What Do We Learn from the Price of Crude Oil Futures?

63 Pages Posted: 5 Jun 2008

See all articles by Ron Alquist

Ron Alquist

AQR Capital Management LLC

Lutz Kilian

University of Michigan at Ann Arbor - Department of Economics; Centre for Economic Policy Research (CEPR)

Date Written: November 2007

Abstract

Based on a two-country, two-period general equilibrium model of the spot and futures markets for crude oil, we show that there is no theoretical support for the common view that oil futures prices are good predictors of the spot price in the mean-squared error sense; yet under certain conditions there is support for the view that oil futures prices are unbiased predictors. Our empirical analysis documents that futures-based forecasts are biased and typically inferior to simple and easy-to-use forecasting methods such as the no-change forecast. This does not mean that there is no useful information in oil futures prices. We demonstrate that fluctuations in the oil futures basis are larger and more persistent than fluctuations in the basis of foreign exchange futures. Within the context of our theoretical model, this anomaly can be explained by the marginal convenience yield of oil inventories. We show that increased uncertainty about future oil supply shortfalls causes the basis to decline and precautionary demand for crude oil to increase, resulting in an immediate increase in the real spot price that is not necessarily associated with an accumulation of oil inventories. Our main result is that the negative of the basis may be viewed as an index of fluctuations in the price of crude oil driven by precautionary demand for oil. Our empirical analysis of this index provides independent evidence of how shifts in market expectations about future oil supply shortfalls affect the spot price of crude oil. Such expectation shifts have been difficult to quantify, yet have been shown to play an important role in explaining oil price fluctuations. Our empirical results are consistent with related evidence in the literature obtained by alternative methodologies.

Keywords: basis, crude oil, expectations, forecasting, futures market, precautionary demand, spot market, spread

JEL Classification: C53, D51, G13, G15

Suggested Citation

Alquist, Ron and Kilian, Lutz, What Do We Learn from the Price of Crude Oil Futures? (November 2007). CEPR Discussion Paper No. DP6548. Available at SSRN: https://ssrn.com/abstract=1140075

Ron Alquist

AQR Capital Management LLC ( email )

Greenwich Plaza
Greenwich, CT NY 06830
United States

Lutz Kilian (Contact Author)

University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States
734-764-2320 (Phone)
734-764-2769 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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