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The Strategic and Tactical Value of Commodity Futures

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What they found

A more skeptical companion to Gorton and Rouwenhorst. Erb and Harvey argue that the average individual commodity futures contract has had a risk premium close to zero and that the attractive returns of commodity indices came largely from 'diversification return', the rebalancing bonus that comes from regularly rebalancing among volatile, low-correlated assets. They show that the term structure of an individual commodity (backwardation or contango) strongly predicts its return, that momentum works in commodities, and that a long-short strategy based on roll yield beats a long-only index.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Contango and backwardationTwo futures curves against contract expiry: one rising above spot, one falling below it.The same commodity, priced for delivery at different dates.78.0076.0074.0072.0070.00Futures pricespot+1m+2m+3m+4m+5m+6mMonths until the contract expiresspot price74.00CONTANGOlater contracts cost more than spotBACKWARDATIONlater contracts cost less than spot
Contango and backwardation. A futures curve shows what buyers will pay for delivery in one month, two months and so on. When later contracts cost more than the spot price the curve is in contango; when they cost less it is in backwardation.

What you can use

  • The average single commodity has earned roughly nothing; the returns of commodity indices came from rebalancing and from the contracts that were in backwardation.
  • Whether a commodity's futures curve is in backwardation or contango has been the single most useful predictor of its return.
  • A long-only commodity index is a poor way to capture the premium; long backwardated, short contangoed is the research-supported version.

Caveats

Practitioner-focused with a sample ending 2004. The diversification-return argument has been debated (Willenbrock 2011). A free SSRN version exists.

Tags: commodities, futures, roll-yield, backwardation

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.