A novel regime-switching commodity pricing model with stochastic convenience yield

The May 2020 futures (CLK20) price of WTI crude oil went negative for the first time in history during the COVID-19 pandemic. Yuan and Kwon in 2023 proposed a novel Markov regime-switching model to incorporate the price negativity and to allow price structural switching between two categories of regimes (Normal vs Lognormal). However, the model assumes constant net convenience yield of the commodity, misrepresenting its time-varying paradigm which is more realistic and strongly supported in the literature. Thus, to fix the problem, we have proposed a new model to contain both model structural change and regime-specific stochastic convenience. An effective algorithm with Kalman filter is proposed for model parameter calibration. The average calibration accuracy of interpreting the dynamic term structure of WTI is significantly increased by the new model by more than 60%, compared to Yuan and Kwon’s model, and by more than 20%, compared to the conventional RS model established by Almansour in 2016. The stress test we conducted verifies that this new model can well capture price negativity and appropriately explain large price movements under extreme market scenarios. Furthermore, the stochastic differential equation (PDE) of futures price is derived assuming strong regime persistency, and both Monte Carlo (MC) and PDE finite difference methods are successfully applied to price European futures options under the new modelling framework. It stresses that the model can be employed in many other fields associated with interest rates, natural gas, electricity power and more.