Convenience Yield - Theory of Storage

CFA Level II Alternative Investments
#1

For example, when civil war broke out in Libya in 2011, the production of that country’s high-quality crude oil was placed in jeopardy, constricting supply. In reaction, the spot price for high-quality crude oil increased. At the same time, the convenience yield decreased in the futures contracts closer to expiration because there was a scramble to tap into alternative oil supplies for European refiners. The high quality of Libyan crude oil also restricted which substitute crude oil supplies could be used to replace production from the blocked oil fields and how soon these replacements could be available. The real-world constraints and complications imposed by geography and the logistics of the oil industry resulted in a multi-month delay on replacement supplies. As a result, in the further-out (i.e., longer time to expiration) futures contracts, the reaction was muted as traders assumed that such replacement supplies would be available. _ Thus the convenience yield remained lower in the deferred months. For this and other reasons, crude oil was pressured to trade in backwardation during 2011. _

Futures price = Spot price of the physical commodity + Direct storage costs (such as rent and insurance) – Convenience yield

There are two points for which clarification is needed:

  1. Whether the convenience yield factor is from point of view of producer or consumer

  2. What happens when convenience yield reduces or increases. As per the above formula, if convenience yield increases (assuming no changes in spot price), Future price should be reduced and vice - versa. As underlined in example, convenience yield remains lower, which should lead to ‘Contango’ then why they say it as ‘Backwardation’

#2

I wouldn’t place too much emphasis on such deep and detailed understanding… be able to describe the theory and perhaps calculate futures prices. You will not be any better off on exam day by going beyond what the curriculum is teaching…

#3

  1. Convenience yield is from the point of view of the buyer of crude.

  2. The front month contracts would’ve traded in a deep backwardation but further out contracts would’ve traded in a relatively less backwardation. Lower convenience yields doesn’t necessarily mean contango. As such, the spot price would’ve exploded so high that even low convenience yields wouldn’t help in forming a contango.

#4

Thanks for clarification