$100 Oil, Nigeria, and Convenience Yield

Yesterday, futures for February delivery of light sweet crude reached $100, before settling at $99.62. Some people view futures prices as the opinion of the market on what the price of something will be at a certain point in the future. This is not quite correct. Futures prices really reflect the spot price, combined with the time value of money--except, however, when you are talking about consumable commodities like oil.

This relationship is pretty much inviolable for most futures; for instance, futures contracts on interest rates, currencies, stock indices, or gold. In these cases, the future price equals the spot price continuously compounded by the risk free rate, combined with dividend yield, bond yield, foreign risk free rate and/or storage costs, depending on the type of future contract. If the future price doesn't have this relationship with the spot price, there is an arbitrage opportunity (which will very rapidly be exploited by enough futures traders to bring the prices back in line).

Now it's not quite so simple with consumable commodities like oil or wheat. People don't buy , say, orange juice as an investment. They buy it to sell to Kroger. Likewise oil. People who have long positions in oil futures tend to be refiners who actually will use that oil. (There are, of course, speculators who buy and sell futures.) Because commodities are physical and used in industrial processes, there is one other factor affecting the future price besides those mentioned above. It's called the "convenience yield."

John Hull defines convenience yield as "the benefits from holding a physical asset" (as opposed to waiting to receive it on a future date) and adds that "convenience yield reflects the market's expectation concerning the future availability of the commodity." Unlike the other yields that affect the future price of oil (storage and risk free interest), convenience yield cannot be easily determined. In fact, it's literally defined as the difference between what the future price would be if we only considered storage and risk free rates and what the actual future price is. (Therefore, there is no arbitrage opportunity in a "mispriced" convenience yield.)

So when we are dealing with orange juice, an unexpected freeze will change the convenience yield and thus the future price. With oil, unrest in a major oil producing country can change the convenience yield.


(photo copyright 2008 by AFP)
This is what happened yesterday. The violence in Port Harcourt, Nigeria, caused the convenience yield--the dollar value of expectation of the market that February light sweet crude will be delivered as contracted--to go up. Port Harcourt is Nigeria's primary oil town, and one of the buildings attacked was a hotel frequently used by foreign oil workers.

Sometimes one hears terms like "terror premium" and "war premium" used to explain higher oil prices. This is the convenience yield in action. The countries that produce a lot of oil are unstable, and that instability adds cost to world oil prices. This is contra the peak oil guys--for them, the reason oil is so high is the declining supply. Even if that is true, though, it cannot be denied that if Nigeria and the Middle East were more stable and settled, the proce of oil would necessarily be lower. Furthermore, the more oil from stable areas that is brought on the market, the lower the convenience yield. An obvious example would be ANWAR. The US is very stable, so bringing ANWAR on line would lower oil prices by more than could be predicted by virtue of increasing the world supply (which ANWAR wouldn't affect all that much, frankly).

A new source of oil that will have a bigger effect than ANWAR is the Brazilian Tupi field, which will take several years to develop, but if and when it comes on line, it will add a lot of new oil from a stable country to the world market, reducing convenience yield.