In this paper we study whether the commodity futures market predicts the commodity spot market. Using historical daily data on four commodities—oil, gold, platinum, and silver—we find that they do. We then show how investors can use this information on the futures market to devise trading strategies and make profits. In particular, dynamic trading strategies based on a mean–variance investor framework produce somewhat different results compared with those based on technical trading rules. Dynamic trading strategies suggest that all commodities are profitable and profits are dependent on structural breaks. The most recent global financial crisis marked a period in which commodity profits were the weakest.
Our focus on commodity futures and spot markets is motivated by the fact that commodity markets—gold and oil in particular—have been at the forefront of financial and economic news over the last half-decade. Oil and gold prices have risen persistently over the last five years. Oil prices, for instance, peaked at over US$140 per barrel, after reaching the US$100 per barrel mark for the first time in 2008. So great was the influence of the oil price rise that when it reached the US$100 per barrel mark, it created a psychological barrier for investors in the US market (Narayan and Narayan, 2013). Gold prices have also risen sharply over the last decade, having quadrupled over the 2001–2010 period; a detailed analysis can be found in Baur and McDermott (2010). As noted in Baur and McDermott (2010), gold prices tend to react positively to negative market shocks, which is a behavior inconsistent with other asset classes. With respect to oil prices, Narayan and Sharma (2011) show that all sectors on the New York Stock Exchange respond significantly to oil price shocks. It follows that the relevance of oil and gold prices to the functioning of financial markets has been well-documented by the literature.
The commodity futures market is even more relevant because, as explained by French (1986), it serves two social functions. The first function is that the futures market facilitates the transfer of commodity price risk. Risk transfer refers to hedgers using futures contracts to shift price risk to others (Garbade and Silber, 1983). The second function is that futures prices forecast spot prices. In other words, investors can use futures prices for pricing cash market transactions (Working, 1953). The subject of the current paper is based on the second function of the futures market with respect to four commodities, namely, crude oil, gold, silver, and platinum. We test whether the commodity futures market predicts the commodity spot market. This line of research is nothing new, however. Several studies (see, inter alia, Coppola, 2008) examine evidence of commodity spot price predictability using the commodity futures price. That there is a motivating theory behind this predictability relationship has provoked significant interest in this topic. The key limitations of this literature, however, are the economic implications and the significance of the role of the commodity futures market. In this regard, two questions remain unanswered. The first question is: if the commodity futures market predicts the commodity spot market, as shown by Coppola (2008) for instance, can investors devise profitable trading strategies? The second question is: can different trading rules, such as the simple moving average technical trading rules, break trading rules, and the dynamic trading strategies based on a mean–variance investor framework, produce statistically significant profits across all four commodities? In other words, are profits, if they exist, in these four commodity markets robust? These questions are relevant for investors. Deciding whether or not the futures market predicts the spot market is only the first step in informing investors. How such knowledge from the futures market can be used to devise profitable trading strategies is equally, if not significantly more, interesting. Subsequently, this is our contribution to this literature.
Our results provide three main messages. First, we find that commodity futures returns do predict commodity spot returns. We observe that these results hold in both linear and non-linear models and in models that account for structural breaks. Thus, we find robust evidence that the commodity futures market predicts the commodity spot market. Second, we observe that the simple moving average technical trading rule and trading range break rule-based strategies consistently produce statistically significant profits in three of the four markets—with the exception of the platinum market. We also note that profits, like predictability, are influenced by structural breaks in the data. Finally, we devise dynamic trading strategies based on a mean–variance investor framework. We find that regardless of whether or not we allow for short-sales, profits from the oil, gold, and silver markets are statistically significant. Platinum remains the only market where investors do not make statistically significant profits.
The rest of the paper is organized as follows. In Section 2, we discuss the theory that motivates our research question and explain the estimation approach. In Section 3, we discuss the results, and in the final section we provide the concluding remarks
