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Backwardation in Oil Futures Markets: Theory and Empirical Evidence

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  • Robert H. Litzenberger
  • Nir Rabinowitz

Abstract

Oil futures markets frequently exhibit backwardation whereby more distant oil futures prices are below the current spot price. This is inconsistent with Hotelling’s theory that the net price of an exhaustible resource rises over time at the interest rate. We characterize an oil well as a call option and show that backwardation is necessary to induce production. Production is shown to be non-increasing in the riskiness of future prices. The empirical analysis indicates that U.S. oil production is directly related to the backwardation and inversely related to implied volatility. Backwardation is positively related to implied volatility and to the at-the-money put option price.

Suggested Citation

  • Robert H. Litzenberger & Nir Rabinowitz, "undated". "Backwardation in Oil Futures Markets: Theory and Empirical Evidence," Rodney L. White Center for Financial Research Working Papers 7-93, Wharton School Rodney L. White Center for Financial Research.
    • Handle: RePEc:fth:pennfi:7-93
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    Cited by:

    1. Sykuta, Michael E., 1996. "Futures trading and supply contracting in the oil refining industry," Journal of Corporate Finance, Elsevier, vol. 2(4), pages 317-334, July.

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