The effects of futures markets on oil spot price volatility in regional US markets

Abstract

Given the importance of petroleum for functioning of the overall US economy, it is important to understand better to what degree futures markets stabilize or destabilize spot oil prices in both short and long run. The objective of the paper is to empirically test and determine if the impact of futures markets on spot price volatility of oil in the US is either stabilizing or destabilizing. Underlying theory implies that futures price stabilizing or destabilizing impact on oil prices in the US is dependent on the source of disturbance in oil market: consumption, production or inventory holding. A sequence of methodologies used to test this theory is novel in this context. It consists of the use of directed acyclic graphs and Granger causality to determine the direction of causality and endogeneity among futures and spot prices, and ending stocks, and then formulating proper vector autoregression model and in turn resulting impulse responses and variance decomposition to test for the volatility of spot prices due to shocks to futures markets. Empirical analysis results indicate that regional oil spot prices are destabilized initially, while they are stabilized in the long run following a shock to futures oil price. Our results support the theory suggesting largely stabilizing role of oil futures markets on oil spot prices which is consistent with the prevailing role of demand side shocks in futures markets, while smaller yet significant destabilizing impact of futures markets on regional oil spot prices is consistent with supply side shocks.