Explain what drives the returns earned on a commodity futures position
The idea
A commodity futures position earns from three distinct sources, and confusing them is a common error. Spot return is the change in the price of the commodity. Roll return arises because a futures position must be rolled forward as contracts expire: it is positive in backwardation, where the futures price is below spot, and negative in contango, where it is above. Collateral return is the interest earned on the cash backing the position, since futures require only margin. Commodities pay no income and cost money to store, so the long-run case for holding them rests on diversification and inflation sensitivity rather than on any expected yield.
Formulas
Return on a commodity futures position
total return = spot return + roll return + collateral return
- spot return
- the change in the price of the commodity itself
- roll return
- what is gained or lost replacing an expiring contract with a later one
- collateral return
- the interest earned on the cash posted as margin
Roll return is the part with no equivalent in equities: positive in backwardation, where the later contract is cheaper, and negative in contango. A commodity whose spot price went nowhere can still have lost money on the roll.
A practice question
The three sources of return on a commodity futures position are spot return, collateral return and:
- roll return — correct
- dividend returnWhy not: Dividends are paid by companies. A commodity has no issuer and distributes nothing.
- coupon returnWhy not: Coupons belong to bonds. The cash backing a futures position earns interest, which is the collateral return already listed.
Rolling an expiring contract into the next one gains or loses depending on the shape of the futures curve.
A harder one
Roll return is positive when the futures curve is in:
- contangoWhy not: An upward-sloping curve means the replacement contract costs more than the one expiring, which is a drag.
- backwardation — correct
- a flat shapeWhy not: A flat curve means the two contracts cost the same, so the roll contributes nothing either way.
The expiring contract is dearer than the one being bought, so each roll is made at a favourable price.
The hardest tier
A convenience yield arises because holders of the physical commodity gain:
- interest on the positionWhy not: Interest accrues on cash collateral, which is a feature of the futures position rather than the physical holding.
- a tax advantageWhy not: No general tax benefit attaches to holding physical inventory; the benefit is operational.
- the benefit of having supply on hand — correct
That benefit behaves like income in the pricing formula, which is what can push a curve into backwardation.
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