In continuing the series on what makes energies different, here I take a bird’s eye view on two related price drivers: storage and convenience yield. (Incidentally, next week I will be attending the 2010 EIA-SAIS Energy Conference in Washington, where one of the sessions is on price drivers—let’s see which the panel considers most important.)
First, it is important to understand the concepts of “storage” and “convenience yield.” Storage is the physical holdings of a commodity; maintaining an inventory allows for holders to meet unexpected demand with little disruption to production processes. Convenience yield is the benefit of holding an underlying product (versus holding, say, a contract). Thus, storage and convenience yield are intricately linked.
When storage reserves are down, commodity prices increase (this holds for non-energy commodities too, like aluminum). And if inventories are low, and there is a sudden shock in demand, prices can skyrocket. Commodity prices and volatility are positively correlated because both are negatively related to inventory levels.
Convenience yield, according to Helyette Geman, can be “defined as the difference between the positive gain attached to the physical commodity minus the cost of storage.” Depending on the commodity, the length of time, and inventory levels, the convenience yield can be positive or negative.
Storage also affects the shape of short- and long-term forward curves, and for different reasons. As noted, storage may have an effect on short-term pricing, but long-term pricing is reflective of potential new energy to be discovered and captured. Imagine, then, the short-term curve of natural gas when a series of freak weather patterns comes through a region. In comparison, the long-term curve would remain fairly steady and predictable.
Moreover, the effects of storage and convenience yield across energy commodities vary widely. Take crude oil, for instance: because it is traded on a nearly “just-in-time” basis, actual storage of crude oil is minimized. Crude generally takes 30 days (85 days for long trips) to get from well-head to end-user, which does not allow for long-term physical holding. Moreover, with crude, rather than being held for a length of time at the point of export or import, it often changes owners en route (by ship and pipeline), giving little time to actually store the commodity. Natural gas, on the other hand, is traditionally associated with seasonal needs. Thus, natural gas can be stored for months at a time until it is actually needed (indeed, natural gas can be stored indefinitely). And electricity is a whole different beast, since it is not storable at all!
Knowing the connections between storage and convenience yield can help one model the benefits of the latter to the commodity owners. As such, the convenience yield is a feature unique to energy and commodity markets. It is not necessarily easy to determine its value, but to dismiss it entirely is risky business in the energy sector.
For more, see the excellent discussion on the subject peppering Helyette Geman’s Commodities and Commodity Derivatives: Modeling and Pricing for Agriculturals, Metals and Energy (Hoboken, NJ: John Wiley & Sons, 2005).
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First, it is important to understand the concepts of “storage” and “convenience yield.” Storage is the physical holdings of a commodity; maintaining an inventory allows for holders to meet unexpected demand with little disruption to production processes. Convenience yield is the benefit of holding an underlying product (versus holding, say, a contract). Thus, storage and convenience yield are intricately linked.
When storage reserves are down, commodity prices increase (this holds for non-energy commodities too, like aluminum). And if inventories are low, and there is a sudden shock in demand, prices can skyrocket. Commodity prices and volatility are positively correlated because both are negatively related to inventory levels.
Convenience yield, according to Helyette Geman, can be “defined as the difference between the positive gain attached to the physical commodity minus the cost of storage.” Depending on the commodity, the length of time, and inventory levels, the convenience yield can be positive or negative.
Storage also affects the shape of short- and long-term forward curves, and for different reasons. As noted, storage may have an effect on short-term pricing, but long-term pricing is reflective of potential new energy to be discovered and captured. Imagine, then, the short-term curve of natural gas when a series of freak weather patterns comes through a region. In comparison, the long-term curve would remain fairly steady and predictable.
Moreover, the effects of storage and convenience yield across energy commodities vary widely. Take crude oil, for instance: because it is traded on a nearly “just-in-time” basis, actual storage of crude oil is minimized. Crude generally takes 30 days (85 days for long trips) to get from well-head to end-user, which does not allow for long-term physical holding. Moreover, with crude, rather than being held for a length of time at the point of export or import, it often changes owners en route (by ship and pipeline), giving little time to actually store the commodity. Natural gas, on the other hand, is traditionally associated with seasonal needs. Thus, natural gas can be stored for months at a time until it is actually needed (indeed, natural gas can be stored indefinitely). And electricity is a whole different beast, since it is not storable at all!
Knowing the connections between storage and convenience yield can help one model the benefits of the latter to the commodity owners. As such, the convenience yield is a feature unique to energy and commodity markets. It is not necessarily easy to determine its value, but to dismiss it entirely is risky business in the energy sector.
For more, see the excellent discussion on the subject peppering Helyette Geman’s Commodities and Commodity Derivatives: Modeling and Pricing for Agriculturals, Metals and Energy (Hoboken, NJ: John Wiley & Sons, 2005).
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