Market Structure, Inventories and Oil Prices: An Empirical Analysis Jennifer I. Considine and Philipp Galkin and Abdullah Aldayel January 2020 Doi: 10.30573/KS--2020-DP02 Market Structure, Inventories and Oil Prices: An Empirical Analysis 1 About KAPSARC The King Abdullah Petroleum Studies and Research Center (KAPSARC) is a non-profit global institution dedicated to independent research into energy economics, policy, technology and the environment across all types of energy. KAPSARC’s mandate is to advance the understanding of energy challenges and opportunities facing the world today and tomorrow, through unbiased, independent, and high-caliber research for the benefit of society. KAPSARC is located in Riyadh, Saudi Arabia. This publication is also available in Arabic. Legal Notice © Copyright 2020 King Abdullah Petroleum Studies and Research Center (“KAPSARC”). This Document (and any information, data or materials contained therein) (the “Document”) shall not be used without the proper attribution to KAPSARC. The Document shall not be reproduced, in whole or in part, without the written permission of KAPSARC. KAPSARC makes no warranty, representation or undertaking whether expressed or implied, nor does it assume any legal liability, whether direct or indirect, or responsibility for the accuracy, completeness, or usefulness of any information that is contained in the Document. Nothing in the Document constitutes or shall be implied to constitute advice, recommendation or option. The views and opinions expressed in this publication are those of the authors and do not necessarily reflect the official views or position of KAPSARC. Market Structure, Inventories and Oil Prices: An Empirical Analysis 2 Market Structure, Inventories and Oil Prices: An Empirical Analysis Key PointsJennifer I. Considine and Philipp Galkin Key points According to conventional storage theory, the difference between spot and futures prices (known ccording to conventionalas the storage ‘basis theory,’) can the be difference explained between by the spot total and cost futures of pricesstoring (known a commodity as for a specific period of the ‘basis’) can be explained by the total cost of storing a commodity for a specific period of time. time. This ‘cost’ is knows as cost of carry and includes storage expenses, foregone interest on This ‘cost’ is known as cost of carry and includes storage expenses, foregone interest on capital, capital, and the marginal convenience yield, which measures the benefits of owning a physical Aand the marginal convenience yield, which measures the benefits of owning a physical asset. The theory predicts a positive relationshipasset between. The inventory theory predicts levels and a the positive basis, andrelationship a negative correlationbetween inventorybetween levels and the basis, and a inventories and marginal conveniencenegative yield.correlation between inventories and marginal convenience yield. This study investigates whether• thereThis is study a defined investigates and quantifiable whether relationship there is abetween defined inventory and quantifiable relationship between levels and market structure—definedinventory for the levelspurpose and of this market research structure as the basis—defined or the correspondingfor the purpose of this research as the basis degree of contango/backwardation—andor the correspondingwhat the exact nature degree of that of relationshipcontango/backwardation might be. —and what the exact nature of that relationship might be. The analysis indicates that basic• Thepredictions analysis of inventory indicates theory that are basic valid predictions for daily and weeklyof inventory theory are valid for daily and frequencies but become less reliableweekly for lower frequencies frequency butdata. become less reliable for lower frequency data. • We propose an alternative: a spread We option-based propose an formulation alternative that: a adds spread a locational option -dimensionbased formulation to the that adds a locational theory and is based on the pricesdimension of crude oil atto two the different theory locations, and is based factoring on inthe costs prices of storage of crude and oil at two different locations, transportation, and the time requiredfactoring to transport in costs oil between of storage them. and transportation, and the time required to transport oil between them. This methodology offers a viable• Talternativehis methodology to the traditional offers cost a viableof carry alternative approach; it canto the also traditional cost of carry approach; it can estimate implied convenience yieldsalso and estimate the shadow implied price ofconvenience inventories, aiding yields commodity and the tradingshadow price of inventories, aiding strategies. commodity trading strategies. The three key drivers of inventories—theThe three key cost driversof carry, ofconvenience inventories yield— andthe spreadcost of option carry, value—are convenience yield and spread option estimated for eight primary internationalvalue—are storage estimated hubs locatedfor eight at major primary seaports international using daily storagedata from hubs located at major seaports using December 21, 2015 to Januarydaily 25, data2019. from December 21, 2015 to January 25, 2019. Snapshot of the major drivers ofSnapshot inventories of on theJanuary major 25, 2019.drivers of inventories on January 25, 2019. Source: KAPSARC internal calculations.Source: KAPSARC internal calculations. Market Structure, Inventories and Oil Prices: An Empirical Analysis Market Structure, Inventories and Oil Prices: An Empirical Analysis 3 Summary Summary nderstanding the relationship between crude a negative one between inventories and marginal oil prices and inventory levels is critical for convenience yield, as are often exhibited in policymakers and economic actors. The commodity markets. Usize of the ‘basis,’ or spread between spot and futures prices, reflects the level of inventories and This study investigates whether there is a can trigger arbitrage trading. The basis also reflects defined and quantifiable relationship between broader underlying market conditions and can be inventory levels and market structure—defined useful to policymakers such as the International for the purpose of this research as the basis Energy Agency and OPEC attempting to monitor and corresponding degree of contango/ and stabilize world oil markets. backwardation—and what the exact nature of that relationship might be. The basic economics of storage and the relationship between the basis and inventories have been The paper makes two contributions to existing addressed by two popular theories. The first, risk literature. The first is the analysis of daily data on premium theory, explains the difference between crude oil inventory levels collected from real-time spot and futures prices in terms of two values: a satellite imagery, facilitating a detailed examination risk premium and a forecast of future spot prices. of world oil markets. The second is the application The former encapsulates all systematic ‘risk’ of a spread option-based approach to model the factors that affect futures prices, such as political behavior of commodity price responses to changes instability and natural disasters; the latter reflects in inventory levels. expectations of future spot prices. The results show that the basic theories of The second, conventional storage theory, suggests inventory hold for daily and weekly frequencies but that the basis can be explained by simply adding become less reliable for lower frequency data. up the total costs of holding a physical commodity for a given time period. This includes foregone We show that a locational spread option-based interest on capital, marginal storage cost and approach offers a viable alternative to the marginal convenience yield. The latter reflects the prevailing methodology; it can also be used to convenience of owning the physical commodity estimate implied convenience yields and shadow to meet contractual obligations or to mitigate the prices of storage. This is because the spread adverse effects of supply shocks; it is not directly option-based approach incorporates all information observable. found in the futures curves for all major competing crudes, thereby accounting for the implied volatility The risk premium theory of storage is the subject of of prices across the spectrum of relevant futures considerable controversy. There is no consensus curves. on the ability of futures prices to forecast future spot prices, or whether the risk premium exists in Finally, we calculate three variables that are the any meaningful way. The principles of conventional primary drivers of global crude inventories—the storage theory, on the other hand, are widely cost of carry, convenience yield and spread option accepted. The model reliably predicts a positive value—for key storage locations, providing a relationship between inventories and the basis, and snapshot of global oil inventories at any point in Market Structure, Inventories and Oil Prices: An Empirical Analysis 4 Summary time from December 21, 2015 to January 25, 2019. (United States), Ningbo (China), Rotterdam Specifically, we estimate the three variables for (Netherlands), Saldanha Bay (South Africa), eight primary international storage hubs located Singapore and Ulsan (South Korea). The result will at major seaports: Fujairah (United Arab Emirates), be available on the KAPSARC website, and the Jamnagar (India), Kagoshima (Japan), Louisiana underlying