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Equilibrium Commodity Prices with Irreversible Investment and Non-Linear Technology

Author

Listed:
  • Jaime Cacassus
  • Pierre Collin-Dufresne

Abstract

We model the properties of equilibrium spot and futures oil prices in a general equilibrium production economy with two goods. In our model production of the consumption good requires two inputs: the consumption good and a 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. Equilibrium spot price behavior is determined as the shadow value of oil. The resulting equilibrium oil price exhibits mean-reversion and heteroscedasticity. Further, 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. Further, our model captures many of the stylized facts of oil futures prices. The futures curve exhibits backwardation as a result of a convenience yield, which arises endogenously due to the productive value of oil as an input for production. This convenience yield is decreasing in the amount of oil available in the economy. We test out model using crude oil data from 1982 to 2003. We estimate a linear approximation of the equilibrium regime-shifting dynamics implied by our model. Our empirical specification successfully captures spot and futures data. Finally, the specific empirical implementation we use is designed to easily facilitate commodity derivative pricing that is common in two-factor reduced form pricing models.

Suggested Citation

  • Jaime Cacassus & Pierre Collin-Dufresne, 2004. "Equilibrium Commodity Prices with Irreversible Investment and Non-Linear Technology," 2004 Meeting Papers 863, Society for Economic Dynamics.
  • Handle: RePEc:red:sed004:863
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    Keywords

    Finance;

    JEL classification:

    • G0 - Financial Economics - - General

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