Pricing and Hedging Oil Futures: A Two-Regime Approach

Abstract

We develop and empirically test a continuous-time equilibrium model for the pricing of oil futures. Our model provides a link between no-arbitrage and expectations-oriented models, and highlights the role of inventories in identifying different pricing regimes. We compare the hedging performance of our model with five other one- and two-factor pricing models. Our hedging problem relates to Metallgesellschaft's strategy to hedge long-term forward commitments with short-term futures. In the base case, the downside risk distribution of our inventory-based model stochastically dominates those of the other models. We test the stability of our results by varying the empirical design.