Markets
Key words: Financial assets, Convenience assets, Convenience Yield, Backwardation,Contango
Convenience assets

Financial assets such as stocks, fixed income instruments, currencies are examples of pure assets that are held for investment purposes.
The capital gains are the main reason to hold these assets. Future value of such assets is defined as:

Future Value = Spot value + Financing + Storage costs – Cash Yield

Convenience assets are held for reasons other than pure investments.
Most energy, metal commodities, except precious metals that can be considered as currencies, agricultures are used in production.
Therefore these assets are not pure but rather convenience assets. Owning the physical assets in reserve may give an additional marginal benefit that is called convenience yield. Convenience yield varies from user to user and can be explained as an additional cash yield. Therefore:

Future Value = Spot value + Financing + Storage costs – Cash Yield – Convenience Yield

Backwardation in the commodity futures is related to convenience yield.
When the convenience yield is large subsequent futures prices are smaller than the previous ones and the spot price.

Financial assets are more likely to be in Contango.
Actually, it can be said that cost of financing exceeds cash yield, subsequent futures prices higher than the previous ones and the spot price.

Currently, both Gold and Brent futures are in Contango. You can use “CCRV” function in BBG.

Brent, Gold contango

Usually the oil futures are the other way round when we can sell oil for a higher price today than in the future. Various explanations abound for the condition. Why do we have convenience yield or when people have additional marginal benefits from holding physical oil?
From my point of view there are simply demand-supply reasons:

1. Backwardation occurs when there are structurally low inventories for oil. It often happens in the periods of relatively rapid economic growth. Producers dictate terms, prices and conditions during this phase.
Consumers need oil today not tomorrow. They are willing to pay more today.
During these periods keeping oil in the ground potentially has option value. Why to sell today if tomorrow prices will be higher? There is a floor on oil prices without a ceiling. Therefore oil producers wait for higher prices until selling physical oil because keeping oil in the ground costs nothing.

2. Periods of stagnation and decline slow down the oil consumption. The spot price goes down. It is worth to sell oil today until it is too cheap. Production companies will try to sell oil at spot prices and realized profit from these operations can be deposited and will give extra return. There is no additional incentive to leave oil in the ground.
Consumers will prefer to wait, i.e. no need for additional storage of oil that might not have a use and have to be inventoried.

This is a contango market. Consumers dictate terms, prices and conditions during this phase.

Brent backwardation

1998-1999 Contango: Russian financial crisis

2001-2003 Contango: Dot-com bubble

2006-2007 Contango: Beginning of Credit crunch crisis

2008-2009 Contango: Credit Crunch

2014-2015 Contango: Recent sharp movement – as current demand can’t take on more oil production, the abundance of stored oil has pushed spot price below futures prices

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