Storage Cost and Commodities

[doobsmeister]

Guys, in the curriculum on page 236 in “primer to commodity investing” it says:
In reference to exhibit 4
“Backwardation is no temporary phenomenon. The energy sector and the livestock sector, which contain the majority of nonstorable commodities, are characterized by a high percentage of backwardation”
Ok, so since these are nonstorable, in a hypothetical world, if someone were to “hold and sell” these futures, where would thse commodities be placed? For instance, you can store livestock in a farm.. but going back to the question, since these are non-storable, that means that the holder doesn’t bear the cost of storage? Is that why there is backwardation? Backwardation is a result of the holder benefiting from holding the commodity, thus this “nonstorable” feature allows the holder not to bear any costs of the commodity… Does this make sense..
Now to the second sentence:
” The precious metals sector, on the other hand, has been almost exclusively in contango due to its low storage costs”
Why does low storage costs equal contango? Don’t benefits to the holder reduce the price of futures? For instance, i have a stock and i get paid dividends, that is subtracted from the current price before calculating futures price.. Same theory goes for commodities, lower storage costs (benefit) should result in a decrease in futures price… So why is this saying the opposite?
Any help would be great.

 

[doobsmeister]

Or I guess I should ask the question why oil and livestock futures are in backwardation and gold in contango? I would think that the convenience yield of gold would be very high (imagine its use as collateral) and thus in a backwardization state.

 

[BlueTrin]

I cannot make sense of the second statement, but if storage is cheap and plentiful, it put a cap to the forward price, therefore the forward price cannot be higher than the implied cost. However I cannot see why it would go automatically in contango, in fact it would put a cap to the maximum forward price …

 

[Galli]

Oil is in contango because storing oil is expensive and risky. You actually have to deliver the oil in the future so you would want a minimum price (at t = 6m) that reflects your storage cost (and risk).
Gold is in backwardation because storing it is cheap and not risky. You actually have to deliver the gold in the future but you aren’t able to pass on your storage costs to your customer because it doens’t actually exist (realtively speaking). The gold future equation becomes more of a R and the convience yield (Y). Since there is high convience yield (implied), then your future’s price is expected to be lower than the current spot price.

 

[doobsmeister]

Thanks Galli but why does Schweser say this:
“Backwardation is no temporary phenomenon. The energy sector and the livestock sector, which contain the majority of nonstorable commodities, are characterized by a high percentage of backwardation”
If this are non-storable, like oil, shouldn’t they be expensive to hold and thus in a state of contango?
Now to the second sentence:
” The precious metals sector, on the other hand, has been almost exclusively in contango due to its low storage costs”
No, this would be equivalent to gold, and like you said, gold should be in backwardation.. so why do they say this?

 

[dvictr]

the reason Gold and precious metals markets are contango most of the time is that the leasing rate is lower than the borrowing cost of the dollar. when that leasing rate is higher than the dollar, the market is in backwardation.
it trades more like a financial instrument for various reasons including the fact that annual production is only a fraction of global stockpiles, compared to other commodities that get consumed. Gold does not deplete.
A bit related is when silver hit $50 in 2011, the 3 month out futures contract was maybe $37.50.. the physical demand was so strong that dealers couldnt move it fast enough.

 

[Galli]

doobsmeister wrote:
Thanks Galli but why does Schweser say this:
“Backwardation is no temporary phenomenon. The energy sector and the livestock sector, which contain the majority of nonstorable commodities, are characterized by a high percentage of backwardation”
If this are non-storable, like oil, shouldn’t they be expensive to hold and thus in a state of contango?
Now to the second sentence:
” The precious metals sector, on the other hand, has been almost exclusively in contango due to its low storage costs”
No, this would be equivalent to gold, and like you said, gold should be in backwardation.. so why do they say this?

I don’t know why the book is mentioning Oil since it is mostly storable, a better example would be porkbellies . Porkbellies suffer from rot/decay and once produced, they need to be delivered immediatey otherwise they lose their value. Said differently, you can’t physically buy pork bellies 3-months from now if the pork belly doesn’t exist yet. You can, however, give a producer of pork bellies some money (and a promise), to deliver a pork belly in 3 months. He will give you a discount to spot equal to the same rate you would receive on your money if you just kept it in the bank and bought the expected spot 3 months from now. When the forward comes due, you receive a pork belly and the producer keeps the original purchase price + any interest he received from investing at the risk-free rate. The discount he gave you actually ended up becoming the expected spot in 3-months due to the interest he earned on your upfront payment.
In effect, there is no storage cost (because you can’t store it!) and the convience yield is high, high convience yield (scarcity) implied by the perishable nature of the good (and perhaps seasonality!)
Fp = Soe^[Rf + (U - Y) ]
U < Y = Backwardation
Y > U = Contango
Rf = Fixed no matter what the condition!