January 27, 2013
A new Review of Finance article investigates the link between commodity inventories on the one hand and futures returns and curve backwardation on the other. Most prominently, low inventories mean that the convenience yield of physical holdings is high (more need of insurance against a “stock-out”). In this case, producers and inventory owners are willing to pay a surcharge for immediate access to the physical. This will (normally) translate into a higher risk premium, more backwardation, and higher expected excess returns. Moreover, external factors, such as price volatility, can induce producers and physical inventory holders to pay a higher premium for future price certainty that translates into a positive basis and expected return on futures positions. The inventory connection explains why commodity futures returns and futures curve shape are correlated, i.e. backwardation is more often than not a profit opportunity. According to this paper, mainstream theory is backed by empirical evidence for 31 commodities over more than 40 years.
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