Why and When Do Spot Prices of Crude Oil Revert to Futures Price Levels?

29 Pages Posted: 5 Oct 2005

See all articles by Mark W. French

Mark W. French

Board of Governors of the Federal Reserve System - Macroeconomic Analysis Section

Date Written: August 2005

Abstract

Recent studies of crude oil price formation emphasize the role of interest rates and convenience yield (the adjusted spot-futures spread), confirming that spot prices mean-revert and normally exceed discounted futures. However, these studies don't explain why such backwardation is normal. Also, models derived in these studies typically explain only about 1 percent of daily returns, suggesting other factors are important, too. In this paper, I specify a structural oil-market model that links returns to convenience yield, inventory news, and revisions of expected production cost (growth of which is related to backwardation). Although its predictive power is only a marginal improvement, the model fits the data far better. In addition, I find reversion of spot to futures prices only when backwardation is severe. Convenience yield behaves nonlinearly, but price response to convenience yield is also nonlinear. Equivalently, futures are informative about future spot prices only when spot prices substantially exceed futures.

Keywords: Oil prices, oil futures, backwardation, convenience yield

JEL Classification: G12, Q40

Suggested Citation

French, Mark W., Why and When Do Spot Prices of Crude Oil Revert to Futures Price Levels? (August 2005). FEDS Working Paper No. 2005-30. Available at SSRN: https://ssrn.com/abstract=813227 or http://dx.doi.org/10.2139/ssrn.813227

Mark W. French (Contact Author)

Board of Governors of the Federal Reserve System - Macroeconomic Analysis Section

20th & C. St., N.W.
Mailstop 80
Washington, DC 20551
United States
202-452-3801 (Phone)
202-452-3819 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
611
Abstract Views
2,369
rank
42,859
PlumX Metrics