A share of stock represents a claim on a company's future earnings. A government bond represents a promise to repay cash. But a barrel of crude oil, a tonne of copper, or a megawatt-hour of electricity is a physical thing. It exists somewhere, has to be kept somewhere, deteriorates or changes if not used, and must be physically delivered from point A to point B. This physical reality gives commodity markets properties that are fundamentally different from all other asset classes.
Physical Delivery and Its Consequences
Every commodity futures contract ultimately connects to a physical delivery obligation. A NYMEX WTI crude oil futures contract represents 1,000 barrels of light sweet crude deliverable at Cushing, Oklahoma, during the delivery month. A CME natural gas contract represents 10,000 MMBtu deliverable at Henry Hub, Louisiana. An LME copper contract represents 25 tonnes of Grade A copper, deliverable at an LME-approved warehouse.
In practice, most financial participants close their positions before delivery. But the possibility of delivery is not theoretical — it is the anchor that connects futures prices to physical market reality. When a contract approaches expiry, anyone still long must either roll to the next month (sell the expiring contract, buy the next) or take physical delivery. This roll creates predictable liquidity patterns and, in extreme cases, severe price distortions.
Storage and the Forward Curve
Unlike financial assets, commodities must be physically stored, and storage is costly. Storing crude oil in a tank farm costs money for rental, insurance, and financing the oil itself. Storing natural gas requires pipeline injection capacity or LNG facilities. Storing copper requires a warehouse and security.
These storage costs directly shape the forward curve — the set of prices for delivery at different future dates. Under normal conditions, the forward curve is in contango: futures prices for later delivery months are higher than the spot price, by roughly the cost of carrying the commodity forward in time. This cost includes storage costs, insurance, and the financing cost of owning the physical commodity.
The theoretical forward price for delivery at time T is:
Forward Price(T) = Spot Price × e^((r + s − y) × T)
Where r is the financing rate, s is the storage cost rate, and y is the convenience yield — the implicit benefit of holding physical inventory rather than a futures contract.
Convenience Yield: The Value of Having It Now
The convenience yield is one of the most important and least intuitive concepts in commodity markets. It represents the non-financial benefit of holding physical inventory — the ability to respond immediately to demand spikes, to maintain production continuity, to avoid the risk of supply disruption.
A refinery that holds physical crude oil inventory can run its plant even if spot prices spike or supply is disrupted. A power company that stores natural gas can meet peak demand without relying on spot markets during cold snaps. This operational flexibility has real value — the convenience yield.
When inventories are low (tight physical market), convenience yields are high — physical holders can command a premium for immediate delivery. This drives the forward curve into backwardation: spot prices exceed futures prices. Backwardation signals tight physical supply and high convenience yields.
When inventories are high (plentiful supply, full storage), convenience yields are low, and the forward curve reverts to contango. Traders can make money by buying spot, storing, and selling forward — the "cash and carry" trade — until the contango premium equals the cost of storage.
Negative Oil Prices: April 2020
The most dramatic illustration of commodity market uniqueness was the WTI futures price going negative on 20 April 2020. The front-month May 2020 WTI contract fell to minus $37.63 per barrel — the first time any commodity futures contract had traded at a negative price.
The cause was specific to WTI's delivery mechanics at Cushing, Oklahoma. COVID-19 had destroyed demand globally; refineries were cutting runs; storage at Cushing was filling rapidly. With the May contract expiring in two days, anyone still holding it faced the obligation to take delivery of physical crude at Cushing — but there was almost no tank space left. Rather than pay to store oil they couldn't use or move, long holders accepted negative prices (they paid others to take the barrels off their hands). Brent crude, which settles financially rather than physically, fell to $19 but never went negative.
This episode is a masterclass in how the physical dimension of commodity markets can drive prices to places that are inconceivable in financial markets. No equity or bond can trade at a negative price due to storage constraints — but commodities can and do.
Seasonality
Demand for many commodities is inherently seasonal: natural gas demand peaks in winter (heating) and summer (air conditioning), creating predictable price patterns across the forward curve. Agricultural commodities follow crop cycles. Power markets spike during cold snaps and heat waves. Gasoline demand rises in summer driving season.
Commodity trading desks build detailed seasonality models. Storage decisions (when to inject gas into storage, when to withdraw) are driven by the forward curve's shape across seasons. The "summer/winter spread" — the difference between summer and winter gas prices — is itself an actively traded market, reflecting the market's expectation of seasonal demand patterns and storage economics.
Commodity Trading Houses
A feature of commodity markets that has no parallel in financial markets is the dominant role of the commodity trading houses — Glencore, Trafigura, Vitol, Gunvor, Mercuria. These companies are not just financial intermediaries: they physically own and move commodities around the world. They own tankers, pipelines, warehouses, mines, and refineries. They arbitrage price differences between locations, grades, and time periods.
Trading houses can take physical delivery on futures contracts, store the commodity, transport it to where it is needed, and sell it for a profit — an integrated physical and financial operation that pure financial trading firms cannot replicate. Their ability to engage with the physical market makes them essential liquidity providers in commodity derivatives and physical markets simultaneously.
Location and Grade Basis Risk
Physical commodities vary in quality and location. WTI crude at Cushing is not the same as Brent crude in the North Sea, which is not the same as Dubai crude in the Gulf, which is not the same as a specific West African sour grade. Each grades' price relative to the benchmark is the differential, and managing these differentials is the core of physical commodity trading.
A refinery optimised for light sweet crude will discount sour crude heavily; a refinery configured for heavy grades can process sour crude economically. The crack spread (crude to products), the grade differential, and the location differential all create basis risk that financial hedges using benchmark futures cannot fully eliminate. This residual basis risk is the primary source of commodity-specific risk for industrial companies.