There are three primary theories of futures returns.

Insurance Theory

Commodity futures allow producers to hedge their commodity price risk exposures. Because hedging is a form of insurance, hedgers must offer investors in long-only commodity futures an insurance premium. That is, the futures curve should be in backwardation "normally."

Hedging Pressure Hypothesis

Hedging pressure plays an important role in explaining futures returns. Hedging by risk-averse producers causes futures prices to be below the expected spot rate in the future. On the other hand, hedging by risk-averse consumers causes future prices to be higher than the expected spot rate in the future.

Both the insurance perspective and the hedging pressure hypothesis reflect a view that commodity futures are a means of risk transfer and that the providers of risk capital charge an insurance premium. The hedging pressure hypothesis is more flexible in that it does not presume that hedgers only go short on futures contracts.

Theory of Storage

This theory focuses on the role that inventories of commodities play in the determination of commodity futures prices. In this framework, inventories allow producers to avoid stockouts and production disruptions. Having a level of inventory that will reduce the impact of production disruption is beneficial. This benefit is termed convenience yield. The convenience yield is high when desired inventories are low and low when desired inventories are high.

In the theory of storage, futures price = spot price + direct storage costs (e.g., rent, insurance) - convenience yield.

The equation shows that the shape of the future price curve can be affected by changes in the available inventory and in actual and expected demand and supply. The convenience yield can be thought of as a risk premium linked to inventory levels that helps explain observed futures prices.

Components of Futures Returns

The return from a collateralized portfolio of commodity futures contracts comes from three main sources:

Total Return = Spot Return + Roll Return + Collateral Return

• The spot return is simply the price appreciation in the spot price, which is based on immediate delivery of the commodity.

• As an investor in futures contracts has to roll contracts, he has to deal with contango and backwardation. If the term structure is in backwardation the roll yield is positive, whereas it is negative when the term structure is in contango.
  The roll return is effectively the weighted accounting difference (in percentage terms) between the near-term commodity futures contract price and the farther-term commodity futures contract price.
  The roll return is very sector-dependent. It typically has a modest contribution to total return in any single period, but can be significant over multiple periods.

• Collateral return is the return accruing to any margin held against a futures position. It is normally the U.S. T-bill rate (risk-free rate return).

In addition, rebalancing return is the incremental return earned by a rebalanced portfolio. The underlying source of the diversification is the rebalancing.