The Fundamentals of Commodity Futures Returns
Gary B. Gorton, The Wharton School, University of Pennsylvania and NBER
Fumio Hayashi, University of Tokyo and NBER
K. Geert Rouwenhorst, Yale University

Commodity futures risk premiums vary across commodities and over time depending on the level of physical inventories, as predicted by the Theory of Storage. Using a comprehensive dataset on 31 commodity futures and physical inventories between 1969 and 2006, we show that the convenience yield is a decreasing, non-linear relationship of inventories. Price measures, such as the futures basis, prior futures returns, and spot returns reflect the state of inventories and are informative about commodity futures risk premiums. The excess returns to Spot and Futures Momentum and Backwardation strategies stem in part from the selection of commodities when inventories are low. Positions of futures markets participants are correlated with prices and inventory signals, but we reject the Keynesian “hedging pressure” hypothesis that these positions are an important determinant of risk premiums.

Commodities are becoming an increasing important asset class as economic development and population growth make them relatively scarce and cause their prices to become more volatile. Characterizations of how their prices are formed, and of regularities in their prices thus are quite important to investment managers. This study shows how risk premiums have varied over time and in relation to inventories. The results should be of particular note to investors in and managers of hedge funds that seek to profit by effectively offering price insurance to hedgers in the futures markets.