Commodity Prices and the Option Value of Storage
30 Pages Posted: 1 Aug 2007 Last revised: 14 Nov 2014
Date Written: November 14, 2014
Abstract
Commodities are physical, not financial, assets. We investigate the effects on equilibrium spot-price behavior of frictions in the storage process, which introduce an element of irreversibility to storage decisions and lead to periods when storage operators do not trade in the spot market. We value the real option to delay selling a stored commodity, which comes bundled with the stored commodity itself and generates a convenience yield. The latter arises if the spot price is incorrectly used to measure the market value of the stored commodity, ignoring the embedded real option. It can be interpreted as the expected excess return on the real option to delay selling the stored commodity. Rather than equalling a flow of benefits received during the period over which the return from storage is being calculated, it actually represents changes in the present value of benefits that will be received only some time after the measurement period, when the commodity is released from storage. Storage frictions also generate heteroskedastic spot prices, with volatility being much higher when storage operators decide not to trade in the spot market.
Keywords: Commodity Prices, Convenience Yield, Real Options, Frictions
JEL Classification: D51, G13, Q1, Q4
Suggested Citation: Suggested Citation
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