Forecasting petroleum futures markets volatility: The role of regimes and market conditions

Abstract

In this paper we employ regime volatility models to describe time dependency in petroleum markets. Using a sample of NYMEX and ICE futures contracts, we establish the existence of a regime process and link this process to market fundamentals. This formulation results in two distinct states: a highly persistent conditional volatility process, characterised by long memory and low sensitivity to market shocks, and a relatively short-lived nonstationary process with less memory but higher sensitivity to shocks. Moreover, to investigate the relationship between disequilibrium and volatility of oil futures across high and low volatility regimes we use augmented regime GARCH models to address in a realistic way the potential diverse response of volatility to forward curve shocks. The performance of these models is compared to benchmarks, using both statistical tests and risk management loss functions. To test the robustness of the forecasting strategies, we also perform a reality check employing the stationary bootstrap approach. The findings of this paper have important implications for decision making concerning trading and risk management, as well as energy market operations, such as refining and budget planning, by providing valuable information on the oil price volatility dynamics and the ability to predict risk.