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Equilibrium Commodity Prices with Irreversible Investment and Non-Linear Technology

Author

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  • Jaime Casassus
  • Pierre Collin-Dufresne
  • Bryan R. Routledge

Abstract

We model equilibrium spot and futures oil prices in a general equilibrium production economy. In our model production of the consumption good requires two inputs: the consumption good and a commodity, e.g., Oil. Oil is produced by wells whose flow rate is costly to adjust. Investment in new Oil wells is costly and irreversible. As a result in equilibrium, investment in Oil wells is infrequent and lumpy. Even though the state of the economy is fully described by a one-factor Markov process, the spot oil price is not Markov (in itself). Rather it is best described as a regime-switching process, the regime being an investment `proximity' indicator. The resulting equilibrium oil price exhibits mean-reversion and heteroscedasticity. Further, the risk premium for exposure to commodity risk is time-varying, positive in the far-from-investment regime but negative in the near-investment regime. Further, our model captures many of the stylized facts of oil futures prices, such as backwardation and the `Samuelson effect.' The futures curve exhibits backwardation as a result of a convenience yield, which arises endogenously. We estimate our model using the Simulated Method of Moments with economic aggregate data and crude oil futures prices. The model successfully captures the first two moments of the futures curves, the average non-durable consumption-output ratio, the average oil consumption-output and the average real interest rate. The estimation results suggest the presence of convex adjustment costs for the investment in new oil wells. We also propose and test a linear approximation of the equilibrium regime-shifting dynamics implied by our model, and test its empirical implication for time-varying risk-premia.

Suggested Citation

  • Jaime Casassus & Pierre Collin-Dufresne & Bryan R. Routledge, 2005. "Equilibrium Commodity Prices with Irreversible Investment and Non-Linear Technology," NBER Working Papers 11864, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:11864
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    Cited by:

    1. Almansour, Abdullah, 2016. "Convenience yield in commodity price modeling: A regime switching approach," Energy Economics, Elsevier, vol. 53(C), pages 238-247.
    2. repec:eee:moneco:v:94:y:2018:i:c:p:1-26 is not listed on IDEAS
    3. Boyarchenko Svetlana & Levendorskii Sergei Z, 2006. "General Option Exercise Rules, with Applications to Embedded Options and Monopolistic Expansion," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 6(1), pages 1-51, June.
    4. Ejarque, João Miguel, 2008. "Evaluating the Economic Cost of Strategic Storage of Natural Gas," Economics Discussion Papers 8922, University of Essex, Department of Economics.
    5. Branger, Nicole & Grüning, Patrick & Schlag, Christian, 2016. "Commodities, financialization, and heterogeneous agents," SAFE Working Paper Series 131 [rev.], Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    6. Lyudmyla Hvozdyk & Valerie Mercer-Blackman, 2010. "What Determines Investment in the Oil Sector?: A New Era for National and International Oil Companies," IDB Publications (Working Papers) 2659, Inter-American Development Bank.
    7. Boyarchenko, Svetlana & Levendorskii, Sergei, 2008. "Exit problems in regime-switching models," Journal of Mathematical Economics, Elsevier, vol. 44(2), pages 180-206, January.
    8. Evans, Lewis & Guthrie, Graeme, 2007. "Commodity Price Behavior With Storage Frictions," Working Paper Series 3966, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    9. Jaime Casassus & Peng Liu & Ke Tang, 2011. "Relative Scarcity of Commodities with a Long-Term Economic Relationship and the Correlation of Futures Returns," Documentos de Trabajo 404, Instituto de Economia. Pontificia Universidad Católica de Chile..
    10. Casassus, Jaime & Ceballos, Diego & Higuera, Freddy, 2010. "Correlation structure between inflation and oil futures returns: An equilibrium approach," Resources Policy, Elsevier, vol. 35(4), pages 301-310, December.
    11. Lyudmyla Hvozdyk & Valerie Mercer-Blackman, 2010. "What Determines Investment in the Oil Sector?: A New Era for National and International Oil Companies," IDB Publications (Working Papers) 9393, Inter-American Development Bank.

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    JEL classification:

    • C0 - Mathematical and Quantitative Methods - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies

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