Curve placement strategies
One important investment theme that can be employed to generate alpha in commodity trading is curve placement strategies. To understand what these strategies do we should review the basics of commodity forward curves. The forward curve represents the relationship between future prices of commodities and time to maturity. Besides this, the forward curve also reflects the dynamics of carry costs over time. The normal forward curve which has an upward slope is associated with positive carry costs. Inverted forward curve has a negative slope, and is associated with negative carry costs. So we can say that the shape of most commodity forward curves can be explained by storage and financing costs.
It is not that hard to understand that theoretically storage costs should be equal to the difference between forward and spot prices; otherwise, there is a room for arbitrage opportunities. If storing the commodity is costlier than this difference, then owners of that commodity would sell the physical storage on the spot market and buy it forward. On the contrary, if the forward price is higher than spot price plus storage costs (which is equivalent to “storage cost is less than the difference between forward and spot prices”), then once would buy the physical storage and sell the forward.
However, the real world differs from our simplistic theoretical model. Physical market participants have to own and store the commodity. Therefore, sometimes the relationship between storage costs, spot prices and forward prices cannot be arbitraged away. Curve placement strategies take advantage of differences in the storage market value over time. These strategies also exploit market segmentation across the forward curve. Different market players focus on different maturities through the forward curve.
Many market players use commodity futures to hedge their risks. Producers and consumers pay a premium and thus decrease their profit to be hedged against big market moves in commodity prices. There are also index hedgers who on a regular basis buy and sell commodity futures to rebalance their indices. These market participants prefer trades across different parts of the forward curve due to the nature of their risk.
Since producers’ risk is price decline, they hedge their positions by shorting futures. They tend to do it on the back-end (far-dated months) of the forward curve. Consumers hedge their positions against price increases by going long futures contracts. Index hedgers usually sell the front-end contract and buy the second or third nearest contract.
Curve placement strategies exploit this market segmentation by going long on the far-dated part of the curve. Here they meet the hedging needs of producers who want to get rid of their price risk. These strategies also short contracts in a nearby segment of the curve where index hedgers and consumers create buying pressure.
This all applies to the normal forward curve, i.e, when the curve is in contango.
If the curve is backwardated, curve placement strategies will not work.
When demand starts to outstrip supply, spot prices go up and inventories go down which reduces storage costs. This in its turn causes forward prices to decline to the level of spot prices which means that the forward curve flattens or even goes to backwardation. When commodity prices rise, being in the long position in far-dated contracts and in the short position in nearby contracts will lose money. One solution is to monthly rebalance the strategy when the curve is backwardated. This will decrease the exposure of the short leg of the curve placement strategy in comparison to its long leg. Another solution is to change the strategy and go long front-end contracts. The idea is to get the most from the shape of the forward curve in both cases. Another way of explaining the idea is to put it this way - go long contracts with low net cost of carry and short the contracts with high net cost of carry.