Energy futures markets allow transferring risk from producers or consumers to financial investors. According to the hedging pressure hypothesis, net shorts of industrial producers and consumers bias futures prices towards the low side. According to the theory of storage, inventory and supply shortages bias spot and front futures’ prices to the high side relative to back futures. Under both popular hypotheses, “backwardated” futures curves are – all other influence being neutral– indicative of premia paid to longs in back futures. A new paper finds sizeable hedging pressure premia. Long-short positions across a range of energy futures based on hedging pressure and term structure factors seem to have produced significant returns. A promising approach is to integrate various factors into a single long-short portfolio across the spectrum of energy futures.

Fernandez-Perez, Adrian, Ana-Maria Fuertes and Joelle Miffre (2021), “The Risk Premia of Energy Futures.”

The below quotes are from the paper. Headings, cursive text and text in brackets has been added.

This post ties in with this site’s summary on implicit subsidies, particularly the section on commodity futures.

Theories of risk premia in energy futures markets

“The hedging pressure hypothesis…asserts that energy futures markets exist to enable the transfer of price risk from hedgers, that is, energy producers and consumers, to speculators. In other words, well-functioning energy futures markets ought to reward speculators for absorbing the risk that hedgers seek to avoid: speculators shall earn a positive risk premium by taking long positions in relatively cheap (or backwardated) contracts on which hedgers are net short, and by taking short positions in relatively expensive (or contangoed) contracts on which hedgers are net long.”

Backwardation is the market state where the current price of an asset in the spot market is higher than its current price in the futures market, whereas contango is the opposite state where the spot price is lower than the futures price. The hedging pressure hypothesis rationalizes the backwardation versus contango dynamics with reference to the net positions of hedgers. When hedgers are net short, futures prices are set low relative to their expected values at maturity to entice net long speculation (backwardation). When hedgers are net long, futures prices are set high relative to their expected values at maturity to induce net short speculation (contango).”

“The theory of storage…asserts that the term structure of energy futures prices, that is, the futures prices of different maturity contracts at a given point in time, reflects [physical] supply and demand levels. In particular, a downward-sloping term structure (and thus a positive roll-yield) for a specific energy commodity indicates that the front-end price (that proxies the spot price) is high relative to the prices of more distant contracts, suggesting that the energy commodity is currently under-supplied relative to demand or that inventories are low; the market is backwardated and thus, futures prices are expected to increase. Vice versa, an upward-sloping term structure (negative roll-yield) for a given energy commodity indicates that the front-end price is low relative to the prices of more distant contracts, or that the energy commodity is over-supplied (high inventory); the market is contangoed and thus, futures prices are expected to fall.”

Roll yield, also called basis, is the difference between the spot price of an asset and that of the corresponding futures contract at a particular point in time. A branch of the empirical finance literature measures the commodity futures roll yield using the front-end contract price as proxy for the spot price. This approach is vindicated by the fact that the futures prices converge upon maturity to the spot price.”

“For electricity, which is non-storable, the theory of storage does not apply and thus the risk premium has been linked to other factors such as: i) the expected variance and skewness of the wholesale prices, ii) the uncertainty in the spot price, demand for electricity and revenues…iii) unexpected variation in hydro-energy capacity and in the demand for hydro-energy and iv) past risk premia and basis.”

Evidence of risk premia in energy futures markets

“Our empirical findings…of a sizeable hedging pressure risk premium in energy futures markets suggest that a risk transfer mechanism is at play between hedgers such as producers, refiners or consumers of energy who wish to shun the risk of energy price fluctuations, and speculators who are willing to take on risk with the expectation of earning a return…Speculators fulfil the important role of providing price insurance to hedgers.”

“We do not seek to measure the risk premium associated with a specific energy futures contract (e.g., crude oil, electricity or natural gas futures) but rather our goal is to compare different long-short portfolio strategies to effectively extract the risk premium in the energy futures sector as a whole. Therefore, for this purpose we exploit the heterogeneity in the cross-section of energy futures contracts as regards various characteristics. Put differently, our paper adopts the perspective of a futures market investor that contemplates the whole energy sector as a source of risk premia.”

“We first consider long-short portfolios that define the investor’s asset allocation based on a single style or signal. Some of these styles capture the fundamentals of backwardation and contango (term structure, hedging pressure, speculative pressure and past performance). Other styles are associated with asset pricing factors that are pervasive across markets and that could likewise matter to the pricing of energy futures contracts (value, liquidity and skewness)…the single-style portfolio is long the energy futures with positive standardized signals and short the energy futures with negative standardized signals. The weight allocated to a given asset depends on the strength of the signal.”

“To capture the risk premium associated with a specific energy commodity characteristic or signal, at each month end we form a long-short portfolio by allocating 50% of the total investor’s mandate to long positions on the energy futures contracts that are expected to appreciate the most or depreciate the least according to the characteristic or signal (e.g., roll-yield), and the remaining 50% to short positions on the energy futures contracts that are expected to depreciate the most or appreciate the least. The long-short positions are held for one month on a fully-collateralized basis, and this portfolio formation-and-holding process is rolled forward. As in the asset pricing branch of the broad commodity futures markets literature, the risk premium is defined as the expected excess return of characteristics-based long-short portfolios and represents the compensation that investors obtain for exposure to the risk associated with a given characteristic such as roll-yield or hedging pressure.”

“The main data for the analysis are the daily front-end, second- and third-nearest prices of US-exchanged futures contracts on oil (Brent crude oil, heating oil, light sweet crude oil, WTI crude oil), gas (natural gas, ethanol, RBOB gasoline and unleaded gas), electricity PJM and coal…The sample start is December 1990. All portfolios are made up of front-end futures contracts which we roll to second nearest contracts at the end of the month prior to the maturity month.”

“The empirical findings reveal a hedging pressure risk premium of 7.58% a year (t-statistic of 2.22) which represents the compensation that speculators require for meeting the hedgers’ demand for futures contracts, namely, for bearing hedgers’ risk of price fluctuations. Furthermore, we find a term structure risk premium of 11.70% a year (t-statistic 2.79) that represents the compensation demanded by futures investors for taking on the risk of energy inventory risk fluctuations. These two particular results endorse both the hedging pressure hypothesis and the theory of storage for the pricing of energy futures contracts.”

“We note a propensity for the futures with higher annualized mean returns (e.g., ethanol) to present backwardated characteristics such as higher roll-yields, higher hedging pressure (HP), higher speculative pressure and higher momentum signals.”

The style-integrated portfolio idea

“The style-integration idea is simple and intuitive: the long leg of the portfolio comprises the energy futures contracts that most signals recommend to buy, and the short leg those contracts that most signals recommend to sell…Would the approach of integration of the separate styles into a unique portfolio be more effective at capturing energy futures market risk premia?…We test the ability of various integration methods (that differ in their weighting scheme for the different characteristics) at capturing the energy risk premia.”

Jointly exploiting all seven signals into style-integrated portfolios increases the premium up to 12.4% a year (t-statistic 4.05). The simplest style-integration approach that ascribes equal weights to the different signals stands out as the most effective…[This] highlights the effectiveness of an integrated portfolio that gives equal importance to all the energy commodity characteristics at hand…The findings are robust to trading costs, alternative designs of the integrated portfolio, data snooping tests and sub-periods.”

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Ralph Sueppel is founder and director of SRSV, a project dedicated to socially responsible macro trading strategies. He has worked in economics and finance for over 25 years for investment banks, the European Central Bank and leading hedge funds. At present, he is head of research and quantitative strategies at Macrosynergy Partners.