Theories of Commodity Future Returns

Insurance Theory

The theory proposes that producers use commodity futures markets for insurance by locking in prices and making their revenues more predictable. It is also known as the theory of “normal backwardation” and has been proposed by economist John Maynard Keynes in 1930

Keynes’ theory assumes that the futures curve is in backwardation “normally” because farmers would persistently sell forward, pushing down prices in the future. Alternatively, the theory suggests that the futures price has to be lower than the current spot price as a form of remuneration to the speculator who takes on the price risk and provides price insurance to the commodity seller.

However, evidence has served to discredit Keynes’ theory.

Kolb (1992) analyzed 29 futures contracts and concluded that “normal backwardation is not normal.” This means that the presence of backwardation does not necessarily generate positive returns in a statistically significant fashion for the investor (or that contango leads to negative returns, for that matter).

The weakness of insurance theory led to the development of the hedging pressure hypothesis theory. This theory explains futures markets in contango (i.e., when the shape of the futures price curve is upward sloping with more distant contract dates), recognizing that certain commodity futures markets often show persistently higher prices in the future unlike the backwardation outlined by Keynes. 

Hedging Pressure Hypothesis

De Roon, Nijman, and Veld (2000) proposed this theory that drew from Cootner (1960). They analyzed 20 futures markets between 1986 to 1994 and concluded that Hedging Pressure plays an important role in explaining futures returns.

Hedging Pressure occurs when both producers and consumers seek to protect themselves from commodity market price volatility. Producers and consumers enter price hedges to stabilize their projected profits and cash flow.

The theory states that producers will tend or want to sell commodities forward and, as such, sell commodity futures. In contrast, consumers of commodities want to lock in their commodity purchase prices and buy commodity futures.

The commodity producers are more interested in selling forward (seeking price insurance) than commodity consumers (as per the concept of normal backwardation). Speculators come in when there is a relative imbalance in demand for price protection. They ensure that futures prices trade at a sufficient discount to compensate for the price risk they will take on.

The theory has equally contradicted proponents such as Hicks (1939). Hicks, for instance, argues that producers generally have greater exposure to commodity price risk than consumers.

Firms (and countries) are almost entirely dependent on commodity production and are therefore very concentrated in one sector, such as energy, grains, and metals. On the other hand, commodity consumers are very diverse and often have other priorities.

Firms that purchase and use commodities in their products have a mixed record of price hedging, depending on the importance of the commodities in their cost structure.

In conclusion, it is challenging to apply the Hedging Pressure Hypothesis because determining the irregularity in hedging pressure between buyers and sellers of a commodity is very difficult.

Theory of Storage

This theory was advanced by Kaldor (1939). It focuses on how the level of commodity inventories helps in outlining commodity futures price curves. The theory attempts to explain whether the supply or demand of the commodity dominates in terms of its price economics.

Since commodities are physical assets and not financial assets like stocks and bonds, they attract storage costs. Consequently, they incur additional costs related to renting, inspection, insurance, etc., for longevity. Therefore, a regularly stored commodity should have a higher price in the future (contango) to account for those storage costs; thus, supply dominates demand. In contrast, a commodity consumed along a value chain that allows for just-in-time delivery and use (i.e., minimal inventories and storage) can avoid these costs. In this scenario, demand dominates supply, and current prices are higher than futures prices (i.e., backwardation).

The theory suggests that available inventory generates a benefit known as convenience yield. The convenience yield is low when stock is abundant. Otherwise, the yield rises as inventories diminish and concerns regarding future availability of the commodity increase.

The Theory of Storage, therefore, proposes that the future price is determined as;

\(\text{Futures price}=\text{Spot price of the physical commodity}+\text{Direct storage costs}-\text{Convenience yield}\)

This equation indicates that price returns and the shape of the curve can move in conjunction with the changes in the available inventory and actual and expected supply and demand.

The downside of this theory is that it has highly volatile components and is hence not reliably calculable. For example, events (weather, war, technology) can fundamentally adjust convenience yield in a short time with unknown magnitude. Corn suitable for feed may not be suitable for human consumption. This makes defining inventories, in such an instance, tricky. In the end, there are frameworks and theories, but they are not easily applied and they require judgment and analysis by a trader or a valuation system.

Question 1

Under the Hedging Pressure Hypothesis, when hedging activity of commodity futures buyers exceeds that of commodity futures sellers, that futures market is most likely:

1. Flat.
2. In contango.
3. In backwardation.

Solution

The correct answer is B.

Under the Hedging Pressure Hypothesis, a market in contango typically results when excess demand for price insurance among commodity futures buyers drives up the futures price to induce speculators to take on price uncertainty risk.

A is incorrect.  A flat market will likely occur if futures demand activity largely equaled that of supply.

C is incorrect. Under this scenario, the futures market would be in contango, not backwardation.

Question 2

Which of the following best describes the Insurance Theory of futures returns?

1. Speculators will not provide insurance unless the futures price exceeds the spot price.
2. Producers of a commodity will accept a lower future price (versus the spot price) in exchange for the certainty of locking in that price.
3. Commodity futures markets result in a state of contango because of speculators insisting on a risk premium in exchange for accepting price risk.

Solution

The correct answer is B.

Under the Insurance Theory of futures returns, Keynes states that producers of a commodity  prefer to accept a discount on the potential future spot price in return for the certainty of knowing the future selling price in advance.

A is incorrect. The futures price must be below the spot price (normal backwardation) under the Insurance Theory of futures returns.

C is incorrect. The Insurance Theory of futures returns implies markets are in backwardation, not contango.

Reading 35: Introduction to Commodities and Commodity Derivatives

LOS 35 (f) Compare theories of commodity futures returns.