Christian Stepanek
Phone: + 49 821 598 4865
Email: christian.stepanek@mrm.uniaugsburg.de
Matthias Walter
Phone: + 49 821 598 4881
Email: matthias.walter@wiwi.uniaugsburg.de
Authors affiliation:
FIM Research Center,
Institute of Materials Resource Management,
University of Augsburg
Universittsstrasse 12
86159 Augsburg, Germany
Abstract
Due to a rapid growth in emerging markets the demand for commodities strongly increased in
the past decade. For some commodities, this will have major impact on their future
availability. Thus, to avoid disruptions in production processes and with it financial losses, the
importance of assessing a commoditys criticality continuously increases for manufacturers.
As most of the existing indicators for criticality have shortcomings regarding their predictive
power, we analyze whether the convenience yield of commodity futures has predictive power
on the future criticality.
In the paper we used historical convenience yields from 3, 15, and 27 months futures
contracts for five major industrial metals. We compared the convenience yields at the
beginning of the contracts with known criticality indicators at the time of maturity. We found
evidence that the convenience yield in general has predictive power on the static stock
lifetime (inventory volume / turnover) and future spot prices.
Keywords
Convenience Yield, Theory of Storage, Commodities, Criticality, Scarcity
MFSClassification
Commodity Derivatives, Forwards and Futures, Capital Markets
Industrial metals such as Copper or Nickel are important basic materials for almost all
industrial products like cars, batteries or electronic devices. Hence, their demand is closely
related to business cycles (RosenauTornow et al., 2009). Especially due to a rapid growth in
emerging markets their production and consumption increased strongly in the past decade.
For example, the Copper world mine production increased from 13.2 million tons in the year
2000 to 16.2 million tons in 2010 (U.S. Geological Survey, 2011). It is obvious that this has
impact on the future availability of these commodities: With more fast growing economies in
other emerging countries, the availability of the industrial metals Aluminum, Copper, Nickel,
and Zinc, which have a very high economic importance, can become difficult in the future
(European Commission, 2010). In order to avoid disruptions in the production process, it
becomes more and more relevant for manufacturers to assess the future availability of
commodities. Especially for justintime production strategies with low stocks, a delay in
supply can cause production losses and in consequence financial losses for a single company
as well as for the economic system as a whole.
For the assessment of a commoditys future availability it is important to know its criticality
which is measured by its economic importance and its supply risk (European Commission,
2010). In the literature exist various indicators for estimating the criticality of a commodity
(e.g., HerfindahlHirschmann Index, spot prices, etc.). However, all of these indicators have
shortcomings. For example, there is no indicator for criticality which is at the same time (a)
available with a daily frequency, (b) marketdriven and (c) forwardlooking to a sufficient
extent. To close this gap we propose the convenience yield of commodity futures as an
indicator for criticality.
The central idea in doing so is that prices of exchange traded commodity derivatives contain
all information available in the market and hence on the availability of a commodity in the
future. In particular, we focus on the convenience yield which is a component of futures
prices. According to the theory of storage it is equivalent to a liquidity premium for physically
holding a commodity in stock. Our analysis is based on the efficient market hypothesis which
states that market prices of financial assets contain all information on the market situation in
their trading prices (Fama, 1970). Our research question is whether the convenience yield is a
good indicator for a commoditys future criticality which avoids the shortcomings of existing
criticality indicators. It would provide managers and policy makers an appropriate, easy and
continuously accessible information source with essential information on criticality.
Therefore we compared the convenience yields of different industrial metals at the beginning
of the futures contracts lifetime with known criticality indicators at the time of maturity.
Thereby we were able to empirically analyze whether the convenience yield has predictive
power for a high criticality of a commodity in the future. In the following, we first introduce
the underlying theory of commodity criticality as well as on commodity futures and the
convenience yield. Derived from theory, we then formulate our hypotheses and explain the
details of the methodology. To test our hypotheses we calculated convenience yields from
historical spot and futures prices of the London Metal Exchange for five major industry
metals (Aluminum, Copper, Lead, Nickel, Zinc) with different maturities (3, 15, 27 months).
After preparing both the methodology and the data, we test which of the hypotheses are
statistically valid and conduct several robustness checks. Finally, the knowledge gained by
our empirical analysis is summarized and some suggestions concerning the improvement and
extension of our work are also provided.
Supply and demand situation which is influenced by the market balance, the stock
keeping and the utilization of resource production facilities
Future supply and demand situation, which is determined by the degree of exploration,
the investments in new refining facilities and the future market balance
)(
(1)
In the literature several studies try to explain the existence of a convenience yield as well as
the driving forces behind it. Existing contributions suggest that there is a relation between the
convenience yield and the current stocks of a commodity. Brennan (1958) and Telser (1958)
found such a relationship for some agricultural commodities. The energy commodities Oil
and Natural Gas were examined by Geman and Ohana (2009). They found dependencies for
the convenience yield on the inventory level for both commodities. As Natural Gas shows a
seasonal behavior in its stock pile, the results were more accurate for a detrended inventory
measure. According to these studies, the convenience yield is expected to be high, if stocks
are low and vice versa, which is in accordance with the theory of storage. Casassus and
CollinDufresne, (2005) developed a stochastic model with a convenience yield dependent on
5
spot prices and interest rates. They found for Copper and Oil a spot level dependence of
convenience yields. Routledge et al. (2000) developed an equilibrium model for forward
curves and incorporate a stock level dependent convenience yield.
Apart from that, Weymar (1966) derived from theoretical considerations that convenience
yields should also depend on the expected future stock level of a commodity. He also found
first empirical evidence in the behavior of Cacao prices for this relationship. To the best of
our knowledge, further studies on the predictive power of the convenience yield have not
been conducted so far. Especially for practical applications this seems to be desirable, as this
yields the opportunity to gain a forward looking criticality indicator.
Hypotheses
As shown above, convenience yields are driven by the benefit of holding the commodity
physically and thus by the liquidity premium respectively the flow of services. According to
existing research both increase with a declining stock level and therefore with the
commoditys criticality (Brennan, 1958; Fama and French, 1988). As Fama and French
(1987) showed, this is the case, if a commodity is an input factor for the production or if it is
necessary to hold inventories to meet unexpected demand (particularly for strategic
commodities). From the perspective of the consumer who holds a futures contract, the
availability of the commodity in the future is much more relevant. This is supported by
Weymar, who shows that the convenience yield should also depend on the inventory level in
the future (Weymar, 1966). In case of efficient financial markets, this means that prices
fully reflect available information (Fama, 1970). This leads to the hypothesis, that a high
convenience yield is an indicator for a high criticality of the commodity up to the futures
maturity and vice versa.
To operationalize this relationship we focus on the static lifetime of the inventory, which we
define as the quotient of the inventory and the turnover rate of the warehouse, and spot prices
at the maturity of the futures contract. We argue that the often used absolute inventory level
has to be set in the context of the turnover rate. Especially when time series over a period of
several years are examined, trends in the long run level of inventories can exist due to
changes in demand, e.g. from developing countries. Furthermore the inventory level at a
given time has predictive character for future inventory levels, which can be seen from high
autocorrelation of inventory time series. For time lags of 3 months we found autocorrelation
coefficients of up to 0.98 and for 27 months up to 0.24. Hence, it can be expected that under
the classical theory of storage the convenience yield should have a predictive character for
future inventory levels because of the autocorrelation between inventory levels at different
points in time. Therefore we use the static lifetime to avoid this bias in our analysis. Our first
hypothesis is therefore:

Hypothesis 1 (H1): If the convenience yield of a futures contract is high, then the static
lifetime of inventory at the maturity of the contract is low and vice versa, while the static
lifetime declines with a decreasing marginal rate.
This means that there should be an inverted relationship between the convenience yield and
the static lifetime of inventories. This can be understood, if one considers that the marginal
benefit of an additional unit of inventory (and hence of the static lifetime) decreases with
higher inventory levels (Brennan, 1958; Fama and French, 1988). Therefore the marginal
6
Hypothesis 2 (H2): If the convenience yield is high, the commoditys spot price at the
maturity of the futures contract is high and vice versa.
In the following chapter we derive appropriate regression models to test these two hypotheses.
METHODOLOGY
For testing the hypotheses, the convenience yield is calculated according to equation (1)
solved for ytT (with t=0):
( )
(2)
To test H1, we expressed the future static lifetime of stocks at the maturity of the contract
SLTT as a function of the inverse convenience yield CYt at the beginning of the contracts
lifetime t. The error term is expressed by e and is assumed to be normally distributed:
(3)
This model reflects that the marginal static lifetime is a decreasing function of the
convenience yield. This yields an inverted relationship between the convenience yield and the
static lifetime at a given point in time and is predicted by the theory of storage (Brennan,
1958; Fama and French, 1988). This approach also seems to be appropriate, as the static
lifetime approaches zero with increasing convenience yield. From an economical point of
view this makes sense, as the flow of services of an additional unit of static lifetime is most
valuable when it is low.
The coefficient 1 will be estimated in the following regression analysis from the static
lifetime of commodity stocks at the end of a commodity futures contract and the convenience
yield 3, 15 and 27 months in advance. As in some cases the convenience yield calculated from
equation (1) takes on small but economically implausible negative values, the data has to be
rescaled to conduct the regression with equation (3). The data is therefore shifted along the xaxis until the smallest value of the convenience yield is equal to zero. Due to this rescaling all
values of the exogenous given 1/CYt are larger than zero (the smallest value has to be
omitted, as division by zero is not allowed). According to the theory of commodity futures
pricing negative convenience yields should not occur anyway, as they would give the
opportunity for arbitrage profits by buying the commodity in the spot market and taking on a
short position in futures contracts.
For testing H2, we express the logarithmic spot price ln(PT) at the maturity of the futures
contract as a function of the futures convenience yield CYt at the beginning of the contracts
lifetime t and the normally distributed error term e:
7
(4)
The data sources for the test of the regression models are presented in the following chapter.
DATA SOURCES
For the test of the hypotheses with the above mentioned regression models we used time
series with daily data frequency. The data for the spot and futures prices as well as the
inventory and the turnover was retrieved from the London Metal Exchange (LME), which is
one of the leading markets for industrial commodities worldwide. Inventory levels of some of
these commodities can amount on average to about 23% of the world production of one year.
As the warehouses are located all over the world, we assume the LME inventory as well as
their prices and turnover as representative for the world market of the respective commodity.
In our analysis we used cash and futures prices for Aluminum, Copper, Lead, Nickel and Zinc
in the time period from 19990104 until 20110315 with a daily frequency. The maturities
of the contracts were 3, 15, and 27 months (for Lead only 3 and 15 months were available
with a longterm record), the price quotation was in US $ per metric ton (MT). The five
metals were chosen because of their economic importance for many sectors, e.g. the
electronic sector or the automotive sector. Also the supply situation of Aluminum, Copper,
Nickel and Zinc can become unsecure in the future (European Commission, 2010).
For testing the hypotheses, we also used data on a daily basis on the total stock keepings in
MT in the worldwide LME warehouse network of these commodities. Furthermore, we used
the daily turnover in the cash market in number of contracts at the LME to calculate the static
lifetime of the inventory. For that purpose the daily turnover was multiplied by the contract
sizes. To estimate the storage cost we draw on the LME warehouse rents, which are fixed as a
price in USCent/MT/day for one year and are specific for a commodity. To calculate the
storage cost rate we set the rent in relation to the daily spot prices and calculated it as a
continuous rate. The source for all data mentioned above was the Thomson Reuters
Datastream, except for the warehouse rent, which was provided directly by the LME.1
As risk free interest rate on a daily basis we used US treasury yields on actively traded noninflationindexed issues adjusted to constant maturities and accounted in US$. The maturities
of the bonds were 3, 12, 24, and 36 months. To approximate the risk free rate for the 15 and
27 months futures, we interpolated between the bonds with the next longer and shorter
maturity (e.g., to approximate for 15 months we interpolated between the 12 and 24 months
rate). The data was retrieved from the Board of Governors of the Federal Reserve System.
Due to the fact, that these interest rates are discrete while the convenience yield is based on a
continuous formula, the discrete interest rates were transformed to continuous interest rates.
low static lifetime of stocks at the contracts maturity and vice versa. The statistical
significance of the results depends on the time to maturity of the respective contract. For the 3
months contract 1 is statistically significant for all commodities. The futures with the 15
months maturity show significant results for Copper, Nickel and Zinc, while the 27 months
contracts produced significant results only for Nickel and Zinc. 2 Even though there is no clear
dependency of the value of 1 on the time to maturity for every single commodity, it can
generally be stated, that 1 is larger for shorter maturities than for longer ones. But it has to be
noted, that this does not hold strictly for all commodities. Hypothesis H1 can be accepted in
general on the basis of these results, even though the significance of the results decreases with
increasing time to maturity.
Table 1: Predictive power of a futures contracts convenience yield on the static lifetime of the underlyings inventory
at the date of maturity. Values for the regression coefficient 1 (value in brackets are the tvalues; ***significance on a
0.1% level; **significance on a 1% level; * significance on a 5% level).
Aluminum
Copper
Lead
Nickel
Zinc
3 months
4.033***
(3.483)
2.243***
(17.612)
0.017***
(7.387)
1.871***
(51.970)
8.808***
(21.696)
15 months
0.097
(0.666)
0.148***
(4.011)
0.001
(1.788)
2.040***
(59.532)
2.229***
(13.661)
27 months
0.866
(1.374)
0.013
(0.877)
0.746***
(22.544)
2.453***
(12.440)
Hypothesis H2
Hypothesis H2 is tested with equation (4): ( )
. The results of the
regression are listed in Table 2. The data shows, that there exists a positive relationship
between the convenience yield today and the spot price at the futures contract maturity in
many cases. This means that high convenience yields predict high spot prices, and vice versa.
The value of the coefficient 1 is positive and statistically significant for all commodities with
3 and 15 months maturity except for Aluminum 3 months. For the 27 months maturities
positive values are obtained for Copper and Zinc with statistical significance only for Copper.
Aluminum and Nickel show negative coefficients with only the one for Nickel being
significant. Hence H2 can be accepted for 3 and 15 months futures and for Copper in the case
of 27 months. Only for Nickel it has to be rejected for 27 months.
The values of R2 are not presented here, as they are misleading for regression models without a constant term.
Table 2: Regression of logarithmic prices at the maturity on convenience yields 3, 15 and 27 months prior. Values for the regression coefficients 1, 2 and explanatory power R2 (value in
brackets are the tvalues; ***significance on a 0.1% level; **significance on a 1% level; * significance on a 5% level).
Aluminum
Copper
Lead
Nickel
Zinc
3 months
1
0.002
(1.911)
0.026***
(18.650)
0.016***
(12.390)
0.011***
(9.874)
0.052***
(34.051)
2
7.514***
(1602.828)
8.000***
(607.463)
6.811***
(531.736)
9.426***
(761.432)
7.267***
(957.135)
R
0.001
0.100
0.047
0.030
0.269
15 months
1
0.016***
(17.419)
0.045***
(31.820)
0.035***
(22.002)
0.004***
(3.098)
0.029***
(21.246)
2
7.472***
(1269.104)
7.865***
(534.907)
6.697***
(422.436)
9.512***
(575.765)
7.174***
(672.377)
10
R
0.095
0.262
0.145
0.003
0.135
27 months
1
0.001
(1.160)
0.058***
(36.072)

2
7.563***
(859.580)
7.778***
(458.825)

R2
0.001
0.005**
(2.968)
0.001
(0.639)
9.660***
(477.991)
7.323***
(512.712)
0.003
0.334

0.000
Robustness Check
Test of the statistic regression models
As robustness check for the regression models we conducted ttests. The results for the ttest
of hypothesis H1 are presented in Table 3. For the test we divided the data sets for the
convenience yield and the static lifetime of stocks into two sub sets. The ttest compares the
average static lifetimes of those two sets. The first set contains all data points with CYr+c
(i.e. Contango), the second sample with CY>r+c (i.e. Backwardation), where r and c were the
average values over the time period for the specific contracts. As the first group should have
lower convenience yields according to H1, one expects that this is the group with the higher
average static lifetime of stocks. Therefore tvalues should be positive.
Table 3: Robustness check for the predictive power of convenience yields on future static lifetime of inventories with a
ttest (***significance on a 0.1% level; **significance on a 1% level; * significance on a 5% level)
Aluminum
Copper
Lead
Nickel
Zinc
3M
0.863
10.686***
0.596
33.826***
13.368***
15M
0.113
3.285***
0.450
31.514***
2.282*
27M
0.677
0.709
4.431***
0.147
As can be seen from the results, the test produces positive values for all commodities except
Lead, the 27 months Copper and the 15 and 27 months Aluminum contracts. Significant
values are positive in all cases, while the negative ones are not at all. The ttests support the
regression results obtained from equation (3) in general. In the case of Lead it contradicts the
results from the regression, where the 3 months contract led to an acceptance of H1. Also in
the case of the 27 months Copper contract the result of the regression model is not verified.
Additionally it yields negative tvalues for 15 and 27 months Aluminum futures, which are
not significant on the other hand. Both data sets did not yield significant results in the
regression model either, even though the regression parameter had the right sign. In summary
the robustness test contradicts the significant results from the regression model only in the
case of the 3 months Lead futures. The ttest furthermore does not confirm the regression
results on a significant level for 3 months Aluminum and 27 months Zinc futures. We also
conducted a Wilcoxon ranksum test which is not presented here. The test produced
confirming significant values for the regression model for all commodities except Lead and
the 27 months Copper contract. Anyway these additional tests support the results from the
regression in general and show that the model is quite robust.
Additionally, we tested the robustness of the regression results for H2. Therefore we applied a
ttest on the data set, where we separated the samples again by the convenience yield (see
above). H2 leads to the expectation of negative tvalues in our analysis, as group one with the
lower convenience yields is expected to be related to lower logarithmic prices. The ttest
supports H2 in all cases on a significant level with two exceptions (Table 4): The 3 and 15
months Nickel tests yield positive tvalues, which are not significant. In summary the test
fully supports the significant results from the regression model for 3 and 15 months except for
Nickel as well as for 27 months Copper. The test even yields negative and significant results
for Aluminum and Zinc. In the case of Nickel the robustness check yields results with
different signs as the regression model. The acceptance of H2 based on the regression model
11
is supported for this commodity only for 27 months, where it was rejected with the regression
test.
Table 4: Robustness check for the predictive power of convenience yields on future spot prices with a ttest
(***significance on a 0.1% level; **significance on a 1% level; * significance on a 5% level)
3M
Aluminum
Copper
Lead
Nickel
Zinc
15M
2.249*
27.927***
12.892***
1.017
28.968***
27M
23.068***
24.218***
21.477***
2.213*
13.909***
3.749***
26.707***
4.633***
0.673
Aluminum
Copper
Lead
Nickel
Zinc
3 months
0.001
0.056**
0.003
0.680**
0.077**
15 months
0.000
0.024
0.002
0.387**
0.039*
27 months
0.001
0.002
0.101**
0.015
The results show for all commodities except for Nickel very low correlation coefficients of
0.077 or less which are also not significant in most cases. In the case of Nickel the correlation
coefficients are significant and much higher with values from 0.680 down to 0.101. On basis
of this it seems to be unlikely that the results from the regression model (3) are due to effects
of the theory of storage, except in the case of Nickel. For this one also autocorrelation effects
could yield the very robust results especially in the case of 3 and 15 months maturities. For 27
months maturity we do not have such a strong autocorrelation coefficient (0.101) so that we
can assume the regression result not being a pure effect of this. In summary, the
autocorrelation test supports the results from the regression model as it excludes effects of the
classical theory of storage in most cases.
To exclude influences from long term price trends which might occur due to inflation effects
or other fundamental effects like increasing production costs over time, we checked the
predictive relationship between the convenience yield and relative prices at the futures
contracts maturity. We therefore divided the commodity spot prices by the value of the CRB
12
BLS Metals SubIndex to obtain the relative price development of the spot prices relative to
an index. The relationship was checked with the regression model ( )
where pT is the relative price at the time of maturity T, 1 and 2 are regression coefficients
and e is an error term. The results are shown in Table 6.
Analogue to the regression of the future spot price on the convenience yield we expect in this
test also a positive value for 1, if the convenience yield is a predictor for future criticality.
For the three months regression we obtained positive and highly significant values for all
commodities. In case of the 15 months time lag the test yields positive values for all
commodities except for Nickel. Except for the coefficient of Lead all results are significant,
while the one for Nickel shows only weak significance. For 27 months we obtain only for
Copper a positive value. All coefficients are significant.
Comparing the results of our robustness check with the regression test from above we find
only for 15 months Nickel contradictive results. In the first regression we obtained a positive
coefficient whereas the robustness check yielded a negative coefficient. Both cases were
significant while the robustness check result is only weakly significant. The robustness check
furthermore confirms the negative trends for 27 months Aluminum and Nickel which were
not significant respectively significant on a 1% level. In the case of 27 months Zinc we
obtained no significant result in the regression, whereas the robustness check led to a highly
significant negative result.
The robustness check supports therefore the acceptance of H2 in the case of the 3 and 15
months maturities from our regression model. In case of the 27 months it also strongly
confirms the acceptance of H2 whereas it does not support the acceptance in the other cases.
13
Table 6: Alternative regression of relative prices at the maturity on convenience yields 3, 15 and 27 months prior. Values for the regression coefficients 1, 2 and explanatory power R2
(***significance on a 0.1% level; **significance on a 1% level; * significance on a 5% level)
Aluminum
Copper
Lead
Nickel
Zinc
3 months
1
2
R2
0.111***
4.961***
(19.589)
(169.705)
0.086***
8.385***
(40.166)
(420.110)
0.013***
2.479***
(14.972)
(287.033)
0.473*** 32.277***
(32.081)
(188.698)
0.082***
3.812***
(25.417)
(239.672)
0.331
0.341
0.067
0.248
0.172
15 months
1
2
R2
0.050***
4.718***
(7.754)
(113.410)
0.088***
8.341***
(40.553)
(373.775)
0.002
2.562***
(1.780)
(222.175)
0.050* 36.268***
(2.447)
(135.856)
0.011***
3.705***
(3.904)
(166.895)
14
27 months
1
2
R2
0.021
0.036***
4.936
(4.298)
(82.855)
0.365
0.022***
8.884
(6.891)
(260.919)
0.001
0.002
0.005
0.114***
(4.437)
0.043***
(15.585)
37.108
(108.363)
3.915
(154.913)
0.007
0.018
0.008
0.086
15
Third we find for the futures with 27 months maturity less reliable results, what can be
additionally influenced by the market efficiency of futures prices with long maturities. In
general, the open interest increases in the last months before the futures maturity dates and
therefore yields efficient prices. For longer maturities we presume markets to be not as
efficient and therefore yielding less reliable convenience yields. It is also likely that in the
long run producers adapt to this situation and increase their production level (Samuelson,
1965). As long as this is possible for reasons of general availability of the commodity and
production facilities, it is not to be expected to find strong relationships in the long run. This
effect can mitigate scarcity in the market.
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