On the Pricing of Storable Commodities

TL;DR

This paper develops an information-based model for pricing storable commodities, incorporating market information about future supply and demand, and derives closed-form option prices when the dividend rate follows an Ornstein-Uhlenbeck process.

Contribution

It introduces a novel information-based framework for commodity pricing that accounts for partial future supply/demand information and models dividends with an Ornstein-Uhlenbeck process.

Findings

Closed-form option pricing formulas derived

Model applicable to assets with negative cash flows

Framework incorporates market information and physical ownership benefits

Abstract

This paper introduces an information-based model for the pricing of storable commodities such as crude oil and natural gas. The model uses the concept of market information about future supply and demand as a basis for valuation. Physical ownership of a commodity is taken to provide a stream of convenience dividends equivalent to a continuous cash flow. The market filtration is assumed to be generated jointly by (i) current and past levels of the dividend rate, and (ii) partial information concerning the future of the dividend flow. The price of a commodity is the expectation under a suitable pricing measure of the totality of the discounted risk-adjusted future convenience dividend, conditional on the information provided by the market filtration. In the situation where the dividend rate is modelled by an Ornstein-Uhlenbeck process, the prices of options on commodities can be derived in closed form. The approach that we present can be applied to other assets that yield potentially negative effective cash flows, such as real estate, factories, refineries, mines, and power generating plants.