Inventories and Commodity Price Volatility: A Test of the Theory of Storage

The theory of storage implies that commodity price volatility is inversely related to inventories, and that as inventories decline, spot prices become relatively more volatile than futures prices, and vice versa. These implications are directly tested using inventory and price data for six non-ferrous metals traded on the London Metal Exchange over the period 1989 to 2000. The conditional variances are specified as multiplicative heteroskedasticity models. For four of the metals, the observed relationships between the inventories and the variance of spot and futures prices support the implications of the theory of storage. For the other two metals contracts, the results do not support the theory. The findings thus lend qualified support to the notion that market fundamentals, rather than ‘animal spirits’, drive commodity price volatility.