Inventories and the term structure of oil prices: A complex relationship

According to conventional storage theory, the difference between spot and futures prices (known as the ‘basis’) can be explained by the total cost of storing a commodity for a specific period of time. The theory predicts a positive relationship between inventory levels and the basis, and a negative correlation between inventories and marginal convenience yield. We investigate whether there is a defined and quantifiable relationship between inventory levels and market structure – defined as the basis or the corresponding degree of contango/backwardation – and what the exact nature of that relationship might be. The major drivers of inventories – the cost of carry, convenience yield and spread options value – are estimated for eight major international storage hubs using daily data from December 21, 2015, to January 25, 2019. The analysis indicates that basic predictions of inventory theory are valid for daily and weekly frequencies but become less reliable for lower frequency data. We propose an alternative: a spread option-based formulation that adds a locational dimension to the theory and is based on the prices of crude oil at different locations, factoring in costs of storage and transportation, and the time required to transport oil between them. This methodology offers a viable alternative to the traditional cost of carry approach; it can estimate implied convenience yields and the shadow price of inventories. The data and methodology proposed in this study can give policy makers a better understanding of implied convenience yields, shadow storage prices, and market direction. It can also facilitate the construction of timely and efficient policies in the domains of energy security, market stability, and the management of public crude oil inventories. A better understanding of the relationship between inventories and the term structure of oil prices can assist market participants in trading, hedging and inventory management.