contango and backwardation of commodity

[itsyourz]

Hi,

question 27, in 08 practice exam part III

27. Which of the following best describes what we would normally expect to see in a seasonal agricultural
market like wheat? Assume “the harvest” is normal and not unusually big or unusually small. Now
consider the following statements about the market.

I. Prices fall at the harvest and rise after the harvest.
II. Prices are constant on average across the year regardless of seasonality.
III. Prices rise at the harvest and fall afterwards.
IV. The market is in contango when the harvest comes in.
V. The market is in backwardation when the harvest comes in.
VI. If the market goes into contango, it is most likely to do so right before a new harvest.
VII. If the market goes into backwardation, it is most likely to do so right before a new harvest.

Now choose the letter that best describes which of the above statements is true.

could you explain how the price changes according to harvest?

downward sloping before harvest and then upward after harvest , is it right??
that is, backwardation before harvest and contango after harvest
so confused,,
both IV and VII are true but aren't they clashed each other?
"when the harvest comes in" means.. approaching to harvest ? or exactly at the harvest?
i need to improve my english first of all,,

thanks!

suk

 

[skcd]

Here is what i would think about it:
Main decision lever is harvest and decision point at harvest or just before harvest.
So right before harvest, a "wow" (positive supply shock sort of) hence prices fall in near term.
After harvest, there are other factors that set in, is there sufficient demand, where to store the stuff age old crap.
So prices normalize (or fall).
The other side, is very counterintuitive (and rare) meaning why would someone think prices will rise even as your supply is going to increase and why would it fall after that?

So yes, I over III and definitely II is bogus. IV for sure as market is definitely contango. So definitely IV over V.
Now, harvest has come in & prices have reacted already (fallen) so now they normalize i.e. go to contango. That is IV not V.

As for VI, VII my earlier explanation should be good. Just before harvest, supply shock (+ive) hence price is expected and hence market goes to backwardation.

 

[skcd]

typo:
After harvest, there are other factors that set in, is there sufficient demand, where to store the stuff age old crap.
So prices normalize (or fall).
Not fall. PRICES NORMALIZE OR INCREASE BACK AFTER SHARP FALL.

 

[David Harper CFA FRM]

I agree the question is correct, but it's *tough*

The reference may as well be Culp on corn - i.e., seasonality in production.

Suk, what you said here is exactly correct: "downward sloping before harvest and then upward after harvest"

Say the wheat harvest is (I make this up, when does wheat harvest?) July.
The price of wheat in January will be high, given constant demand over the year, because it is supplied from STORAGE. Cost of carry: storage (like financing) is increasing the forward/future cost. So, in January, price is high to reflect storage. (in contango, here)

Now go to June (this is VII above), "right before the new harvest." Wheat supplied in June is highly priced to reflect is has been STORED FOR A LONG TIME (tip of upward sloping contango segment). But July price drops because no storage is necessary. July wheat goes directly to supply. June (high forward price) to July (low forward price) is downward slope = backwardation.

Now go to July (low price) - forward curve will be upward sloping to reflect storage required in forward months = contango.

Seasonality implies alternating contango/backwardation. Like natural gas, too, except is season due to demand instead of supply

David

 

[[email protected]]

Hi David

My understanding from the forum is set out below, correct me if I am wrong.

Statement IV and VII
Jan01 ---->F(Jan01)=S(July00)^storage cost*6/12
.
.
Jun01 ---->F(June01) = S(July00)^storage cost*11/12
July01 (Harvest) --> F0 = S0 = S(July01) =======Price is reset. And it is assumed to reset back to July00 price level??
Aug01 ---> F1=S(July01)e^storage cost *1/12
Sep01 ---> F2=S(July01)e^storage cost *2/12

Statement I
Prices fall at the harvest (due to Supply more than Demand)
Price rise after the harvest (due to DD is greater than Supply)

Your guidance, please.

Regards
Learning

 

[David Harper CFA FRM]

Hi Learning,

1. Yes I agree with your price pattern characterizations
Re: Price is reset. And it is assumed to reset back to July00 price level??
...not necessarily back to July 00, but just a forward price that reflects lack of storage ... could be increases for inflation/etc

2.
Re: "Prices fall at the harvest (due to Supply more than Demand). Price rise after the harvest (due to DD is greater than Supply)"
well, i don't think the question says anything about demand
(e.g, natural gas has seasonal demand; here i think the seasonality refers to supply)
so, Statement I (IMO) still fits into your pricing dynamics: the fall at harvest is here simply due to the fact that no storage cost (or very little) is incurred

David