Commodity Forward Curves Models and Data Pirrong Geneva Slides 2

Intertemporal Allocation Basics • Want to carry goods from where they are abundant to where they are scarce but . . . • With intertemporal allocation, can only move in one direction: from the present to the future • Can’t move in the other direction: from the future to the present (though that would be nice) • This constraint is essential in understanding forward curves Scenario 1 • Supplies of the commodity are currently abundant because demand is low • Substantial excess capacity • Already have a lot of inventory • Demand is expected to rebound, so commodity is abundant today relative to what we expect in the future • Under these circumstances, optimal to store commodity for future use Forward Curves in Scenario 1 • Forward curve should adjust to provide an incentive to store • Futures prices at or near full carry provides this incentive Examples • Financial Crisis: Immediate and large transient decline in demand • Supply increase and demand decline in 2014-2015 oil market • COVID crisis Scenario 2 • Current supplies very tight • Inventories low, and operating at nearly full capacity • Commodity scarce today relative to what is expected in the future • Would like to bring stuff from the future to today, but can’t • The best we can do is NOT to store • May want to consume all inventories Forward Curves in Scenario 2 • Want to punish storage • If spot price is above forward price net of carrying costs, anticipate losing money by storing: certainly lose money if you hedge inventory • Therefore, backwardation in time of scarcity gives the right price signals Examples • Polar vortex: Immediate short term demand shock • Mine closure (e.g., Escondido Mine in Chile): Immediate short term supply shock • Major refinery outage: Immediate short term supply shock Future Shock • Most shocks are to current supply and demand, but there can be shocks to anticipated future S&D • These lead to different inventory, price and forward curve movements • These are often considered to be anomalous Shock to Expected Future Supply • Future supply expected to decline (e.g., OPEC considering extending output cuts beyond April, 2017) • Desirable to store more today to mitigate future supply loss: inventories rise • Spot price rises to reduce current consumption necessary to increase storage • Futures rises relative to spot to encourage more storage Shock to Expected Future Demand • Increase in expected future demand (e.g., Energy Policy Act of 2005 which mandated increased biofuel consumption in 2006 and beyond) • Store more today to meet anticipated future demand increase • Supply fixed in short run, so spot price must rise to reduce consumption to allow more storage • Futures rise relative to spot to reward storage Implication • Markets should be in full carry when inventory is very high • Markets should be in backwardation when inventory is low • “Supply of Storage Curve” Supply of Storage Curve (Lead) LME Lead Supply of Storage Curve 50 0 0 50000 100000 150000 200000 -50 Spot-3 Month Spread -100 -150 -200 -250 -300 -350 -400 Stocks 250000 300000 350000 400000 A Refinement • Market may be in full carry for very short-dated deliveries, but below full carry for more distant dates • EG, LME metals: one day prices may be at carry, cash-3 month spread at less than full carry • This occurs when there are positive inventories, but there is some possibility of a stockout in the period prior to the expiry of the forward in question • Departure from full carry/amount of backwardation depends on likelihood of stockout over period prior to expiry: higher the likelihood, bigger departure from full carry • In a competitive market, backwardation between spot and 1 day forward occurs only during a stockout