An equilibrium model for spot and forward prices of commodities

TL;DR

This paper develops an equilibrium model for commodity spot and forward prices considering interactions between producers and financial investors, explaining how market participation and correlations influence prices.

Contribution

It introduces a new equilibrium framework incorporating both producers and investors, with semi-explicit solutions and analysis of parameter effects on prices.

Findings

Increased investor participation can raise spot prices.

Higher correlation between commodity and stock markets can lower forward premia.

The model provides insights into price dynamics based on market structure.

Abstract

We consider a market model that consists of financial investors and producers of a commodity. Producers optionally store some production for future sale and go short on forward contracts to hedge the uncertainty of the future commodity price. Financial investors take positions in these contracts in order to diversify their portfolios. The spot and forward equilibrium commodity prices are endogenously derived as the outcome of the interaction between producers and investors. Assuming that both are utility maximizers, we first prove the existence of an equilibrium in an abstract setting. Then, in a framework where the consumers' demand and the exogenously priced financial market are correlated, we provide semi-explicit expressions for the equilibrium prices and analyze their dependence on the model parameters. The model can explain why increased investors' participation in forward commodity markets and higher correlation between the commodity and the stock market could result in higher spot prices and lower forward premia.