Is roll yield still a useful concept in evaluating crude oil futures markets? This is a timely question because of skepticism on the benefits of roll yield: The dramatic drop in oil prices has led investors to question whether crude-oil-futures positions deserve a role in a diversified investment portfolio.
Are roll yield benefits illusory?
The article “The truth about the GSCI roll yield,” Futures, October 2014, concluded that the benefits of roll yield are illusory, and that there is no observable correlation between roll yields and returns. The author defined roll yield as the “price difference between delivery months in a roll. And this price difference results from the “shape of the futures price curve for a commodity futures contract.” The roll yield is positive when the near-month futures contract trades at a premium to deferred-delivery contracts, forming a curve shape referred to as “backwardation.” Conversely, the roll yield is negative when the near-month futures curve contract trades at a discount to deferred-delivery contracts, forming a curve shape referred to as “contango.”
Author George Rahal examined the corn and crude oil futures markets to find out whether monthly returns in each market had been correlated to their respective monthly roll returns from May 2009 through August 2014. Rahal produced research to back his assertion that there is no correlation between roll yield and performance.
Given how the author has defined the issue, his conclusion on the lack of usefulness of roll yield is clearly correct. But then, how can there be so many articles that point out the utility of roll yield in trading and investing? The answer: The roll yield becomes useful only under historically well-defined circumstances. There are at least three circumstances where a historical example appears useful:
- Over sufficiently long time horizons, a clear relationship between a futures market’s returns and its roll yield is clearly observable.
- Over sufficiently long time horizons, curve shape is a useful toggle for determining whether one should continue with structural positions in crude oil futures contracts.
In choosing among commodity futures contracts for long-term investing, roll yield has been a key differentiator among commodity markets.
Long holding periods
Essentially, roll yield is not useful in the short-term. Like all yield effects where importance builds slowly, an investor usually needs at least five-year time frames for this effect to be noticeable in statistical studies. The same is true for dividend yields as a driver of equity returns. In contrast to Rahal’s work, “Better with time” (below) shows that over a very long time frame (1950 to 2004) the relationship between returns and roll yields in the grains is indeed observable once one watches returns over five-year holding periods.
When to hold crude oil futures
“Should I stay or should I go?” (below) shows how substantial the return difference is, depending on whether one holds WTI crude oil futures contracts unconditionally versus only if the first-month futures price minus the second-month futures price is positive (i.e., if the front-to-back spread is in backwardation, and therefore has positive roll yields). For this latter state-of-the-world, one only held a near-month WTI futures contract if the curve was in backwardation the previous day.
The chart shows a remarkable 5X improvement when only remaining long crude in periods of backwardation from 1987 through the end of August 2014. While a trader might discount the outperformance of the second half of 2008 as a one-off event in “Should I stay or should I go?,” the backwardation-only model produces a 50% improvement prior to that event. The annualized returns from 1987 through the end of August 2014 for holding and rolling WTI futures contracts were 6.2% per year over Treasury bills. Correspondingly, the returns over the same period for only holding a WTI futures contract when the contract’s front-to-back spread was in backwardation the previous day were 12.8% per year over T-bills.
A number of analysts have shown how strongly roll yields have been related to returns across individual commodity futures contracts, once one evaluates this relationship over more than 15-year time frames (see Backwardation and excess returns,” below).