'Contango' and InventoriesFutures markets are priced on the principle of equivalence. In a perfectly balanced market, you should be indifferent between buying a physical commodity now and storing it yourself for later consumption and buying it for future delivery and letting someone else pay for the storage costs. This idyllic situation, also known as full carry, seldom applies in practice. The world's stackers of wheat and butchers of hogs, not to mention its smelters of copper and refiners of crude oil, cannot afford to run out of inventories, and therefore they pay for the "convenience" of having excess supplies available. This number, dubbed convenience yield, can be viewed as the commodity buyer's insurance payment for supplies. It also represents the producer's cost of hedging by selling forward in the futures market. For commodities such as crude oil and copper, where the cheapest place of storage is with the producer, the convenience yield measure could be quite high. At present, the crude oil market's forward curve is in "contango," a situation characterized by negative convenience yield. Negative convenience yield means negative insurance costs for refiners, and that in turn means they can buy crude oil, pay for all of its storage costs and hedge it by selling the next month's future. Even better, they can make a profit on the transaction, and, in a topic I will mention and drop quickly, realize an embedded call option on their hedged commodity in storage. Not bad for a day's work, is it?
|NYMEX Forward Curve and Convenience Yield |
March 10, 2006
|Convenience Yield and Inventory Changes |