Returns Earned by an Invester

Roll yield, simply put, is the difference between returns earned by an investor from investing in futures contracts of an asset as against the spot commodity itself. i.e. Roll yield = Futures returns  - Spot returns.

As an investor, suppose I invest in spot oil today at $45bbl for 5 years. Assume the spot after 5 years is $80bbl. My returns will be the total of capital gains (80-45) + convenience yield – cost of carry (cost of capital + storage costs + insurance costs etc.) over the 5 years.

Alternatively, I can invest in near-term oil futures today and keep rolling the position continuously for 5 years. I save on the entire cost of carry except for interest on margin money. However, I lose out on convenience yield. Since futures price is equal to spot price plus cost of carry less convenience yield, roll yield is nothing but convenience yield less cost of carry.

 The return that I will finally earn from the futures position will be the sum of a) the profit or loss that I will earn at each roll over i.e. sale price of each futures contract just before its expiry less purchase price of that futures contract and b) the ‘saving’ or ‘cost’ that comes about from the difference between the price at which I am exiting the old futures contract and entering into a new futures contract.

The reason I have put the saving/ cost in quotes is because this is NOT a realized profit or loss.  Only the profit/loss in (a) is actually realized in cash. However, (b) leads to an overall saving/ cost over the life of the futures contracts and this comes about from the shape of the ‘yield curve’ of the futures contracts (similar to the yield curve for interest rates that you may have studied).

Let us use the Metallgessellschaft case for a moment to understand how the MGRM management planned to profit from their futures position.

Expectation of management: a) Spot prices will rise and b) Oil futures will be in backwardation. (See figure at the end of the document for reference).

What does this mean? Backwardation is a situation where far period futures are cheaper than near period futures i.e. an October 2015 contract is more expensive than the November 2015 period on any particular day. This can be represented as F(0,1)>F(0,2)>F(0,3)..... Here, the futures yield curve, i.e. plotting futures prices today for various maturities will be a downward sloping yield curve. Futures for later deliveries will cost less than those for earlier deliveries.

Very often, this is confused with ‘basis’. What is basis? Basis is the difference between today’s spot price and the near-most futures contract on an asset, today. A positive basis occurs when S0>F(0,1). Of course, it has been seen that a backwardation situation is almost always accompanied by a positive basis situation.

There is a difference therefore, between a positive basis situation and a backwardation situation. The former is when S0>F(0,1) and the latter is when E(S1)>F(0,1) i.e. expected spot price at the expiry of the near-most contract is greater than the going futures price for that contract. Put another way, if I am looking at the November 2015 futures today which expire on say, 29 November, expected spot price on 29 November is greater than the price at which those futures are trading today.