Long-Term Economic Relationships andCorrelation Structure in Commodity Markets

This paper finds that the long-term co-movement among commodities is driven by economic relations, such as, production, substitution or complementary relationships. These economic linkages imply that expected commodity prices, which are determined by convenience yields and risk premia among other factors, tend to move with each other. This source of co-movement is not captured by traditional commodity pricing models. We build a model where the convenience yield of a certain commodity is determined, among other things, by the prices of related commodities. We test this prediction in a multi-commodity model that disentangles a short-term source of co-movement from the long-term component allowing for a flexible correlation structure. We estimate the model using three commodity pairs: heating oil-crude oil, WTI-Brent crude oil and heating oil-gasoline. We find that long-term relations are pervasive and significant, both, statistically and economically. The correlation structure implied from our model matches the upward sloping patterns observed in the data. The long-term economic relationship considerably reduces the long-term volatility of the spread between commodities which implies lower spread option prices. An out-of-sample test using short-maturity crack spread options data shows that our model considerably reduces the negative bias generated by traditional models.