Volatility, Contango, and Crude Oil Inventories: A Complex Relationship – The Changing Nature of World Oil Markets

The general theory of storage suggests that the level of inventories is a key factor in determining the basis over time. The basis is the difference between the price of oil in the futures market and the price of oil in the spot market. As an indicator of future price movements, the basis follows a different dynamic when inventories are in scarce supply or in surplus, implying that there are different market states that reflect different underlying crude oil market conditions. We apply a Markov regime switching model to analyze this complex relationship, using a spread option value of storage metric to represent market structure, which enables us to draw preliminary conclusions on how to potentially impact oil-market-price stability via precise inventory decisions.