Last con-Tango in Paris

Publié le 7 mai 2020 Marché et recherche
Last con-Tango in Paris
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Simon ANINAT

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Written by Simon Aninat, Volatility Portfolio Manager at Seeyond, on 30th of April 2020

As you know, Oil market has recently made the news with negative prices. I thought it could be a good opportunity to highlight the parallel that exists between the Oil market and the Volatility market. Do you know what those two markets have in common? Not the 1972 movie “Last Tango in Paris”, starring Marlon Brando and Maria Schneider, no, but rather the “conTANGO”!

Except if you are an oil producer or a refinery, you cannot invest the Oil “spot market”. As an investor, you would indeed have to invest in Oil “futures”. With those contracts, you agree to buy Oil barrels at a certain future date. If you hold the future contract to expiry Oil barrels will be physically delivered to you. Exchanges specify the conditions of delivery for the contracts they cover. The exchange designates warehouse and delivery locations for many commodities. For US WTI, there is a large storage facility in the city of Cushing where the barrels are delivered by default. When delivery takes place, a warrant or bearer receipt that represents a certain quantity and quality of a commodity in a specific location changes hands from the seller to the buyer who then makes full payment. The buyer has the right to remove the commodity from the warehouse or has the option of leaving the commodity at the storage facility for a periodic fee.

Let’s say that today the cost of Oil is very low. It is tempting to buy a lot today for later use, when the Oil price is higher for example. If you do so, you have to store barrels yourself, secure the storage facility etc.: it involves a lot of costs. This is why storage cost is an important part of Oil investing and this is why the Oil futures curve is often in “contango”. This term refers to the shape of futures curve in delivery date order: the first listed future expiring this month, the second future expiring the next, etc. If this curve is upward sloping, the curve is said to be in “contango”. If it is downward sloping, it is said to be in “backwardation”. Market anticipations aside, the cost of the two-month future should be the cost of Oil today + the cost of storage for two months. Due to high storage costs, Oil futures curves are most of the time in contango to reflect this storage cost.

Typical Contango
Typical Backwardation

Source: Seeyond. Illustration of 2 typical Oil Futures curves

The longer the maturity, the stickier the price. It means that if, for some reasons, demand for Oil is high but there is a temporary disruption in the offer, short term futures can be a lot higher than long term futures, reflecting a sort of mean reversion to more acceptable prices as the disruption disappears. At contrary, if prices are low, they can go very low on short term futures due to a temporary lack of demand, as we are currently experiencing, however long term futures remain significantly higher as the situation is likely to improve in coming months.

This doesn’t explain how Oil prices can get negative…

Part of the explanation lies in the existence of a large ETF providing investors with a constant exposure to Oil futures. To keep the exposure constant, the ETF sells everyday a bit of the front month future and buy a bit of the second one, which artificially steepens even more the slope between the first and second future, as we can see on the 31st of March 2020:

Future Prices as 31 mars 2020

Source: Bloomberg, Seeyond, as of 31/03/2020. Oil Futures curves refers to USCRWTIC Index for the first point and CL1 to CL8 Comdty futures contracts

Lured by a front month future around 20, lots of investors rushed into it with the expectation of a quick rebound and nice profits. But as the future got closer to expiry (on the 21st of April), price went even lower and as they couldn’t afford to get barrels delivered, they needed to cut the position, i.e. finding someone happy to buy and get delivered. As there were no buyer due to massive stocks of Oil and Cushing storage facilities being almost full, investors had to sell at “any” price, ending up PAYING someone to get rid of their future contracts. Here is the Oil future curve on the 20th of April:


Future prices as of 20 avr 2020

Source: Bloomberg, Seeyond, as of 20/04/2020. Oil Futures curves refers to USCRWTIC Index for the first point and CL1 to CL8 Comdty futures contracts

Beyond this very technical “expiration related” event, there is a lesson to be learned: If you buy Oil on low levels, you need to be right quickly otherwise the contango will make your future investment slide lower every day. To illustrate this, let’s look at an investment made on the 22nd of December 2008, the bottom day for the Oil spot price during the Great Financial Crisis, at 31.41. As the spot price rebounds sharply, an investment made on the investable ETF would have lagged by a huge amount.

8

Source: Bloomberg, Seeyond, from 22/12/2008 to 30/04/2010. Oil Theoretical refers to USCRWTIC Index and Oil ETF refers to USO US Equity

Everything I said above is also true for Volatility investments: you cannot invest directly on Vix but only on Vix futures. When the Vix is low, the curve is usually in contango, and when the Vix is high the curve is in backwardation. Which means that a Vix at 10 is not always a good “BUY”. For example, if you had invested on Vix futures through a Vix ETN on the 3rd of November 2017, when the Vix spot closed at a cycle low of 9.13, your investment would have returned a mere 10% at the end of April 2020 when the Vix spot would have returned almost 400%.

10

Source: Bloomberg, Seeyond, from 03/11/2017 to 30/04/2020. Vix Theoretical refers to Vix Index and Vix ETN refers to SPVXSP Index

On short term volatility, the cost of holding volatility is most of the time more important than the absolute level of volatility as a driver of performance for a volatility strategy. You have to invest on longer term volatilities to see the level of volatility to be the main driver of performance. However the longer the maturity, the more stable the volatility level, so less reactive in case of a volatility spike. This is why at Seeyond we look at volatility through different angles: level but also cost of carry, momentum across various maturities and strikes, to provide our investors with optimized strategies which aim at benefiting the most from volatile environments with a reduced cost of holding volatility when markets are quiet.

This article has been provided for information purposes only to professional clients as defined in the MiFID Directive. It must not be used for retail investors. The provision of this material or reference to specific sectors or markets in his article does not constitute investment advice or a recommendation or an offer to buy or sell any security. Investors should consider the investment objectives, risks, and expenses of any investment carefully before investing. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.