Commodity Futures: Storage and Convenience Yield

Commodity futures pricing differs from financial futures because physical commodities incur storage costs and provide convenience yield to holders. These factors determine whether futures trade above spot (contango) or below spot (backwardation), with significant implications for hedgers and investors.

Definition and Key Concepts

The Cost-of-Carry Model

Commodity futures prices are linked to spot prices through the cost-of-carry relationship:

Futures Price = Spot Price + Storage Costs + Financing Costs - Convenience Yield

Or more formally: F = S × e^((r + s - c) × T)

Where:

• F = Futures price
• S = Spot price
• r = Risk-free interest rate
• s = Storage cost rate
• c = Convenience yield
• T = Time to expiration

Storage Costs

Storage costs include:

• Warehouse or tank rental
• Insurance
• Handling and inspection fees
• Spoilage or deterioration (for perishable commodities)

These costs are incurred by holders of physical inventory and must be compensated in futures pricing.

Convenience Yield

Convenience yield is the benefit of holding physical inventory rather than a futures contract:

• Ability to meet unexpected demand
• Avoid production shutdowns
• Capture spot price spikes during shortages
• Maintain customer relationships

Convenience yield is implicit—not directly paid—but affects pricing.

Contango vs. Backwardation

How It Works in Practice

Contango Example: Crude Oil

Market conditions:

• Spot crude oil: $75.00/barrel
• 6-month interest rate: 5%
• Storage cost: $0.50/barrel/month
• Convenience yield: minimal (ample supply)

6-month futures pricing:

Storage cost = $0.50 × 6 = $3.00 Financing cost = $75.00 × 5% × 0.5 = $1.88 Convenience yield = $0 (high inventory)

Futures price = $75.00 + $3.00 + $1.88 - $0 = $79.88

The market is in contango—futures trade above spot by approximately $4.88.

Backwardation Example: Natural Gas in Winter

Market conditions:

• Spot natural gas: $4.00/MMBtu
• 3-month futures (April): $3.50/MMBtu
• Current month: January (peak heating demand)

Why backwardation?

During winter, gas is needed immediately for heating. Holders of physical gas won't sell at spot and buy futures because:

• They can't wait 3 months for delivery
• Current demand justifies premium pricing
• Convenience yield exceeds carry costs

Convenience yield implied: Backwardation = $4.00 - $3.50 = $0.50 This $0.50 represents the convenience yield of having gas now vs. later.

Term Structure of Futures

Futures prices across different expirations create a term structure:

Crude Oil Term Structure (Contango):

Natural Gas Term Structure (Backwardation in Winter):

Worked Example

Roll Return Analysis: Contango vs. Backwardation

An investor maintains continuous crude oil exposure by rolling futures monthly.

Scenario A: Contango Market

Roll mechanics:

• Sell expiring contract at $75.00
• Buy next month at $76.00
• Loss on roll: $1.00 per barrel

Annual roll cost (12 monthly rolls): 12 × $1.00 = $12.00/barrel = 16% drag on returns

If spot crude is flat at $75.00 year-end, the investor loses 16% from roll costs alone.

Scenario B: Backwardation Market

Roll mechanics:

• Sell expiring contract at $75.00
• Buy next month at $74.00
• Gain on roll: $1.00 per barrel

Annual roll return (12 monthly rolls): 12 × $1.00 = $12.00/barrel = 16% return enhancement

If spot crude is flat, the investor gains 16% from positive roll yield.

Impact on Total Returns

Summary (spot unchanged):

Roll returns can dominate total commodity returns, especially in extreme contango or backwardation.

Risks, Limitations, and Tradeoffs

Contango Decay for Long Investors

Persistent contango erodes returns for buy-and-hold commodity investors. ETFs and ETNs that roll futures (like USO for oil) suffer this decay during normal market conditions.

Backwardation Can Reverse

Backwardation during supply shortages can flip to contango when supply normalizes. Don't assume current term structure persists.

Storage Arbitrage Limits

In theory, contango shouldn't exceed full storage costs (arbitrageurs would buy spot, store, and sell futures). In practice, storage capacity constraints, financing access, and counterparty limits restrict this arbitrage.

Convenience Yield Is Unobservable

You can't directly measure convenience yield. It's inferred from the difference between theoretical and actual futures prices. This makes forecasting difficult.

Common Pitfalls

1. Ignoring roll costs in contango: A commodity can rise 10% while a futures-based ETF gains only 2% due to roll decay.

2. Assuming stable term structure: Contango and backwardation shift with supply, demand, and inventory levels.

3. Confusing spot and futures returns: Commodity indices and ETFs track futures, not spot prices.

4. Underestimating storage economics: Physical storage is capital-intensive and operationally complex.

5. Misinterpreting backwardation as bullish: Backwardation reflects current tightness, not future price direction.

Checklist for Commodity Futures Analysis

• Check current term structure (contango or backwardation)
• Calculate implied roll yield (front vs. next month)
• Estimate storage costs for the commodity
• Assess current inventory levels and supply/demand balance
• Evaluate convenience yield conditions (shortage vs. surplus)
• Compare futures-based ETF performance vs. spot
• Factor roll costs into return expectations
• Monitor seasonal patterns affecting term structure
• Understand delivery specifications and locations
• Consider spread trades to capture term structure views

Next Steps

For using futures to manage currency exposure, see Currency Futures for Hedging FX Risk.

To understand fixed income futures, review Interest Rate and Treasury Futures Primer.