White-paper: WTI Futures Curve Analysis with PCA (Part 1)
[July 9,2013] This week, we present our fifth installment in our ongoing series of selected case studies. As with the other installments, we use real financial data to construct models with the help of NumXL
Historically, the oil futures curve is often found in backwardation, which means higher prices for short-term contracts than for long term contracts. This is often explained by a theoretical term called "convenience yield". Convenience yield is conceptually similar to dividends in equity, where it favors physical possession of the stock over future delivery due to the dividend cash payments. In the crude oil market, convenience yield may signal market worry on future oil supply (or delivery), due to some geopolitical concerns and the tendency to favor holding the commodity now
In this white paper, we will not delve into the theoretical economics behind the price changes or their spreads. Instead, we will examine the daily prices of the first four (4) contracts of WTIi CLi futures listed on NYMEXi. Next, using exchange rules for WTI/CL contract trading, we will compute the number of days to the delivery month for each contract to construct the futures curve. Finally, we will carry out principal component analysis (PCAi) in an attempt to uncover the core drivers behind the futures curve changes.
Why do we care? The oil future market is very complex in its design, and, in this paper, we will attempt to uncover and simplify the underlying drivers reflected in the daily relative prices of different contracts for a better understanding and better hedging for a portfolio of such instruments.