We show that while a passive investment strategy going long in WTI oil futures yields an annual excess return of 8.1% between January 1985 and June 2010, an active but very simple investment strategy going long in backwardation markets (spot price above futures prices) and short in contango markets (spot price below futures prices) yields an annual excess return of 20 % for the same period. Its statistical significance is also high with a t-value of 3.36 compared to the long only strategy with a t-value of only 1.34. A supplementary investment strategy, where we leave the market for one month after a prior monthly negative return, yields an annual excess return of 22% between 1985 and 2010.
We also show that although the risk is relatively high in oil futures, investors with a perspective of more than 5 years made at least 12% annually after June 1991. Investors entering the market in 2000 and in 2005 made respectively 24.5% and 22.2 % annually.
Between 1985 and 2004, backwardation markets account for more than 66% of the months. In addition, returns are much higher during backwardation months than during contango months. After 2005, however, contango markets have become the norm in oil futures; yet, the excess return has remained high. Roll return, whether in backwardation markets or contango markets is a very stable and safe excess return and accounts for almost all the return compared to spot return.
Several explanations have been put forward regarding the drivers of the return in commodity futures. No explanation seems to fully account for the high returns. However, we do show that risk premium is connected to hedging pressure where short hedgers and long speculators are the most volatile and seem to adjust their volume according to price changes
