Contango and Backwardation - Storage Hypothesis

CFA Level II
#1

This line is directly from the book, Volume 5 page 236 just about exhibit 4: “The energy sector and the livestock sector, which contain the majority of nonstorable commodities, are characterized by a high percentage of backwardation. The precious metals sector, on the other hand, has been almost exclusively in contango due to its low storage costs.”

This is completely opposite of the way I think about it, but maybe I have it wrong. I think of storage costs as supporting contango and therefore, all else being equal, the lower the storage costs the more likely to have backwardation and vice versa. Essentially the value of future delivery (the futures contract) in excess of the anticipated future spot price is the avoided cost of storage. Conversely, the convience yield supports backwardation. If the option to consume the commodity is of great value then it follows that holding the good (having the option) for a period of time is worth more than guaranteed future delivery of the good (by the value of the consumption option or convenience yield).

Can someone help me reconsile my thinking on this (or confirm the book is wrong with regard to precious metals being in contango BECAUSE of low storage costs)?

#2

So this article seemed to make a lot of sense - http://www.investopedia.com/articles/07/contango_backwardation.asp

But it still makes sense to me that - all else equal, the higher the storage costs the more contango-ed the market. This is the opposite of what the book implies.

#3

I agree: higher storage costs should lead to higher forward prices; the longer the term of the forward, the higher the (total) storage cost, so the higher the forward price: contango. The long is paying the short to store the stuff.

#4

Thanks Magic. The world makes sense again.

#5

You’re welcome.

What a relief.