With the oil market futures curve in backwardation and likely to remain so for the foreseeable future, the topic of roll yield has been top-of-mind for many commodity investors. Yet we often hear market participants promote a misconception about this key driver of returns by conflating it with carry – a miscue that may lead investors to underestimate the value of commodity investments.
Generally speaking, carry is a measure of the return that can be expected over the next 12 months assuming spot prices and valuations do not change. In the context of commodities, roll yield is a contributor to carry, and refers to returns generated as a longer-term futures contract over time “rolls” into a shorter-term contract as it nears expiration. However, many investors overlook what we view as a key component of carry for commodities: the short-term rate earned on the collateral underlying these unfunded investments.
Essentially, as we explain in greater detail below, we believe calculating commodity carry boils down to a simple equation:
Commodity carry = roll yield + the short-term rate
Today, estimates of one-year carry that incorporate the short-term rate suggest that investors in a broad commodity basket (such as the Bloomberg Commodities Index) are being paid to hold an asset class that can serve as an inflation hedge while providing diversification from equity and fixed income risk. A better understanding of the distinction between roll yield and carry and the importance of the short-term rate may thus help commodity investors more accurately gauge potential returns.
Commodity roll yield: what it is (and what it isn’t)
To gain insight into commodity carry, we can draw a parallel to bond investing. In fixed income, carry assumes markets (i.e., yields and spreads) remain unchanged and is calculated by taking the yield of the bond plus the roll-down return. While the concepts of roll down and yield are well understood in fixed income investing, we’ve found that in commodity markets, participants frequently equate the concept of roll yield to the notion of carry – after all, commodities don’t pay a coupon/yield. But roll yield, as important as it is, doesn’t tell the whole story.
Roll yield in commodities has always been of great interest to both advocates and skeptics of the asset class. We have written before about its implications for investors—in particular, why roll yield is a strong driver of future returns and why we view a backwardated (downward-sloping) crude oil futures curve as a trade signal to invest in commodity markets. Historically, a backwardated oil curve has been a strong predictor of positive future performance. This tendency has been borne out again recently, with generally strong oil and commodity returns in the months since the oil market shifted from contango into backwardation in the fall of 2017.
Here is how roll yield works, in a nutshell:
With long commodity futures positions, the current futures contract is frequently rolled to the next-out contract before it expires. This prevents the contract holder from having to take physical delivery of the underlying commodity. When commodity futures curves are upward-sloping, the next-out contract will trade at a higher price than the current contract. If the curve does not change, the newly purchased contract “rolls down the curve” as it gets closer to expiring, thereby falling in price and generating a negative roll yield. When commodity curves are downward-sloping, the opposite is true: The distant contracts trade at a lower price, and the prices “roll up the curve,” thereby generating a positive roll yield. In commodity circles, upward-sloping, negative-roll-yield curves are said to be “in contango,” while downward-sloping, positive roll yield curves are said to be “in backwardation.”