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Why and when do spot prices of crude oil revert to futures price levels?

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  • Mark W. French
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    Abstract

    Recent studies of crude oil price formation emphasize the role of interest rates and convenience yield (the adjusted spot-futures spread), confirming that spot prices mean-revert and normally exceed discounted futures. However, these studies don't explain why such "backwardation" is normal. Also, models derived in these studies typically explain only about 1 percent of daily returns, suggesting other factors are important, too. In this paper, I specify a structural oil-market model that links returns to convenience yield, inventory news, and revisions of expected production cost (growth of which is related to backwardation). Although its predictive power is only a marginal improvement, the model fits the data far better. In addition, I find reversion of spot to futures prices only when backwardation is severe. Convenience yield behaves nonlinearly, but price response to convenience yield is also nonlinear. Equivalently, futures are informative about future spot prices only when spot prices substantially exceed futures.

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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2005-30.

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    Date of creation: 2005
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    Handle: RePEc:fip:fedgfe:2005-30

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    Keywords: Petroleum products ; Prices ; Econometric models;

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    1. Malcolm P. Baker & E. Scott Mayfield & John E. Parsons, 1998. "Alternative Models of Uncertain Commodity Prices for Use with Modern Asset Pricing Methods," The Energy Journal, International Association for Energy Economics, vol. 0(Number 1), pages 115-148.
    2. Bryan R. Routledge & Duane J. Seppi & Chester S. Spatt, 2000. "Equilibrium Forward Curves for Commodities," Journal of Finance, American Finance Association, vol. 55(3), pages 1297-1338, 06.
    3. Robert S. Pindyck, 1999. "The Long-Run Evolutions of Energy Prices," The Energy Journal, International Association for Energy Economics, vol. 0(Number 2), pages 1-27.
    4. Robert S. Pindyck, 2001. "The Dynamics of Commodity Spot and Futures Markets: A Primer," The Energy Journal, International Association for Energy Economics, vol. 0(Number 3), pages 1-30.
    5. Danthine, Jean-Pierre, 1977. "Martingale, market efficiency and commodity prices," European Economic Review, Elsevier, vol. 10(1), pages 1-17.
    6. Pindyck, Robert S., 1991. "The present value model of rational commodity pricing," Working papers 3354-91., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    7. Angus Deaton & Guy Laroque, 1990. "On The Behavior of Commodity Prices," NBER Working Papers 3439, National Bureau of Economic Research, Inc.
    8. Schwartz, Eduardo S, 1997. " The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-73, July.
    9. Considine, Timothy J. & Larson, Donald F., 2001. "Uncertainty and the convenience yield in crude oil price backwardations," Energy Economics, Elsevier, vol. 23(5), pages 533-548, September.
    10. Colin A. Carter & Cesar L. Revoredo Giha, 2007. "The Working Curve and Commodity Storage under Backwardation," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 89(4), pages 864-872.
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    Cited by:
    1. Kuper, Gerard H., 2012. "Inventories and upstream gasoline price dynamics," Energy Economics, Elsevier, vol. 34(1), pages 208-214.

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