Economic Linkages, Relative Scarcity, and Commodity Futures Returns

This paper shows that economic linkages among commodities create a source of long-term correlation between futures returns. We extend the theory of storage to a multi-commodity level and find that the convenience yield of a commodity depends on its relative scarcity with respect to other related commodities. This implies a feedback effect between commodities that is necessary to replicate the upward-sloping correlation term structure of futures returns observed for related commodities. We present a multi-commodity affine model that validates our theoretical predictions and considerably reduces the pricing errors in out-of-sample crack spread options. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.