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Equilibrium Commodity Prices with Irreversible Investment and Non-Linear Technologies

50 Pages Posted: 20 Mar 2005 Last revised: 1 Jul 2011

Jaime Casassus

Pontificia Universidad Catolica de Chile

Pierre Collin-Dufresne

Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne; National Bureau of Economic Research (NBER)

Bryan Routledge

Carnegie Mellon University - David A. Tepper School of Business

Date Written: March 25, 2009

Abstract

We model oil price dynamics in a general equilibrium production economy with two goods: a consumption good and oil. Production of the consumption good requires drawing from oil reserves. Investment necessary to replenish oil reserves is costly and irreversible. We solve for the optimal consumption, production and oil reserves policy for a representative agent. We analyze the equilibrium price of oil, as well as the term structure of oil futures prices. Because investment in oil reserves is irreversible and costly, the optimal investment in new oil reserves is periodic and lumpy. Investment occurs when the crude oil is relatively scarce in the economy. This generates an equilibrium oil price process that has distinct behavior across two regions (characterized by the abundance/scarcity of oil). We undertake three empirical tests suggested by our model. First, we estimate key parameters using SMM to match moments of oil price futures as well as other macro-economic properties of the data. Second, we estimate an affine regime switching model of the oil price, which captures the main features of our equilibrium model and preserves the tractability of reduced-form models. Lastly, we compare the risk premium in oil futures implied by our model to the data.

Keywords: Commodity prices, Futures prices, Convenience yield, Scarcity, Investment, Irreversibility, General equilibrium, Simulated Method of Moments (SMM), Regime-switching model, risk premium

JEL Classification: C0, G12, G13, D51, D81, E2

Suggested Citation

Casassus, Jaime and Collin-Dufresne, Pierre and Routledge, Bryan, Equilibrium Commodity Prices with Irreversible Investment and Non-Linear Technologies (March 25, 2009). Available at SSRN: https://ssrn.com/abstract=686542 or http://dx.doi.org/10.2139/ssrn.686542

Jaime Casassus (Contact Author)

Pontificia Universidad Catolica de Chile ( email )

Av. Vicuna Mackenna 4860
Instituto de Economia
Santiago
Chile
(56-2) 2354 4319 (Phone)

HOME PAGE: http://economia.uc.cl/profesor/jaime-casassus/

Pierre Collin-Dufresne

Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne ( email )

Quartier UNIL-Dorigny, Bâtiment Extranef, # 211
40, Bd du Pont-d'Arve
CH-1015 Lausanne, CH-6900
Switzerland

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Bryan R. Routledge

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
(412) 268-7588 (Phone)
(412) 268-7064 (Fax)

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