Backwardation in Oil Futures Markets: Theory and Empirical Evidence
Robert H. Litzenberger
University of Pennsylvania - Finance Department
affiliation not provided to SSRN
JOURNAL OF FINANCE, Vol. 50 No. 5, December 1995
Oil futures prices are often below spot prices. This phenomenon, known as strong backwardation, is inconsistent with Hotelling's theory under certainty that the net price of an exhaustible resource rises over time at the rate of interest. We introduce uncertainty and characterize oil wells as call options. We show that (1) production occurs only if discounted futures are below spot prices, (2) production is non-increasing in the riskiness of future prices, and (3) strong backwardation emerges if the riskiness of future prices is sufficiently high. The empirical analysis indicates that U.S. oil production is inversely related and backwardation is directly related to implied volatility.
JEL Classification: G13
Date posted: August 22, 1998