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Comparing Different Economic Linkages Among Commodity Futures

Authors

  • Michael T. Chng

    Corresponding author
    1. The author is from Deakin University, Australia. He is grateful to an anonymous referee and Peter Pope (editor) for comments that have vastly improved this paper. An earlier draft was written while the author was with the Department of Finance, University of Melbourne. He is indebted to John Handley for his unreserved mentoring support. The author acknowledges funding support from the China Market Research Center (CMRC). He retains full property rights to all existing errors.
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Address for correspondence: Michael T. Chng, School of Accounting, Economics and Finance, Faculty of Business and Law, Deakin University, Burwood VIC 3125, Australia.
e-mail: mchng@deakin.edu.au

Abstract

Abstract:  Gasoline (GA) and kerosene (KO) are extracted from crude oil (CO), such that the three fuel commodities share a chemical link. On the other hand, GA also shares an industrial link with natural rubber (NR) and palladium (PA) as complementary commodities that are heavily consumed by the automobile industry. We contrast the information content embedded in the two economic linkages. Focusing on TOCOM futures contracts written on the five commodities and centering on GA, we confirm that incremental information provided by either CO, KO or NR, PA over a buy-and-hold strategy and a naive forecast, are both statistically and economically significant. While the chemical link forecast is more profitable, a double-link forecast generated from a VECM with two cointegrating vectors (KO-GA and GA-NR prices) outperforms both single-link forecasts based on risk-adjusted profit net of transaction costs. Further comparisons against the profitability of commodity-based momentum strategies documented in Erb and Harvey (2006) and Miffre and Rallis (2007) show that the double-link forecast holds its own against the most profitable of the 75 momentum strategies considered. This strongly suggests that not only are there incremental profits to be gained from harnessing and combining economic links among commodity futures, the resultant incremental profits are economically significant against other proven commodity-based trading strategies in the existing literature.

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