isn’t much of an improvement over buying the nearby contract and rolling it monthly. It’s also not going to be much, if any, of an improvement over $USO.
The post is almost correct about why $USO is such a lousy vehicle for trading long crude oil, but “roll costs” isn’t really the problem. The real problem is that WTI crude oil futures are usually in a “normal” market, otherwise known as being in contango.
Background: Carrying Costs, Contango, and Backwardation
The price of a futures contract includes carrying costs, which are defined as costs to store the commodity, insure it, and pay the interest on money borrowed to finance the inventory.
Let’s suppose that there is no reason to believe the spot price of a commodity will be any different over the next twelve months than it is now. This condition naturally results in a contango market, where each successive futures contract is priced higher than the spot market by an amount that is equal to the carrying costs over the remaining time to expiration.
As expiration grows closer, the carrying costs shrink and the corresponding premium in the futures price shrinks, as well, causing the futures price to drift downward until it converges to the spot price at expiration. The important point is this:
Futures prices in a contango market drift downward relative to the spot market until the futures price converges to the spot price at expiration.
The chart below shows the forward curve for WTI crude oil futures. The left side of the curve shows the current lead contract, Feb-15, and the right side shows the contract twelve months out, Jan-16. The price each month increases by about $0.73/bbl, or about $9/bbl/year. Assuming there are no supply/demand change expectations reflected in this curve, we can conclude that the carrying costs are approximately $0.73/bbl/month.
Crude Oil Futures Forward Curve as of January 10, 2015
The next chart is the same except that I’ve added the forward curve from one year ago (the gold line). A year ago, each successive futures contract traded at a discount to the one preceding it. This is an example of a market in backwardation. The only thing that can cause a backwardated market is an expectation of lower prices in the future. This could be due to changes in supply and demand or external market factors, such as changes in the regulatory environment.
Crude Oil Futures Forward Curves as of January 10, 2015 and January 10, 2014
Because the futures contracts are now priced at a discount to the spot market:
Futures prices in a backwardated market drift upward relative to the spot market until the futures price converges to the spot price at expiration.
How Much Does It Cost to Roll a Futures Contract?
The only cost involved in rolling a contract to the next month is the trade commission. That’s it.
Suppose you’re long the March CL contract, it’s trading at $60/bbl, and you want to roll to the April contract. You sell March and buy April. The only change to the balance of your account is that you’ve paid a round-turn commission. It doesn’t matter whether April is trading at $50/bbl or $70/bbl. After the roll you’re still long a futures contract and the balance of your account is the same (minus the commission).
(If this doesn’t make sense to you, remember that futures are marked-to-market, so there is no change to the balance of your account when you buy or sell a futures contract.)
Contango, Backwardation, and the Crude Oil Market (or, Why Does $USO Suck So Bad?)
$USO is always long NYMEX crude oil (i.e. WTI) futures. If the only cost to rolling forward each month is the commission, why is the performance so much different (i.e. worse) than spot crude?
It’s because crude oil futures are almost always in contango. It’s not because of any costs involved in rolling, but instead because the price of the futures contract relative to spot is decaying over time. It has to decay in order to converge to the spot price at expiration. The longer someone holds a long futures contract in a contango market, the more it will decay. You can think of this as the holder of a long position paying the carrying costs, which accumulate over time.
Years ago, crude oil and a few other markets were typically in backwardation. That was the golden age of the long-only commodity funds, because long positions in a backwardated market have a natural tailwind. If the backwardation continues, futures prices drift upward over time to converge with the spot market instead of drifting downward (which is what happens in a contango market).
The underlying instrument of the $USO ETF is WTI crude futures. The chart below shows the WTI futures prices and an indicator of whether the market is in contango or backwardation. The red curve shows the premium of the first CL contract to the second. When the curve is below the line, the market is in contango, and when it’s above the line, it’s in backwardation. Except for a brief period during 2013 and most of 2014, the WTI crude oil market has been in contango since the end of 2008.
WTI Futures Prices and Backwardation/Contango Indicator
[There has been a lot written lately about a “new” contango in the oil markets. What they’re referring to is the brent crude market, which is not the basis of the $USO ETF. Indeed, brent crude has been in backwardation for most of the last three years and recently transitioned to contango.]
So Am I Better Off Buying the Far Out Contract Instead of the Nearby Contract or Not?
The blog post referenced above mentioned a strategy of buying a contract twelve months out and rolling it once a year instead of buying the nearby contract and rolling twelve times per year. The assertion was that this would reduce the “roll costs” and improve the performance of a long futures position. Does that strategy work?
In a word, no. Or, at least, not by much.
Since there are some nominal costs associated with rolling a contract (the commissions, as discussed above), the cost of buying the far out contract and holding it are lower than buying the nearby contract and rolling twelve times, but only by a little. If your round-turn commissions are $10, we’re talking about lowering the costs by $120/year on a thousand-barrel crude oil contract, where a price change of just $5/bbl is a profit or loss of $5,000.
The important point is that this strategy does not reduce the contango penalty in any way. If you buy the twelve-months-out contract and hold it to expiration (and the contango remains constant), you’re paying carrying costs of about $9/bbl. If you instead buy the lead contract and roll it eleven times, you’re still paying carrying costs of about $9/bbl, but you’re paying it in $0.73 monthly installments. You don’t save anything other than commissions by buying the far out contract.
Additionally, buying the far out contract could expose you to risks you wouldn’t have if you had bought the nearby contract instead. Primarily, there is increased liquidity risk. In last Friday’s trading, the G15 contract traded 375,000 contracts, whereas the G16 contract traded less than 1,000 contracts.
Don’t get me wrong, I’m not saying that buying the far out contract and holding it is a bad idea if that is what satisfies your needs. But if you’re doing that thinking the performance is automatically going to be much better than buying $USO because you’re somehow avoiding a bunch of large roll costs, it won’t be.
My Favorite Illustration of Contango
Both charts below show daily prices of lumber futures contracts from November 2007 to January 2009. These are continuation charts, composed of the most actively traded contracts concatenated together. Below each chart are colored bars showing where one contract rolls to the next.
Lumber Futures Prices Without (top) and With (bottom) BackAdjustment
The upper chart shows the actual futures prices. Note the large price gaps that typically occur when each contract rolls to the next. The lumber market during this time was in contango, and thus each successive contract was more expensive than the preceding one. This is why the gaps on the rolls are usually up-gaps and not down-gaps.
The lower chart is a back-adjusted continuation chart. Going backward in time, each bar’s prices are offset in order to eliminate the roll gaps. It makes sense to do this because there is no cost to rolling to the next contract other than the commission. The prices shown are no longer the actual prices, but instead are the relative price moves that would have happened to a continuous position that was always rolled to the most actively-traded expiration. In effect, we are adjusting the prices to include the price moves that occurred because of the contango in the market.
Note three things about this example:
- What initially looks like a volatile, non-trending market was actually a very profitable short trend-following trade because of the contango in the market.
- Examine the range of prices in each chart. When looking at the actual futures prices (upper chart), the range was slightly over 1000 points. If you include the price movement due to contango, however (lower chart), a short position held this entire time would have actually picked up nearly 2000 points of profit.
- In a contango market, a short futures position actually collects the carrying costs instead of paying them.
- Carrying costs are built in to the price of a futures contract. In the absence of any expectation of falling prices in the future, this naturally leads to a contango market.
- The only cost involved in rolling to the next futures contract is the trade commission.
- If carrying costs remain constant, it doesn’t matter whether you buy the lead contract and roll it twelve times or buy the contract twelve months out and don’t roll it – if the contango remains constant you’ll pay the same amount for carrying costs in both cases.
- In any discretionary trend-following strategy, it’s vital to have a knowledge of whether a market is in contango or backwardation before entering a trade. Even if the spot market price doesn’t move, a short position in a contango market can be profitable.