Oil Futures Prices in a Production Economy with Investment Constraints





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    • Kogan is at the Sloan School of Management, Massachusetts Institute of Technology and NBER. Livdan is at the Haas School of Business, University of California, Berkeley. Yaron is at the Wharton School, University of Pennsylvania and NBER. We would like to thank two anonymous referees, Kerry Back, Darrell Duffie, Pierre Collin-Dufresne, Francis Longstaff, and Craig Pirrong for detailed comments. We also thank seminar participants at University of California, Berkeley, Northwestern University, Texas A&M University, Stanford University, the 2004 Western Finance Association meeting, the 2004 Society of Economic Dynamics meeting, and the 2004 European Econometric Society meeting for useful suggestions. We also thank Krishna Ramaswamy for providing us with the futures data and Jeffrey R. Currie and Michael Selman for discussion and materials on the oil industry. Financial support from the Rodney L. White Center for Financial Research at the Wharton School is gratefully acknowledged.


We document a new stylized fact, that the relationship between the volatility of oil futures prices and the slope of the forward curve is nonmonotone and has a V-shape. This pattern cannot be generated by standard models that emphasize storage. We develop an equilibrium model of oil production in which investment is irreversible and capacity constrained. Investment constraints affect firms' investment decisions and imply that the supply elasticity changes over time. Since demand shocks must be absorbed by changes in prices or changes in supply, time-varying supply elasticity results in time-varying volatility of futures prices. Estimating this model, we show it is quantitatively consistent with the V-shape relationship between the volatility of futures prices and the slope of the forward curve.