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Title: The stochastic behaviour of crude oil futures prices and the valuation of long term oil-linked assets
Author: Lehocky, Milan
Awarding Body: University of Manchester
Current Institution: University of Manchester
Date of Award: 1998
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This study proposes a theoretically consistent approach to the valuation of long-term oil and gas linked natural resources. We develop a model for the arbitrage-free valuation of future cash-flows from oil and gas reserves, arguing that oil and gas reserves themselves can be viewed as contingent claims. Our valuation framework is based on the two-factor stochastic convenience yield model which was first presented in Gibson and Schwartz (1990 a,b ). We also compare the theoretical properties of the Brennan and Schwartz (1985) one-factor model to the two-factor stochastic model of the term structure of crude oil futures prices and their implication with respect to the valuation of oil and gas reserves. The analysis reveals strong mean reversion in the short term convenience yield process suggesting that the constant convenience yield assumption made in the Brennan and Schwartz (1985) one-factor model is unjustified. Additionally, the analysis provides evidence of a term structure of convenience yields which levels off as time to maturity increases. From a theoretical point of view we conclude that the two-factor Gibson and Schwartz (1990 a,b) model performs better in capturing the real life behaviour of crude oil futures prices. The greater flexibility of the two-factor model proves pivotal in modelling the observed term structure smiles observed on the NYMEX WTI market. However, the analysis also highlights potential shortcomings of the two-factor model with respect to the implicit assumptions made in modelling the stochastic variables, and we present findings which are in contrast to the original Gibson and Schwartz (1990 b) study. In particular, our empirical analysis of the time series behaviour of the two stochastic variables casts doubt on the appropriateness of the Brownian motion and simple mean-reversion assumption made for the spot price of oil and convenience yield respectively. Moreover, we also find evidence of time-varying stochastic parameters. Most importantly however, our analysis suggests contrary to Gibson and Schwartz (1990 a,b) that the market price of convenience yield risk is larger and tends to be positive when far out contracts are included in the term structure fits. This finding is in line with Schwartz (1997). Contrary to prior findings, our results suggest that a unit convenience yield is less rewarded in the long-run and the present value of one barrel of crude oil deliverable in ten years loses only about 50% of its value. We also provide evidence that the market price of convenience yield risk is varying both with time and time to maturity and show the average term structure of market prices of convenience yield risk. Moreover, we hypothesise that the market price of convenience yield risk might be inversely related to the level of the convenience yield. This findings might be investigated by future research. Relating alternative economic and accounting based reserve value measures to market prices showed weak evidence that the Gibson and Schwartz (1990 a,b) reserve value estimates dominate other reserve values. In line with previous research, the Rotelling reserve value estimate was found to be insignificant in regressions which contained other reserve value estimates. In general, our results suggest that on average stock market investors tend to be more risk averse than derivatives market investors. However, it should be borne in mind that the discrimination among the reserve value measures were based on ad hoc stepped up regressions using simple F-tests to determine the relative explanatory power among the reserve variables. Each reserve value estimate alone explained variation in market prices well. We also present simple trading strategies in the attempt to profit from apparent deviations of market prices and underlying net asset values. However, none of the trading strategies was successful in creating consistent profits. As the valuation results which are suggesting significant per company over- and under valuations imply that the market for oil and gas reserves is inefficient, future research should relax some of the simplifying assumptions made in the company valuation framework such as the omission of tax issues, the simple 1:6 conversion of gas into oil reserves and omission of potential option values arising from unproven reserves, and address the requirement for further compulsory disclosure of reserve and price data as outlined in the text. The variance analysis of market prices and underlying net asset values along the lines of Pontiff (1997) also suggests considerable inefficiency in the market for oil and gas firms.
Supervisor: Not available Sponsor: Not available
Qualification Name: Thesis (Ph.D.) Qualification Level: Doctoral
EThOS ID:  DOI: Not available