Cost of carry: How Interest Rates Affect Commodity Prices and Hedging Decisions

For a company that produces, sells, or consumes commodities, deciding when to sell, buy, or keep a product in inventory does not depend solely on price expectations.

Storage, insurance, losses, logistics, and, above all, the cost of capital must be factored into this calculation. It is precisely this relationship that lies behind what is known as the “cost ofcarry.”

In a high-interest-rate environment, understanding this concept becomes even more important for evaluating inventories, forward curves, and hedging strategies. In Brazil, the Central Bank of Brazil lowered the Selic rate to 13.75% per year at its September 16 meeting. In the United States, on the same date, the Federal Reserve decided to raise the target range for the federal funds rate by 0.25 percentage points, to 3.75% to 4.00%.

In this context, the cost of capital continues to play a significant role in trading and inventory decisions. Rather than simply tracking whether a particular commodity is rising or falling, companies need to assess whether the expected price movement is sufficient to offset the costs and risks involved in maintaining a position.

In this article, we analyze:

• Cost of carry: the relationship between interest rates and the costs associated with holding inventory;
• Curve structure: how contango and backwardation influence trading decisions;
• Margin protection: why protecting the price does not necessarily mean protecting profits;
• Interest rates and exchange rates: the importance of integrating commodity and FX risks into the hedging strategy.

What is the cost of carry?

The cost of carry encompasses the costs associated with holding an asset over time. In the case of physical commodities, this may include expenses related to storage, insurance, financing, and other operating costs, in addition to the economic benefits associated with keeping the product physically available—a concept known in the market as “convenience yield.” These components influence the relationship between spot and futures prices.

In practice, holding a commodity in inventory means tying up capital. The higher the cost of that capital, the higher the return required to justify the decision to postpone a sale.

Therefore, when interest rates remain high, the financial component can account for a significant portion of the total carrying cost, increasing the opportunity cost associated with maintaining inventory.

Cost of carry in practice

To put it simply, imagine a commodity currently valued at R$ 100 per unit. A company may choose to sell this product immediately or keep it in inventory for three months. During this period, however, the transaction may involve:

• cost of fixed capital;
• storage;
• insurance;
• potential losses;
• logistics or operating expenses.

This means that simply waiting for a higher price in the future may not be enough.

For holding inventory to make economic sense, the expected outcome of that decision must be analyzed in relation to the costs and risks incurred during the period.

This comparison is essential for producers, trading companies, manufacturers, and consumers who need to decide not only what price is attractive, but also when and how to trade a commodity.

Sell or hold onto inventory?

This is one of the decisions where the cost of carry becomes most relevant. Physically holding a commodity entails financial and operational costs. Therefore, waiting for a future price increase without considering the costs involved can lead to an incomplete understanding of the operation’s profitability.

For example, it is not enough to simply compare today’s price with an expected price three or six months from now. It is also necessary to consider how much it costs to finance and maintain that product during that period.

The higher the cost of capital, the higher the return tends to be that is needed to justify holding inventory. The comparison between the current price, the future price curve, and the effective cost of carrying inventory thus becomes part of the business decision itself.

How does the cost of carry influence the futures curve?

Another important application of this concept is in the interpretation of futures curves.

A futures curve aggregates the prices traded for different maturities of a given commodity. Its shape helps reveal how the market is pricing, among other factors, time, physical availability, carrying costs, and supply-and-demand conditions.

Hedging the price does not necessarily mean hedging the margin

This is a key point when the discussion of cost of carry is applied to risk management.

A hedging strategy can significantly reduce exposure to fluctuations in certain prices, but it does not automatically eliminate all the economic risks involved in a transaction.

Futures contracts are standardized in terms of quantity, quality, delivery location, and expiration date. For this reason, a company’s physical exposure may not perfectly match the contract used for hedging, giving rise to what is known as basis risk. Consequently, a company may hedge a commodity and still experience significant changes in its margin.

The focus of risk management should not be exclusively on locking in a specific price. It is necessary to understand which economic outcome and which cash flow the company is seeking to protect. This shift in perspective shifts the discussion from so-called price hedging to margin hedging.

Interest rates, exchange rates, and commodities

For Brazilian companies, there is an additional layer to this equation: exchange rates. Many commodities are traded internationally in dollars, while a significant portion of Brazilian companies’ costs are incurred in reais. At the same time, inventory and working capital may be subject to local financing conditions.

In practice, this means that a company may be simultaneously exposed to:

• to fluctuations in the international commodity price;
• to changes in the basis or premium in the physical market;
• exchange rate fluctuations;
• the cost of financing the transaction;
• the physical costs of storage and logistics.

Hedging against international commodity price fluctuations, therefore, may represent only one step in risk management.

A rise in the commodity’s price in dollars, for example, will not necessarily have an equivalent impact on revenue denominated in reais if the exchange rate moves simultaneously in the opposite direction.

On the other hand, exchange rate fluctuations can affect input costs, financial obligations, or export revenue, depending on each company’s operational structure.

For this reason, commodities and foreign exchange should not necessarily be treated as isolated exposures. A combined analysis provides a better understanding of which factors actually determine the operation’s margin and cash flow.

From Price Hedging to Margin Protection

In environments with higher capital costs, focusing solely on the direction of a commodity’s price may not be enough to determine the best trading decision.

The cost of financing, the structure of the futures curve, the expenses associated with holding inventory, the basis, and the exchange rate can substantially alter the economic outcome of a transaction.

This also changes the way one approaches hedging.

Instead of starting solely with the question “What price should we set?”, companies can broaden the discussion: What margin do we need to preserve?

Based on that answer, it becomes possible to identify which components of the operation pose significant risks and which tools can help manage them.

The standardization of exchange-traded contracts provides liquidity and transparency, but it also means that the instrument used will not always exactly replicate the company’s physical exposure. Therefore, the hedge structure must take into account the characteristics of the transaction and the risks that actually influence its outcome.

Cost of carry as part of the risk management strategy

Understanding the cost of carry, therefore, involves more than simply knowing the mathematical relationship between spot and futures prices. It involves understanding how much it costs to maintain a position over time and how that cost affects a company’s business and financial decisions.

In commodity markets, simply looking at whether prices are expected to rise or fall may not be enough. Interest rates, storage costs, the yield curve, physical availability, basis, and exchange rates can all affect the outcome of a trade, even when the commodity price has been hedged.

Therefore, hedge planning should consider not only the price a company wishes to hedge, but also the margin and cash flow associated with the transaction.

Rather than trying to anticipate the market’s next move, a risk management strategy seeks to identify key exposures and establish protective mechanisms that are consistent with each company’s financial and business objectives.

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