commodity storage and convenience yield

In short

I once watched an old grain farmer stand at the edge of his bin and say he could not tell you what wheat was worth until he knew where the wheat was sitting. If you are holding a futures contract, or only reading about them, that same idea runs through everything here. Storing a physical commodity costs money, and holding it also pays a quiet reward. That reward is called convenience yield. Futures prices tend to reflect both the cost of carrying a commodity and the benefit of having it on hand. When stocks are tight, the benefit grows and the futures curve can bend downward. Watch the gap between the near month and the far month, because that gap carries the story.

The whole of it

What it is

A friend of mine runs a small bakery, and he keeps flour stacked in the back room even though it costs him shelf space and a little worry. He does this because running out on a Saturday morning would cost him far more than the flour itself. That feeling has a name in the markets. Convenience yield is the benefit a person gets from holding the physical commodity itself, as opposed to holding a paper claim on it. It is not a payment sent to anyone. It is a value felt by the one who owns the barrels, the bushels, or the bars.

Storage is the other half. Someone has to rent the tank, pay the insurance, and tie up cash in the goods. Those are the costs of carry, and they include storage fees, insurance, and the interest lost by holding goods instead of cash. A futures contract is a promise to buy or sell a set amount of a commodity at a set price on a set date. Its price sits between what the thing costs to hold and what the holder gains by having it. That is the whole idea in a sentence.

How it works

You have probably noticed that a futures price for a later month is often a little higher than the price for an earlier one. When that happens, traders say the market is in contango. The extra amount roughly pays for the cost of carry. A buyer could buy the goods now, store them, and deliver them later. The later price has to cover that trouble, or no one would bother storing anything.

Now picture a hard winter, and a heating oil tank running low. Anyone holding oil right now is suddenly valuable to a neighbor who cannot get any. The benefit of holding physical oil jumps up. That is convenience yield rising. When it rises past the cost of carry, the later futures price can fall below the nearby price. Traders call that backwardation. It is the market saying that having the stuff today is worth more than a promise of the stuff tomorrow.

Textbooks write this as a simple relation. The futures price is about the spot price, plus the cost of financing, plus storage costs, minus the convenience yield. Spot price means the price for delivery right now. Notice that convenience yield is subtracted. A bigger benefit from holding pulls the futures price down against the spot price. Convenience yield cannot be read off a screen the way a price can. People work it out backward, by comparing the futures price to the other pieces. So it is an estimate, never a quote.

The numbers, and where to find yours

Here is where a careful person goes looking for facts instead of guesses. The exchange that lists the contract publishes the contract specifications, and those spell out the size, the delivery months, and the delivery points. The CME Group posts these for many of the largest US commodity contracts, and the contract rulebook is the final word on what is delivered and where. Current futures prices for each month appear on the exchange pages, and the difference between two months shows you the shape of the curve.

For stocks on hand, the US Energy Information Administration publishes inventory data for crude oil and petroleum products. The US Department of Agriculture publishes supply and demand estimates for grains and other farm goods, including ending stocks. Low stocks relative to use often go along with a strong convenience yield. Your storage cost depends on your own situation, since a warehouse rate or tank fee comes from the facility you would actually use. For interest, use a short term borrowing rate that fits your own case. If any limit or margin figure matters to you, the exchange sets initial margin for each contract and changes it from time to time, so read the current number on the exchange page and not from memory. Margin is the good faith deposit a trader posts to hold a futures position.

A worked example

A neighbor of mine named Dana wanted to understand a corn contract. Say the spot price is $4.50 a bushel. She figures the interest cost of holding corn for six months at $0.12 a bushel. Storage and insurance for those six months come to $0.18 a bushel. Add those up. $0.12 plus $0.18 is $0.30 a bushel.

If there were no convenience yield, the six month futures price would be about $4.50 plus $0.30, which is $4.80 a bushel. That is the contango case, with the curve sloping up.

Now say the real six month futures price on the screen is $4.62. That is $0.18 below the $4.80 she calculated. The gap is a rough read on the convenience yield. In plain figures, $4.50 plus $0.30 minus $0.18 equals $4.62. So the market is telling Dana that holding corn in the bin is worth about $0.18 a bushel to those who have it, over those six months. Maybe stocks are thin this season. Maybe a mill nearby needs corn on short notice.

Dana did not need to guess at a feeling. She took three numbers, spot, carry, and the futures price, and the leftover piece told her what the market thinks of having grain in hand. If stocks later grew and the futures price rose to $4.80, the implied convenience yield would shrink to $0. Same corn, different story.

Where it goes wrong

It is easy to feel sure about a number that is really a guess. Convenience yield is backed out of other prices, so any error in the spot price, the interest estimate, or the storage cost lands in the answer. A small slip in one input can look like a big change in the benefit. Treat the result as a rough gauge.

A second trap is forgetting that not every commodity can be stored. Fresh produce spoils, and electricity cannot be kept in a bin at all. For goods like these the neat link between spot and futures prices loosens, and the carry story does not hold the way it does for metals or grain. Delivery rules matter too. The seller must deliver the exact grade and place named in the contract, and a mismatch can change what the contract is worth.

Margin brings its own sting. The broker requires a deposit, and the account can face a call for more money if the price moves the wrong way. Someone can be right about the long run and still be forced out early. Finally, remember that a curve can flip. A market in backwardation one season can slide into contango the next once new supply shows up. Do not freeze a picture and treat it as permanent.

Questions to answer before you leave this page

Can you say, in your own words, what it costs to hold the commodity you are thinking about, including storage, insurance, and the interest on the cash tied up? Do you know whether the nearby futures price sits above or below the later one, and what that gap suggests about how scarce the goods are right now? Have you looked at the exchange contract specifications so you know the size, the delivery months, and the delivery points? Have you checked the latest inventory reports from the Energy Information Administration or the Department of Agriculture for the market you care about? Do you know what margin the exchange and your broker require, and what would happen to your account if the price moved against you? And can you tell the difference between a price you can read on a screen and a figure like convenience yield that someone had to work out from other numbers?