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Profiting from the oil futures' contango


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There has been some debate elsewhere here about the contango in oil futures. I am not going to repeat all this here now, but I may post the links and some more explanation later. Basically, there is, and has been for a couple of years now, a fairly steep short term contango on oil futures. This is the reason why oil ETFs like OILB have performed so poorly since their inception one to two years ago, even though the oil price has gone up. I estimate that OILB loses about 10% every year in the contango (the loss in the contango alone is actually more, but OILB makes some if this up by earning interest on its collateral cash).

 

The current one month contango for the front month at the time of posting this thread is about $1.50. This means that the second nearest month (May 2007) currently trades $1.50 above the nearest month (April 2007). Assuming that the price of oil does not change substantially, one should therefore expect to earn $1.50 every month from the contango alone by continuously rolling a short position. That equates to $18 a year, assuming the contango remains the same.

 

In other words, all things remaining equal, the oil price has to rise by more then $18 per year for this rolling trade not to be profitable.

 

Now, one obvious risk in all this is that the oil price keeps rising and rising, thus erasing any gains from the contango and producing losses over time. And long term, there is a good chance that oil price will indeed carry on rising. Now, as many readers on this board know, I also hold a long position a long dated crude future contract (Dec 2012). When I bought this contract, the contango compared to the front month was only about $2.50! So in other words, I hold an opposite contract that will protect me against any significant rise in the oil price, and I paid only $2.50 contango for a 6-year contract, whereas I will be making $1.50 in contango every month on the rolling short contract. As a bonus, this rolling short trade also protects my long position in the Dec 2012 against any significant fall in the oil price.

 

The other thing I should mention is that I will only short the mini-contract ($5/cent), whereas my 2012 contract is a $10 contract, so I will still gain from a long term rise in oil prices, which I expect.

 

I will keep a log of this rolling trade below.

Date Buy Price Sell Price Spread Profit/Loss Comm. P/L Total
08 Mar 2007 - - May 07 $62.50 - - -$16 -$16.00
19 Apr 2007 May 07 $62.80 Jun 07 $64.10 $1.30 -$150.00 -$32 -$198.00
07 May 2007 Jun 07 $61.225 Jul 07 $63.25 $2.025 $1437.50 -$32 $1207.50
08 June 2007 Jul 07 $66.25 Aug 07 $67.80 $1.55 -$1500.00 -$32 -$324.50

 

I am also starting a second trading strategy in addition to the rolling short above. This one is a pure spread based strategy. The idea is to buy a one-month spread about four months out at a spread as narrowly as possible, then let the earlier month of the spread come close in time and buy back the spread with hopefully a profit as the spread has widened. For example, For example, in April 2007, sell Aug 2007 and buy Sep 2007. Current spread about 65c. If this widens to $2.00-2.50 come mid-July, when the Aug contract expires, one makes $1.35 to $1.8. I will be trading this strategy with the physical contract, as the e-minis are not liquid enough in the further out months.

 

Here is the table of trades for this strategy:

 

Date Buy Price Sell Price Spread Profit/Loss Comm. P/L Total
07 May 2007 Nov 07 $66.98 Oct 07 $66.34 $0.64 - -$32 -$32.00
22 Jun 2007 Oct 07 $69.55 Sep 07 $69.20 $0.35 - -$32 -$32.00
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  • 4 weeks later...

Some good analysis here http://energy.seekingalpha.com/article/27030

 

When a commodity futures contract is in backwardation, an investor has two potential sources of returns. Since backwardation typically indicates scarcity, one is on the correct side of a potential price spike in the commodity by being long at that time. The other source of return involves a bit more explanation. In a backwardated futures market, a futures contract converges (or rolls up) to the spot price. This is the “roll yield” that a futures investor captures. The spot price can stay constant, but an investor will still earn returns from buying discounted futures contracts, which continuously roll up to the constant spot price. A bond investor might liken this situation to one of earning “positive carry.” In a contango market, the reverse occurs: an investor continuously locks in losses from futures contracts converging to a lower spot price. Correspondingly, a bond investor might liken this scenario to one of earning “negative carry.
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  • 3 weeks later...

I rolled the contract yesterday at $62.80 / $64.10, making a loss for the first month of $0.30. This is a small loss considered how much oil prices are perceived to have "gone up" since early March.

 

I also learnt an important lesson: The spread between the front month and next month can vary wildly within the last two weeks of expiry of the front month. Last week, the spread approached $2.80. I became too greedy and worked an order to roll for a spread of $3. That was never hit and by this week, the spread had reduced to almost $1. I reduced my order to a spread of $1.30, which was filled yesterday.

 

The lesson is that next time I see the spread widen above $2 or so, I should just roll at market. It will be important for the strategy of this rolling trade to maximise the spread at which the position is rolled. The price itself is actually secondary.

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I am also starting a second trading strategy in addition to the rolling short above. This one is a pure spread based strategy. The idea is to buy a one-month spread about four months out at a spread as narrowly as possible, then let the earlier month of the spread come close in time and buy back the spread with hopefully a profit as the spread has widened. For example, For example, in April 2007, sell Aug 2007 and buy Sep 2007. Current spread about 65c. If this widens to $2.00-2.50 come mid-July, when the Aug contract expires, one makes $1.35 to $1.8. I will be trading this strategy with the physical contract, as the e-minis are not liquid enough in the further out months.

 

I will post the table in the first post of this thread as soon as I have opened the first position.

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  • 3 weeks later...

I have rolled my position early this month, about two weeks before expiry. The reason is that a $2 spread has emerged between the front month (Jun) and the second month (Jul). The normal spread further away from expiry is about $1.30. I have decided to take advantage of the $2 spread and roll the position. Last month, the highest spread I observed was $2.70, but that was a short window and after that the spread narrowed considerably towards the expiry date, and in the end I was lucky to get a $1.30 spread (see table in the first post). I suspect too many people are trying to play the same game as I do towards the end of the expiry. So I am now working a general rules that if we are in the last two weeks of the contract and the spread goes over $2, I will take it rather than hang on.

 

So, now it's another month's wait until June for the next roll. So far, the strategy is $1159.50 in profit.

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  • 4 weeks later...

The spread between front and second month has been consistently around $1.10 for the past couple of weeks. I am still waiting to see if the spread starts to widen as the oil ETFs are starting to roll their positions, but it looks like the contango is getting thinner. Perhaps I will have to readjust my expectations and live with a spread of just $1 from now on. That would still be a $12 profit per year by just rolling a short position.

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  • 3 weeks later...

I rolled the contract on 8 June, and I have to admit that this time I cheated a little bit, as I did not take a fully risk-free roll. The spread between July and August contracts was so small (about $1), that I decided to work a limit sell order of $67.80 on the August contract and then try to catch a low for the July contract to buy it back. I was moderately successful, buying the July contract back at $66,25. Of course, the next day, the near month oil contracts plunged by $2, but that's life.

 

The strategy is now about $330 in the red, but this is actually quite good considered how much oil prices have risen since the strategy was started (about $6). It's like sailing into the wind.

 

However, the contango in the oil futures continues to shrink. Currently the near month-second month contango is down to $0.50. This is very worrying. I currently have no explanantion why this contango seems to be dispappearing. The theoretical explanation is is that if a contango disappears or even a backwardation develops, short term supply is seen as more costrained than long term supply. This seems almost incredible, given the abundance of oil right now, and all the risks oil supply may face in the future.

 

If the contango shrinks further or disappears, I will have to abandon the strategy. if it turns into a backwardation, I will reverse the stratregy, i.e. go rolling long.

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I rolled the contract on 8 June, and I have to admin that this time I cheated a little bit, as I did not take a fully risk-free roll. The spread between July and August contracts was so small (about $1), that I decided to work a limit sell order of $67.80 on the August contract and then try to catch a low for the July contract to buy it back. I was moderately successful, buying the July contract back at $66,25. Of course, the next day, the near month oil contracts plunged by $2, but that's life.

 

The strategy is now about $330 in the red, but this is actually quite good considered how much oil prices have risen since the strategy was started (about $6). It's like sailing into the wind.

 

However, the contango in the oil futures continues to shrink. Currently the near month-second month contango is down to $0.50. This is very worrying. I currently have no explanantion why this contango seems to be dispappearing. The theoretical explanation is is that if a contango disappears or even a backwardation develops, short term supply is seen as more costrained than long term supply. This seems almost incredible, given the abundance of oil right now, and all the risks oil supply may face in the future.

 

If the contango shrinks further or disappears, I will have to abandon the strategy. if it turns into a backwardation, I will reverse the stratregy, i.e. go rolling long.

 

Could it just be that more and more people are adopting a similar strategy, depressing the contango? I too find it incredible that the market views long term supply problems as being equal to that of problems now. Dec 2015 oil contracts traded for $71 on the Nymex yesterday.

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I've been pretty disapointed with these oil ETF's, I've just sold a load of OILB today which I bought when oil was $58 a barrel in Novemberish, i've made around 11% so i would of thought this strategy would of worked quite well, but they have seen to tighten the contango recently.

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  • 7 months later...

I may have read this thread before but have only recently got my head round the concept of contango/backwardation and the implications of those for investing in commodities. I guess the contango situation of the last few years is also the reason why my oil certificates have badly lagged behind the oil price last year. I blamed the exchange rate $/€ but I guess I know better now. You live and learn I suppose.

 

As far as I understand the data I looked at on the nymex website the contango has disappeared. There is no difference in the contract prices for the next two months. If this situation remains, the oil ETFs would look attractive again (providing the oil price rises, of course).

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