Exploration Activity, Long-run Decisions, and the Risk Premium in Energy Futures

Abstract

Investment by oil firms positively affects the futures basis and negatively predicts excess returns on crude oil futures. I build an equilibrium model of drilling, exploration, and storage to understand these facts. Firms’ capital stock lowers extraction costs as firms drill in increasingly expensive fields. Drilled wells produce the resource at a geometrically declining rate; however, by specifying consumers’ habit level equaling production from old wells, the futures basis and risk premium are only related to drilling, investment, and inventory. Investment leads to a more elastic drilling response by firms and dampens oil price increases from demand shocks, thus lowering the risk premium.Received October 10, 2015; editorial decision March 30, 2018 by Editor Philip Strahan. Author has furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online