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this paper has enlightened me.
commodity futures returns historically linked to "backwardation" or "roll yield" seem to be simply proxies for inventory indicators from the theory of storage.
namely, the basis (difference between spot price and next nearby futures price), when large and positive is indicative of a steeply backwarded futures curve. when it is negative, the curve is in contango.
low inventory levels amt to low supply and thus high demand now. lower inventory levels also mean higher volatility (concave increasing function according to the paper).
this is just some fo the great insights from this paper:
Fundamentals of commodity futures returns
enjoy!
Barron
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Since the higher returns are asscociated with higher volitility is it safe to assume that low inventory commdoities do not outperform on a risk adjusted basis? Or did the author not address this? Also, a sharp differance between spot and futures is often the result of a high cost of carry and not neccesarily low inventories. At any rate the best advice I ever received about trading commodity futures was to "lie down until the desire to trade went away."
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i think the author did address this but i'll have to reread. what i'm thinking now is that since the relationships are non-linear, it may be the case that there is an increasing concave down relationship between inventory levels and futures price volatility. in that case, the lower inventory levels could indeed have a higher sharpe ratio.
my whole goal here is simply to create a passive portfolio with commodity expore that costs the least and gives the highest sharpe ratio addition....i'm not looking to trade commodities in an active sense in any case other than when i feel i have an edge.
Barron