Permanent and Transitory Demand Shocks and the Term Structure of Oil Futures Prices

Abstract

Based on the existent possible explanations of oil futures term structure, this study provides a more fundamental view, which has a theoretical support from the theory of storage and well-suited intuitions in correspondence with reality. By using structural econometrical models, it divides oil net demand into two components: one is contributed by permanent shocks and the other is contributed by transitory shocks, and finds that only transitory component in oil net demand has a significant and robust impact on the term structure of oil futures prices. Positive transitory shocks push oil futures curve from contango to backwardation and negative transitory shocks pull oil futures curve back to contango from backwardation. This study also applies the analysis framework to OECD and Non OECD countries, respectively, to address the rising importance of emerging markets in the dynamics of world oil prices and futures term structure. Finally, this study also tests rich implications for investing, hedging and arbitraging on oil futures from several practical perspectives.