PCA

of WTI Futures (Part I)

Theoretically,crudeoilfuturepricesreflectthemarketparticipantsexpectationoffuturedemandand supply,aswellastheiroveralluncertainty. Thecrudeoilfuturemarketisaninterestingmarkettoanalyze.Lawsofcostofcarry,supplyand demandstillapply,butgeopoliticalriskweighsonrelativeprices. Historically,theoilfuturescurveisoftenfoundinbackwardation,whichmeanshigherpricesforshort termcontractsthanforlongtermcontracts.Thisisoftenexplainedbyatheoreticaltermcalled convenienceyield.Convenienceyieldisconceptuallysimilartodividendsinequity,whereitfavors physicalpossessionofthestockoverfuturedeliveryduetothedividendcashpayments.Inthecrudeoil market,convenienceyieldmaysignalmarketworryonfutureoilsupply(ordelivery),duetosome geopoliticalconcernsandthetendencytofavorholdingthecommoditynow.

Inthiswhitepaper,wewillnotdelveintothetheoreticaleconomicsbehindthepricechangesortheir spreads.Instead,wewillexaminethedailypricesofthefirstfour(4)contractsofWTICLfutureslisted onNYMEX.Next,usingexchangerulesforWTI/CLcontracttrading,wewillcomputethenumberofdays tothedeliverymonthforeachcontracttoconstructthefuturescurve.Finally,wewillcarryoutprincipal componentanalysis(PCA)inanattempttouncoverthecoredriversbehindthefuturescurvechanges (i.e.levelandgeneralshape).

Why should we care?

Theoilfuturemarketisverycomplexinitsdesign,and,inthispaper,wewillattempttouncoverand simplifytheunderlyingdriversreflectedinthedailyrelativepricesofdifferentcontractsforabetter understandingandbetterhedgingforaportfolioofsuchinstruments.

Background
Thegeneraldemandforpetroleumproductsishighlyseasonalandisgreatestduringthewintermonths, whencountriesintheNorthernHemisphereincreasetheiruseofdistillatedheatingoilsandresidual fuels.Supplyofcrudeoil,includingbothproductionandnetimports,alsoshowsasimilarseasonal variationbutwithasmallermagnitude. Duringthesummermonths,supplyexceedsdemandandpetroleuminventoriesnormallybuild;whereas duringthewinter,demandexceedssupplyandinventoriesaredrawndown.Asaresult,inventoriesalso demonstrateseasonality. Intheory,futurespricesarecomputedasfollows: PCAforWTI/CLFutures

Ft ,T St e

( rt ,T xt ,T qt ,T )(T t )

SpiderFinancialCorp,2013

Where

Ft ,T =futurepricesattime( t )fordeliveryat T St =WTIspotpricesfordeliveryatCushing,OK t =timenow T =futuredeliverytime rt ,T =nominal(perannum)interestrateattime( t )for T maturity

xt ,T nominal(perannum)marginalstoragecostattime( t )for T delivery
=

qt ,T =nominal(perannum)theoreticalconvenienceyieldattime( t )for T delivery

Now,letstakethelogarithmofeachside:

ln( Ft ,T ) ln( St ) (rt ,T xt ,T qt ,T )(T t )

Tocarryoutouranalysis,wewillusethelogarithmoffuturepricesandincludethelogoftheWTIspot pricesintothedataset. Next,wewillcomputethenetoftheinterestrate,storageandconvenienceyieldrates(i.e. t ,T ),which canbeexpressedasfollows:

t ,T rt ,T xt ,T qt ,T

ln( Ft ,T / St ) T t

Notethat t ,T theoreticallyconsistsofthreelooselycorrelatedfactors(interest,storageand convenienceannualyield),sowedexpectthatapplyingaPCAtypeofanalysisshouldyieldnomore thanthree(3)factors.

Data Preparation
Inthispaper,wewillusetheclosingmarksoftheimmediatefour(4)tradedNYMEXCLfuturecontracts oftheEIAwebsite.Furthermore,wealsousethespotpricesforWTIcrudeoilatCushing,OK(delivery locationforNYMEXCLcontracts)oftheEIAwebsiteaswell. Tocompileourdataset,weusethenumberofdaystothe1stdayofthedeliverymonthasourhorizon (i.e.theindependentvariableofthefuturecurve).WerefertothisasdaystodeliveryorDTD. Next,accordingtoNYMEXproductspecification,thetradingofacrudeoilfuturecontractterminates baseonthefollowingrule(s):

PCAforWTI/CLFutures

SpiderFinancialCorp,2013

Tradinginthecurrentdeliverymonthshallceaseonthethirdbusinessdaypriortothetwenty fifthcalendardayofthemonthproceedingthedeliverymonth.Ifthetwentyfifthcalendarday ofthemonthisanonbusinessday,tradingshallceaseonthethirdbusinessdaypriortothelast businessdayproceedingthetwentyfifthcalendarday.IntheeventthattheofficialExchange holidayschedulechangessubsequenttothelistingofCrudeOilfutures,theoriginallylisted expirationdateshallremainineffect.Intheeventthattheoriginallylistedexpirationdayis declaredaholiday,expirationwillmovetothebusinessdayimmediatelyprior Usingthelasttradingdayrules,wedeterminewhenthefrontcontractswitchestothefollowingmonth contract,and,thus,computethepropertradingdaystothe1stdayofthedeliverymonth.For computingthetradingdays,adjustingforweekendsandholidays,weusedtheNumXLcalendar functionswiththeUSDcalendar. Asaresult,foreachtradingday,weusethefour(4)contractstoconstructafuturecurve(futureprices versusnumberofdaystodeliver(DTD)). Next,oneachday,usingthefuturecurveabove,weinterpolate/extrapolate(cubicspline)thefuture pricesfordeliverytermsrangingfrom10daysto120days(12terms). Next,usingtheformulabelow,wetransformthefuturepricesintothenetoftheinterestrate,storage costandconvenienceyield(i.e. t ,T )

t ,T rt ,T xt ,T qt ,T

ln( Ft ,T / St ) T t

Forexample,onApril29,2013,theWTIfuturecurveexhibitsahumpshapedcurve:

PCAforWTI/CLFutures 3 SpiderFinancialCorp,2013

Onthesameday,theimplied(computed)netinterestrate,storageandconvenienceyield(NISC)for eachdeliveryterm,the t ,T exhibitsthefollowingshape(graphbelow).

Althoughthefuturepricesbetween50100DTDremainsflat,theunderlyingnetofinterest,storageand convenienceyieldchangesduetothechangeintimetodelivery. Finally,wecomputetwelve(12)timeseriesforthenetinterest,storageandconvenienceyield(NISC)for deliverytermsrangingfrom10to120days.

Analysis
LetsfirstexaminethecorrelationbetweenthetwelveNISCinputtimeseries.

PCAforWTI/CLFutures 4 SpiderFinancialCorp,2013

Theshorttermdeliveries(<30days)oftheNISCcorrelateweaklywithlongertermsfutures.Notethat thisphenomenonisnotfoundintherawfutureprices.

Now,letsrunPCAanalysis.Beforewelaunchthewizard,insertarowabovetheinputdataforthemask variableandsetallitsvaluesto1.Thiswillhelpustoexcludeinputvariableswithoutredoingthe analysis.

LaunchthePCAWizard,specifyinputvariablesandcomputethePCAstatistics.

PCAshowsthatthefirsttwoprincipalcomponents(akadrivers)accountfor98.7%oftheoverall variation,andthefirstthreeprincipalcomponentscapture99.9%. Letsexaminetheloadingsofthosedriversinanattempttofindapractical/physicalproxyforthem.For thefirstprincipalcomponent:

PCAforWTI/CLFutures 5 SpiderFinancialCorp,2013

ThefirstPCloadings(akatermstructure)exhibitapatternsimilartotheyieldcurve:Contagoinshort term,andflatforlongerterm.Wemaythinkofthefirstcomponentasaproxyfortheinterestrate. Thesecondprincipalcomponents(akadriver)loadingexhibitsthefollowingpattern:

ThispatternissimilartothePC1,withtheexceptionofthekinkfor1020days,andthenegativevalues upto50days.Thismaybeassumedasaproxyfortheconvenienceyield;shorttermtenorshave negativevaluescausingthefuturepricestoriseandpossiblycreatingabackwardation.Forlongerterm tenors,thevalueispositive,reducingthefuturepriceandstrengtheningthebackwardation. Thethirdprincipalcomponentisrelativelyhardertoexplain:

PCAforWTI/CLFutures 6 SpiderFinancialCorp,2013

Canthisbethestoragecostperyear?Unlikely,astheloadinggoesnegativebetween20and70daysto delivery.Fortunately,itsvarianceandcontributiontotheoverallvariationarerelativelysmall.

Conclusion
Insum,wefoundthatthenetinterest,storageandconvenienceyield(NISC)ofWTIfuturesareprimarily drivenbytwouncorrelateddrivers.Thefirstdriverexhibitsatermstructuresimilartotheyieldcurve andtheseconddriverwashypothesizedasaproxytotheconvenienceyield. Wait a minute! Youmaywonder:canIleverageainterestrateinstrument(e.g.Eurodollar,swaps,etc.)tohedgethe interestrateexposureinmyWTIfuturesportfolio? Inafollowuppaper,wewillexaminetheLIBORyieldcurvedataintoouranalysisandfinetuneourrisk driversfurther,isolatingthestorageandconvenienceyieldfromtheinterestrate. Why do we care? AportfolioofWTIfuturecontractscanbehedged(97.8%effective)fornonspotpricechangesusing onlytwo(2)differentfuturecontracts. Whataboutspotchanges? Whatisthehedgingration? Howoftendowerebalancethehedge?

Inafollowuppaper,welldiscussthehedginginrelationtoPCAinfurtherdetails. Why do we stop here? Thereisalotofmaterialheretoswallow,soweoptedtopauseatthisstagetogiveyouopportunityto digestandgetcomfortablewithourearlierdiscussion,andbetterprepareyouforamoreadvanced handlingofthetopic.

PCAforWTI/CLFutures

SpiderFinancialCorp,2013