Fundamentals Versus Speculation: What Really Drives Spillovers and Informed Trading in Futures and Spot Markets of Refined Petroleum Products?

Abstract

In commodities market, the theory of storage suggests that the basis or spread varies with changes in fundamental supply and demand factors. We thus expect these fundamentals, as opposed to speculative trading, to be the primary triggers of volatility in the spot market. Because of structural and functional differences in spot and futures markets, production adjustment cost, sign and sign of the basis, we expect nonlinear price convergence mechanism and time varying volatility. We employ nonlinear and asymmetric error correction model with time-varying volatility to characterize the spot and futures price dynamics of gasoline and heating oil. We show that there is unidirectional and time-varying volatility spillover from futures to spot market since informed trading occurs in the futures markets. We find that error correction process is essentially asymmetric, non-linear, and volatility inducing. The basis account for more than 92% of total volatility suggesting that it is the fundamentals and not speculative trading that drive volatility and spillovers. Moreover, futures prices converge to equilibrium relationship when the basis is positive due to absence of production adjustment costs. We can thus make inference that conventional methodologies that disregard these convolutions in the study of time series dynamics of variables that exhibit mutual stochastic trend may be mis-specified. Our results are robust under different regimes.