Raw Material Convenience Yields and Business Cycle

Abstract

This paper extends the methodology of Milonas and Thomadakis (1997) to estimate raw material convenience yields with futures prices during the period 1996 to 2005. We define the business cycle of a seasonal commodity with demand/supply shocks and find that the convenience yields for crude oil and agricultural commodity exhibits seasonal behavior. The convenience yield for crude oil is the highest in the winter, while that for agricultural commodities are the highest in the initial stage of the harvest period. The empirical result show that WTI crude oil is more sensitive to high winter demand and that Brent crude oil is more sensitive to shortages in winter supply. The theory of storage points out that the marginal convenience yield on inventory falls at a decreasing rate as inventory increases which could be verified through those products affected by seasonality, but could not be observed by products affected by demand/supply. Convenience yields are negatively related to interest rates The negative relationship implies that the increase in the carry cost of commodity – namely the interest rate – would cause the yield of holding spot to decline. We also show that convenience yields may explain the price spread between WTI and Brent crude oil as well as the ratio between soybean and corn. Our estimated convenience yields are consistent with Fama and French (1988) in that commodity prices are more volatile than futures prices at low inventory level, verifying the Samuelson (1965) hypothesis that future prices have fewer variables than spot prices at lower inventory levels.