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Exploration Activity, Long-run Decisions, and the Risk Premium in Energy Futures

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  • Alexander David

Abstract

Investment by oil firms positively affects the futures basis and negatively predicts excess returns on crude oil futures. I build an equilibrium model of drilling, exploration, and storage to understand these facts. Firms’ capital stock lowers extraction costs as firms drill in increasingly expensive fields. Drilled wells produce the resource at a geometrically declining rate; however, by specifying consumers’ habit level equaling production from old wells, the futures basis and risk premium are only related to drilling, investment, and inventory. Investment leads to a more elastic drilling response by firms and dampens oil price increases from demand shocks, thus lowering the risk premium.Received October 10, 2015; editorial decision March 30, 2018 by Editor Philip Strahan. Author has furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online

Suggested Citation

  • Alexander David, 2019. "Exploration Activity, Long-run Decisions, and the Risk Premium in Energy Futures," The Review of Financial Studies, Society for Financial Studies, vol. 32(4), pages 1536-1572.
    • Handle: RePEc:oup:rfinst:v:32:y:2019:i:4:p:1536-1572.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhy067
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    Cited by:

    1. Gao, Lin & Hitzemann, Steffen & Shaliastovich, Ivan & Xu, Lai, 2022. "Oil volatility risk," Journal of Financial Economics, Elsevier, vol. 144(2), pages 456-491.
    2. Chan, Ying Tung & Qiao, Hui, 2023. "Volatility spillover between oil and stock prices: Structural connectedness based on a multi-sector DSGE model approach with Bayesian estimation," International Review of Economics & Finance, Elsevier, vol. 87(C), pages 265-286.
    3. Su, Kuangxi & Yao, Yinhong & Zheng, Chengli & Xie, Wenzhao, 2023. "A novel hybrid strategy for crude oil future hedging based on the combination of three minimum-CVaR models," International Review of Economics & Finance, Elsevier, vol. 83(C), pages 35-50.
    4. Chen, Lin & Wen, Fenghua & Zhang, Yun & Miao, Xiao, 2023. "Oil supply expectations and corporate social responsibility," International Review of Financial Analysis, Elsevier, vol. 87(C).
    5. Wang, Qiao & Balvers, Ronald, 2021. "Determinants and predictability of commodity producer returns," Journal of Banking & Finance, Elsevier, vol. 133(C).

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