Convenience yield and the option to liquidate for commodities with a crop cycle

In this paper we present a simple model which explains convenience yields in line with Keynes ‘liquid stocks’ theory. When the flows of demand and production of a commodity are not synchronised, stored inventories are the source of supply which absorbs demand fluctuations in periods between production times. Since negative storage is not possible, the likelihood of a stockout implies that spot price may rise above futures price between production times. We show that the yield on stored commodities has the payoff structure of a call option. Furthermore, the existence of this call option acts to counter the appearance of normal backwardation in futures prices. Empirical tests on four commodities offer supportive evidence of our theory.