commodity storage costs and convenience yield

In short

A neighbor of mine once kept a barn full of corn through the winter and spent more on the barn than he made on the wait. If you are holding a commodity, or thinking about a fund that tracks one, you pay a quiet bill for the holding. That bill is called the cost of carry, and it covers storage, insurance, and the interest you give up on the cash tied up. Sometimes the person holding the real thing earns a hidden perk, called convenience yield, because having the stuff on hand is worth something. The price of a future delivery reflects both forces at once. Read what a fund says about how it holds its exposure, and look at its expense figures on its own pages. Nobody here is telling you what to buy.

The whole of it

What it is

You have probably stood in a kitchen during a storm and felt glad of a full pantry. A full pantry can be worth more than the groceries in it. When winter turns mean, having flour on the shelf beats having money in the bank. That plain truth is close to what economists mean by convenience yield.

Start with storage costs. Anyone who holds a physical commodity pays to keep it. Grain needs a bin and someone to watch for rot. Oil needs a tank. Metal needs a vault and insurance. Add the interest, because the money spent on the commodity could have earned something sitting in a safe account. Put those together and you have the cost of carry.

Convenience yield is the other side of the ledger. It is the benefit a business gets from owning the physical item today instead of a promise to receive it later. A bakery that holds flour can keep the ovens running if a delivery truck breaks down. That comfort has real value, even though no one sends the bakery a check for it. The benefit is hardest to see when supplies are plentiful and easiest to see when they are tight.

How it works

If you have ever agreed to buy something now and pick it up later, you already know the shape of a futures deal. A futures contract is a deal to buy or sell something at a set price on a set date. The price of that deal tends to line up with today's price plus the cost of carry, minus the convenience yield.

Here is the logic in plain words. If you buy the item now and hold it, you pay storage, insurance, and lost interest. So a later delivery should cost a bit more to cover those bills. That pushes the futures price above the cash price. Traders call this contango. But if holding the real thing brings a big convenience benefit, the person who owns it is reluctant to part with it. Then the later price can sit below the cash price. Traders call that backwardation.

Why does this matter to an ordinary saver? Because many commodity funds do not store barrels or bushels at all. They hold futures contracts and replace them as each one nears expiry. That replacement is called rolling. In a contango market, each roll can mean selling a cheaper near contract and buying a pricier later one. That gap can drag on results even if the cash price stands still. In backwardation, the roll can work the other way. Funds that hold the metal itself pay storage and insurance, and those costs usually show up inside the expense ratio, the yearly fee a fund charges as a share of your money.

The numbers, and where to find yours

If you are looking at a fund, the numbers live in its own documents. The prospectus is the formal sales document, and the fund company posts it on its website. It lists the expense ratio, and it explains how the fund gets its exposure, whether through futures or through physical holdings. Funds that file with the Securities and Exchange Commission also make those filings searchable on the SEC's EDGAR system.

For the interest side of the cost of carry, the rate that matters is a short term safe rate. The Treasury Department publishes its daily yields on its own site, and the Federal Reserve posts its policy rate. Today's figure is the current figure, which the official source publishes each year and I would rather the page fill that in than have me guess. For the futures curve itself, the exchange where the contract trades posts settlement prices for each delivery month. The CME Group, for one, lists them for the contracts it runs.

For a physical commodity, ask the storage provider or the fund what the vault, the warehouse, and the insurance cost. Those charges come from private firms, so they differ from place to place. I will not hand you a number for them. Get yours from the source.

A worked example

Picture a beekeeper named Margaret Doyle who sells honey. She is thinking through a simple version of the idea with a commodity she knows. Say she buys $10,000 of raw material today to resell in one year. She pays $300 for storage and $100 for insurance. And suppose a safe account would have paid her 4 percent on that cash.

The lost interest is 4 percent of $10,000, which is $400. Add the storage and insurance. $400 plus $300 plus $100 is $800. That is her cost of carry for the year. Divided by the $10,000 she tied up, it comes to 8 percent.

So a fair futures price a year out would be about $10,800, which is the $10,000 cash price plus the $800 carry. That is contango at work.

Now suppose Margaret's own shop would be in real trouble without the stock on hand, and she values that peace of mind at $500 for the year. Subtract it. $800 minus $500 leaves $300. The later price that makes her indifferent drops to about $10,300. A bigger convenience benefit pulls the later price down. If it ever grew past $800, the later price would fall under today's price, and that is backwardation.

Now the fund side. Say a futures fund holds $20,000 and rolls into contracts that cost 2 percent more than the ones expiring. That is 2 percent of $20,000, or $400 lost to the roll in that one swap, even if the cash price never moved. Repeat that a few times a year and the drag adds up. This is a made up case to show the arithmetic, not a forecast of anything.

Where it goes wrong

I have made this mistake myself, so I say it kindly. People look at the price of a commodity in the news and assume a fund that tracks it will earn the same. That is not how it works. A futures fund can lag the cash price because of roll costs. A physical fund can lag it because of fees. Neither is a trick. It is just the cost of carry showing up in a statement.

Another slip is treating convenience yield as something you collect. An ordinary investor holding a fund share has no bakery and no ovens to keep running. The convenience benefit belongs to those who truly use the stuff. For the rest of us it shows up only as a clue in how futures are priced.

A third trap is trusting a single year. The shape of the futures curve changes over time. A fund that paid a heavy roll cost one year may have paid little the next. Look at how the fund has behaved across different markets, and read what its own documents say about the risk.

Last, watch for fees tucked into the small print. An expense ratio looks tiny. Yet 1 percent of $20,000 is $200 every year, taken whether the fund goes up or down. Count it.

Questions to answer before you leave this page

Do you know whether the fund you are looking at holds the real commodity or only futures contracts on it? Have you found its expense ratio in the prospectus, and have you multiplied it by the amount you would put in to see the yearly cost in dollars? Does the fund say how it rolls its contracts, and what it says about contango and backwardation? Are you comparing the cost of carry with the short term rate you could earn on plain cash, which is the current figure, which the official source publishes each year today? And do you understand that a price you read in the news is not the same as what a fund share returns to you?