# Kub's Den

## The Theory of Enough

By  Elaine Kub , Contributing Analyst

How much should a commodity be worth, say, six months from now? Like most economic questions, this one has spawned an academic theory, and like a lot of theories, it can't really be proven, but it can provide an interesting way to think about our most pressing concerns for 2019 -- what will grain prices do?

There's a reason that stock prices go up over time (generally-speaking; the last quarter of 2018 notwithstanding). Business activities create future income streams, which compensate investors' risk above and beyond the risk-free interest rate, and hopefully above and beyond the rate of inflation, and those income streams themselves may grow over time as a business expands. But buy-and-hold investors would be silly to get into commodites unless they had some similar framework of understanding for how commodity prices may change from one timeframe to the next.

As far back as 1930, economists tried to build just such a philosophical framework for commodity futures markets. John Maynard Keynes proposed a "theory of normal backwardation," which turned out to be wrong, but it laid some groundwork for Holbrook Working to propose his "theory of storage" in 1933, later expanded by Nicholas Kaldor in 1939 to include the idea of a "convenience yield," which really isn't provably either right or wrong. It is a cute theory, though -- complete with a mathematical equation and everything: Futures price = Spot price + Storage costs - Convenience yield.

For example, the price of December 2019 corn futures today is \$3.97 per bushel. In Kaldor's equation, we would set \$3.97 equal to today's spot price (the DTN National Corn Index at \$3.41 per bushel), plus storage costs over that timeframe (let's say 73 cents), minus this nebulous idea of a convenience yield. According to the arithmetic, today's convenience yield in the corn market appears to be taking back 17 cents off the spot-to-December futures spread. (\$3.97 = \$3.41 + \$0.73 - \$0.17)

What then, is a convenience yield? According to the theory, we're meant to think of it as a measure of the market's concern about supply disruption. When a commodity is abundant, supply chains are more comfortable and industry end-users are happier. They're not antsy about inconveniently running out of that commodity, and prices don't tend to spike. So the "convenience yield" is low when inventories are comfortably ample, and the "convenience yield" gets larger when inventories become scarce. If a market is operating with really tight inventories, the "convenience yield" may become so large that futures spreads become inverted (i.e. go into backwardation), with the nearby contract prices higher than deferred contract prices.

Currently, and for the past 4 1/2 years or so, I think we could safely say the corn market has displayed conveniently ample inventories, and correspondingly low convenience yields. It's hard to say what would be a "low" or a "high" convenience yield, because economic models have a hard time calculating this virtually unobservable metric across timeframes and across markets. A team of Australian academics has had some luck modeling convenience yields in metal futures markets using options prices instead of cost-of-carry calculations, but that's beyond the scope of this column.

In the corn market, there was a brief blip in mid-2016 when the spreads between nearby futures contracts became tight and even inverted by a penny, but otherwise, we've had a long period of relatively normal carry spreads. The front-month corn futures chart itself hasn't ventured below \$3.01 or above \$4.39 1/4 since June 2014.

What would it take to knock the corn market out of its complacency? Potentially bullish influences in 2019 include: continued strong domestic and international demand for feed grain (quite likely), or low yields from the South American crop to be harvested in coming months (somewhat likely after the dry December), or lower-than-expected U.S. corn acres planted in the spring (extremely unlikely unless something changes about the currently dismal soybean-to-corn price ratio), or low yields from corn crops anywhere in the Northern Hemisphere (hard to say at this time, but probably unlikely). The probability of any combination of these factors all occurring at the same time gets increasingly small, and I think we should expect to continue seeing "conveniently" large global inventories for the foreseeable future.

It may be helpful to reframe this idea in our minds as the Theory of "Enough." If there is Enough corn, and Enough confidence that there will continue to be Enough corn, then there's no reason for the market's buyers to get antsy and start paying more than what it costs to make and store the stuff. It's a convenience, indeed, for the industry to feel such calm confidence about supplies.

Elaine Kub is the author of "Mastering the Grain Markets: How Profits Are Really Made" and can be reached at elaine@masteringthegrainmarkets.com or on Twitter @elainekub.

(BAS/SK)