Business cycle, storage, and energy prices

• Date: 01 November 2014
• Published date: 01 November 2014
• DOI: http://doi.org/10.1016/j.rfe.2014.09.001

Business cycle, storage, and energy prices

Oleg Kucher

a,

⁎, Alexander Kurov

b

a

Departmentof Economics, FrostburgState University, GuildCenter, 101 Braddock Rd, Frostburg,MD 21532-2303,United States

b

Departmentof Finance, West VirginiaUniversity, Morgantown,WV, United States

abstractarticle info

Articlehistory:

Received2 November 2013

Receivedin revised form 28 August 2014

Accepted1 September 2014

Availableonline 7 September 2014

Keywords:

Energyprices

Inventory

Businesscycle

Thisstudy examines the effectof the state of the economy andinventory on interest-adjustedbases andexpected

returnsfor five energy commodities.We find that interest-adjustedbases and returns have a businesscycle pat-

tern.Consistent with the theoryof storage, demand shocks nearbusiness cycle peaks generatenegative interest-

adjustedbases and positive returns.In recessions, the bases becomepositive, and the averagereturns are nega-

tive.Our regression resultsalso show that the interest-adjustedbases of energy commoditiesare counter-cyclical

and the expected returns are pro-cyclica l. For petroleum commodities, inventory has a significant effect on

interest-adjusted bases at low levels of inventory, whereasat high inventory levels the effect of inventory on

the bases is weak. Finally,we find that the bases and economic conditionspredict spot returns in energy com-

modity markets.

© 2014 ElsevierInc. All rights reserved.

1. Introduction

This studyexamines the variationof spot and futures pricesof ener-

gy commoditiesover the business cycle.According to the modern view

of the theoryof storage (Fama & French,1987, 1988), when commodity

inventoryis low and the marginal benefitof holding inventory(known

as convenienceyield) is high, the basis tendsto be negative, i.e. the fu-

tures price is below the spot price. This market condition is known as

backwardation.

1

In contrast,when inventory risesand the convenience

yieldfalls, the basis tendsto be positive, i.e.the futures priceis above the

spot price.This condition is called contango.

2

Understanding the relationbetween spot andfutures prices of ener-

gy commoditiesis crucialto economic agents in energymarkets. For ex-

ample, if the crude oil market is in backwardation, oil companies are

likely to increase production (Litzen berger & Rabinowitz, 1995). A

shift to contango increases the benefits of holding inventory.Further-

more, when crude oil market is in backwardation,commodity futures

investors and speculators with lo ng futures positions earn positiv e

returns from rolling over their po sitions. Erb and Harvey (2006a )

show that this so-called “roll return”is a crucial determinant of com-

modity futures returns. The roll returnbecomes negative when prices

exhibit contango. Erb and Harvey (2006b) find that most of the time

series variation in commodity futures returnsis driven by spot return

variation.Energy futurescarry large weightsin most commodityfutures

indices.

3

Therefore, it is important to understandwhat determines the

basis and expected spot returnsof energy commodities.

We examine the effect of the state of the econ omy on interest-

adjusted basis(the basis net of the interest rate)and expected returns

for energy commodities,also incorporating determinantspredicted by

the theory of storage. Several stu dies examine the link between the

basis, returns, and business conditions. Fama and French (1988) find

negative interest-adjusted ba ses for metals around business cycle

peaks, suggesting that metal prices are aff ected by general business

conditions. Bailey and Chan (1993) provideevidence that commodity

bases reflect the macroeconomic ri sks premiums. Gorton, Hayashi,

and Rouwenhorst (2013)find that commodity basesare affected by in-

ventory levels. Hong and Yogo (2012) find that open interest in com-

modity futures predictscommodity returns. They use open interest as

a proxy for economic activity. Gargano and Timmermann (2014) find

that macroeconomic variables, including inflation, producti on, and

money supply growthpredict commodity price movements during re-

cessions. Gospodinov and Ng (2013) argue that commodit y conve-

nience yield reflects future economic conditions and find a significant

relation between convenience yields an d commodity price changes.

Our analysis is differentfrom the previous research in that we directly

examinethe energy bases and short-termexpected spot returnsin rela-

tion to four measures of the stateof the economy.

Our paper makes several contributions to the liter ature. First, we

find that the state of the economy has a significant effect on interest-

Reviewof Financial Economics 23 (2014)217–226

⁎Correspondingauthor. Tel.:+ 1 301 6874418.

E-mailaddress: okucher@frostbur g.edu (O. Kucher).

1

Backwardationis consistent with the theory of normal backwardation,which states

thatfutures price of a commodityshould be belowthe expected spot priceby “the amo unt

of normalbackwardation”(Keynes,1930).

2

Contango in energy commod ities market is also consis tent with the theory of

Hotelling(1931), which states that thenet price of exhaustible resourcesrises over time

at the rateof interest under certainty.

3

For example, the total weight of energy commodities in the popular S&P Goldman

SachsCommodity Index is about 79%.

http://dx.doi.org/10.1016/j.rfe.2014.09.001

1058-3300/©2014 Elsevier Inc. All rightsreserved.

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Review of Financial Economics

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