Backwardation in Oil Futures Markets: Theory and Empirical Evidence




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    • The Wharton School, University of Pennsylvania. We would like to thank Bruce Grundy for helpful discussions. We also acknowledge the comments of Erik Andersen, Sandy Grossman, Shmuel Kandel, Rich Kihlstrom, Srini Rangan, Rob Stambaugh, René Stulz (the editor) and an anonymous referee. We thank the seminar participants at the Wharton School, Tel-Aviv University, the 1993 WFA meetings and the 1994 AFA meetings for helpful comments.


Oil futures prices are often below spot prices. This phenomenon, known as strong backwardation, is inconsistent with Hotelling's theory under certainty that the net price of an exhaustible resource rises over time at the rate of interest. We introduce uncertainty and characterize oil wells as call options. We show that (1) production occurs only if discounted futures are below spot prices, (2) production is non-increasing in the riskiness of future prices, and (3) strong backwardation emerges if the riskiness of future prices is sufficiently high. The empirical analysis indicates that U.S. oil production is inversely related and backwardation is directly related to implied volatility.