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Spotlight on Economics: The Effects of Futures Markets on Oil Spot Price Volatility in Regional U.S. Markets

Petroleum is the most important source of energy consumption in the U.S.

By Dragan Miljkovic, Professor

NDSU Agribusiness and Applied Economics Department

Petroleum historically has been and remains the most important source of primary energy consumption in the U.S.

Given this importance of petroleum for functioning of the overall U.S. economy, we must understand better to what degree futures markets stabilize or destabilize spot oil prices in the short and long run. Considering regional diversity of U.S. petroleum markets and the economy overall, regional analysis of this relationship between oil futures and spot prices in the U.S. is warranted.

I and my former graduate student Cole Goetz addressed this important issue in a paper recently published in Applied Energy, the world’s single most influential academic journal in the area of energy studies. Here, in nontechnical terms, are our findings and implications of our research.

We developed an economic model of the relationship between futures and spot prices for storable commodities that accounts for consumption, production, storage and pure speculation in commodity marketing, as well as for different price risk attitudes among decision makers. Key takeaways from that model are:

  • If the consumption disturbance is dominant, the presence of a futures market stabilizes the volatility of spot prices in the short and long term, no matter the risk attitudes of speculators.
  • When production is the dominant disturbance, we see that spot price is destabilized in the short run but may or may not be stabilized in the long run.
  • Finally, we can see that when the inventory demand disturbance is the main randomly determined factor, futures markets tend to destabilize spot price at time horizons and speculative risk attitudes. Therefore, we cannot make any blanket statements regarding the price stabilizing/destabilizing nature of futures markets.

The empirical analysis findings of this research are that regional oil spot prices are destabilized initially, while they are stabilized in the long run following a shock to the futures oil price. Our empirical findings seem to be consistent with widely held beliefs about the nature of disturbances in energy/petroleum markets in general, as well as in the period under consideration.

Our analysis of regional U.S. markets confirms the main role of the demand side factors such as prevailing shocks in global and national U.S. oil markets. However, advancements in the oil industry via enhanced fracking technologies enabled the U.S. to achieve self-sufficiency in oil production and, in turn, consumption for the first time in modern history.

That increase in domestic oil production was an obvious supply side shock. Hence, the largely stabilizing role of oil futures markets on oil spot prices is consistent with the prevailing role of the demand side shocks in futures markets, while the smaller yet significant destabilizing impact of futures markets on regional oil spot prices is consistent with supply side shocks.

Empirical results may suggest phenomena are at play in regional U.S. oil markets that the current state of theory cannot fully explain. While these results are interesting and allow for some logical interpretation and explanation, they also should serve as a prompt that more work must be done in this field to determine with more confidence the nature of the relationship between speculation and volatility of oil spot prices in the U.S. The U.S.’s firm commitment to oil and natural gas, often as a byproduct of oil production, only reiterates the need for continued research in this area.

NDSU Agriculture Communication - Sept. 2, 2020

Source:Dragan Miljkovic, 701-231-9519, dragan.miljkovic@ndsu.edu
Editor:Ellen Crawford, 701-231-5391, ellen.crawford@ndsu.edu
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