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Uncertainty and the price for crude oil reserves

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  • Considine, Timothy J.
  • Larson, Donald F.

Abstract

Innovations in futures, options, and derivative instruments permit active trading, speculating and hedging - linking markets for physical petroleum products with financial markets. These derivative markets continuously value petroleum delivered today and for future dates, providing a market price for inventories. Underground petroleum reserves are also an inventory defined by exploration surveys and development drilling. Thus, observable market information can be used to value these reserves. Option - valuation models can be used to price reserves using observable markets, but are dependent on unexplained convenience yields revealed by the term structure of futures prices. The authors apply a general inventory pricing model to petroleum inventories and generate an empirical model of the returns to storage for petroleum markets. They examine the determinants of the crude oil convenience yield using a stochastic control model. They specify optimal production and inventory conditions using a third-order cost function and estimate them using monthly observations. Their inventory arbitrage condition embodies the Hotelling principle and Kaldor's convenience yield, and includes a premium on the dispersion in crude oil prices. The empirical results suggest that returns to storage contain both a cost-reducing component and often sizable premiums associated with the dispersion of petroleum prices. Their findings suggest that crude oil markets differentiated by quality and location provide similar premiums. The premiums associated with the dispersion of petroleum prices may account for persistent backwardation in crude oil prices. This finding may also explain the wide discrepancies between Hotelling values and transaction prices found in previous studies.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1655.

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Date of creation: 30 Sep 1996
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Handle: RePEc:wbk:wbrwps:1655

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Keywords: Economic Theory&Research; Environmental Economics&Policies; Markets and Market Access; Labor Policies; Payment Systems&Infrastructure; Oil Refining&Gas Industry; Environmental Economics&Policies; Access to Markets; Markets and Market Access; Economic Theory&Research;

References

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  1. Ray C. Fair, 1990. "The Production Smoothing Model is Alive and Well," NBER Working Papers 2877, National Bureau of Economic Research, Inc.
  2. Pindyck, Robert S., 1990. "Inventories and the short-run dynamics of commodity prices," Working papers 3133-90., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  3. Blinder, Alan S, 1986. "Can the Production Smoothing Model of Inventory Behavior Be Saved?," The Quarterly Journal of Economics, MIT Press, vol. 101(3), pages 431-53, August.
  4. Michael C. Lovell, 1959. "Manufacturers' Inventories, Sales Expectations, and the Acceleration Principle," Cowles Foundation Discussion Papers 86, Cowles Foundation for Research in Economics, Yale University.
  5. Miller, Merton H & Upton, Charles W, 1985. " The Pricing of Oil and Gas: Some Further Results," Journal of Finance, American Finance Association, vol. 40(3), pages 1009-18, July.
  6. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-57, April.
  7. Olivier J. Blanchard, 1982. "The Production and Inventory Behavior of the American Automobile Industry," NBER Working Papers 0891, National Bureau of Economic Research, Inc.
  8. Miller, Merton H & Upton, Charles W, 1985. "A Test of the Hotelling Valuation Principle," Journal of Political Economy, University of Chicago Press, vol. 93(1), pages 1-25, February.
  9. Lester G. Telser, 1958. "Futures Trading and the Storage of Cotton and Wheat," Journal of Political Economy, University of Chicago Press, vol. 66, pages 233.
  10. Krane, Spencer D & Braun, Stephen N, 1991. "Production Smoothing Evidence from Physical-Product Data," Journal of Political Economy, University of Chicago Press, vol. 99(3), pages 558-81, June.
  11. Alan S. Blinder & Louis J. Maccini, 1991. "Taking Stock: A Critical Assessment of Recent Research on Inventories," Journal of Economic Perspectives, American Economic Association, vol. 5(1), pages 73-96, Winter.
  12. Larson, Donald Frederick & DEC, 1994. "Copper and the negative price of storage," Policy Research Working Paper Series 1282, The World Bank.
  13. Gibson, Rajna & Schwartz, Eduardo S, 1990. " Stochastic Convenience Yield and the Pricing of Oil Contingent Claims," Journal of Finance, American Finance Association, vol. 45(3), pages 959-76, July.
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Cited by:
  1. Jorge Barros Luís, 2000. "The Estimation of Risk Premium Implicit in Oil Prices," Working Papers w200002, Banco de Portugal, Economics and Research Department.

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